Tuesday's announcement, which was designed to force the Greek opposition to back the fiscal cuts, sent Europe's stocks, currency and bonds tumbling. It came less than a week after leaders worked through the night in Brussels to establish a new plan to help Greece pay its bills, ring-fence Italy and recapitalise banks.
Until the ballot, an already delayed aid instalment of €8 billion ($14 billion) will remain on hold, Merkel and Sarkozy said.
Papandreou, summoned to Cannes with his hold on power weakening at home and subject to a confidence vote tomorrow, defended his decision.
Greece "needs a wider consensus" for the bailout demands and will choose to stay in the euro, he said.
The Greek premier declined to say how the referendum will be worded, saying it "is not the moment" to give the exact language, only that "the question is not just about a programme, but do we want to be in the eurozone."
EU treaties make no provision for a country to exit the currency, and the European Central Bank's legal department said in December 2009 that an expulsion "would be so challenging, conceptually, legally and practically, that its likelihood is close to zero."
A decade since Greece fudged fiscal data to win entry to the euro and two years after it triggered the crisis by revising its budget numbers, successive rounds of tax increases and cuts to wages and pensions have deepened a recession now in its fourth year.
The economy will contract 5.5 per cent this year and 2.5 per cent next, according to its 2012 budget. Unemployment reached 16.5 per cent in July.
"The reality is the eurozone is telling Greece look, either you're in or you're out," said Jacob Funk Kirkegaard, an economist at the Peterson Institute for International Economics in Washington. "Beggars can't be choosers and you're going to have to make a decision."
While leaving the euro would allow Greece to regain control of exchange and interest rates, economists said its new currency would drop 60 per cent, and local borrowing costs would jump at least 7 percentage points, imperilling the balance sheets of banks and companies. Departure from the European Union would cause trade to fall by half even with devaluation. The cost would be as much as €11,500 a person in the first year outside the euro and €4000 in following years.
Merkel and Sarkozy also pledged to step up work to prevent Greece's travails, now exacerbated by a month-long political campaign, from spilling over to the rest of the 17-country euro area.
Finance ministers will accelerate plans to boost the firepower of the €440 billion rescue fund, they said. On October 27 euro leaders agreed to use leverage to get the fund's clout up to €1 trillion and told banks to raise €106 billion by the end of June to fortify their capital.
- Bloomberg
