Global financial markets were roiled overnight as Greece’s political situation deteriorated, fanning fears that the country will ultimately decide that defaulting on its debts is an easier route than ongoing austerity.

Greek Prime Minister George Papandreou reportedly spent the day in intense negotiations with his main political opponent, Antonis Samaras, leader of the centre-right opposition New Democracy party, in a bid to forge a national unity government.

Papandreou even offered to step aside as prime minister, provided that the new government agreed to accept the stringent conditions that the European Union and the International Monetary Fund imposed on Greece as a condition of last year’s €110 billion ($US156 billion) bailout.

But Samaras was not satisfied with Papandreou’s resignation as head of government. He insisted that the terms of Greece’s rescue package had to be renegotiated. As a result, the two leaders were unable to reach agreement.

In a televised speech overnight, Papandreou said he would form a new government today and seeks a vote of confidence from parliament. “I will continue on the same path”, he vowed. At this stage, it is unclear whether Greek finance minister George Papaconstantinou, who has taken much of the blame for Greece’s unpopular austerity measures, will retain his post in the new government.

The political drama unfolded as tens of thousands of protesters marched in Athens to oppose the Greek government’s latest round of austerity measures for the debt-laden country, and as services across the country were cut as a result of a general strike called by Greece’s two major unions.

Although the protests were largely peaceful, there were several violent skirmishes, with some demonstrators throwing rocks, chairs, bottles and firebombs at police, who responded with tear gas and stun grenades. Papandreou’s car was pelted with oranges as it passed.

The scenes of mass demonstrations unnerved investors, who dumped Greek bonds. As a result, Greek bond yields are now at the highest level since the country joined the eurozone, with two-year bonds now yielding more than 26%, while the yield on 10-year bonds has climbed to 17.7%.

The nervousness spread to Ireland and Portugal, which have also received EU-IMF bailouts, pushing their bond yields higher. There are also growing fears about the risk to the eurozone’s banks from a Greek debt default, especially after the rating agency Moody’s put French banks BNP Paribas, Société Générale and Crédit Agricole on review for a possible downgrade, owing to their holdings of Greek bonds.

The embattled Greek government now faces the daunting task of pushing through a new round of austerity measures by the end of this month, as a precondition of the country receiving its next instalment of its bailout money. The budget cuts are also seen as crucial for securing a fresh financing package — estimated at more than €100 billion — desperately needed by a country which once again finds itself on the brink of bankruptcy.

But the latest austerity measures — which include a 20% cut in the government payroll, and a total of €28.4 billion in budget cuts by 2015, a 20% reduction in the government payroll and a massive €50 billion privatisation plan — have sparked growing sense of disillusionment with the Greek government.

Many Greeks feel betrayed that the financial sacrifices they have already made have not been sufficient to restore the country’s finances. The mood is even more bleak as Greece’s unemployment rate has now climbed above 16%, and is expected to rise further as the economy remains mired in recession.

Investors are watching anxiously to see whether the Greek government can somehow manage to push through with the latest round of deeply unpopular spending cuts, or whether the cuts trigger such political unheaval that further austerity becomes impossible.

*This article was originally published on Business Spectator