By Lefteris Papadimas George Georgiopoulos
Facing public anger over belt-tightening that has erupted into violent protests, Papandreou must now seek a confidence vote for the new team and push on with a five-year campaign of tax hikes, spending cuts and state property selloffs.
Following the defection of one lawmaker from the ruling PASOK party on Tuesday, another stepped down on Thursday but was expected to be replaced with a party loyalist, so the resignation should not affect PASOK's parliamentary numbers.
The reshuffle reflects the unpopularity of the measures and follows aborted talks over a Greek unity government on Wednesday that roiled markets and raised fears efforts to solve the euro zone debt crisis could collapse.
Analysts said an offer by Papandreou on Wednesday to create a coalition with the conservative opposition could complicate his search for new cabinet members but could also have forced his fractious party to rally behind the austerity steps.
The new governing team will face a confidence vote late on Tuesday, a parliamentary aide told Reuters. With 155 of the chamber's 300 seats, the ruling PASOK party is expected to approve it.
"On the vote of confidence, I also believe he will get it, as it will force the party to rally themselves."
Papandreou may seek to replace his finance minister, George Papaconstantinou, the main architect of hugely unpopular budget cuts demanded by the EU and the IMF as part of Greece's 110 billion-euro bailout last year.
Former ECB Vice-President Lucas Papademos is most frequently mentioned as a candidate to replace Papaconstantinou, who local media have said may be on his way to the Foreign Ministry.
Papademos's office said he was out of the country on Thursday and not available for comment.
Tax rises and spending cuts worth 6.5 billion euros ($9.4 billion) are planned this year, doubling already agreed measures that have driven unemployment up to a record 16.2 percent and extended a deep recession into its third year.
The European Union and International Monetary Fund have demanded the new 5-year austerity plan as a condition of releasing the next tranche of 12 billion euros in aid Athens needs to pay back debt that matures in August.
"I can't believe they are doing this (political wrangling), with all the money they are being offered," a European central banker told Reuters on condition of anonymity.
The plan includes new luxury taxes, a crackdown on tax evasion and tax rises on soft drinks, swimming pools, restaurant bills and real estate. The euro zone member's 750,000-strong state workforce would be cut by a fifth. It also aims to raise 50 billion euros by selling off state-owned firms.
Tens of thousands of activists and unionists flooded Syntagma square outside parliament on Wednesday to try to stop lawmakers from debating the measures.
Police used tear gas and stun grenades against scores of masked youths who hurled stones and petrol bombs and wielded long clubs in clashes that left around 46 people injured, including 36 officers. Fifteen protesters were arrested.
The vast majority of the crowd -- which included union workers, political party members, pensioners, and Greeks from all walks of life -- shouted at the parliament building but remained peaceful. Athens was quiet on Thursday.
Some Greek media said Papandreou's failed effort to create a unity government had sown confusion that could destabilize his administration.
"Papandreou behaved with eccentricity and created a chaos without precedent," daily Kathimerini said in an editorial.
The political machinations and international haggling over the terms of a second bailout have battered bond markets, and the cost of insuring Greek debt against default soared to yet another record high on Thursday.
"There is no sovereign in the world that trades wider than Greece now. The closest is probably Venezuela. Greece is out there on its own," said Markit analyst Gavan Nolan.
World stocks and the euro slumped late on Wednesday as the upheaval fed fears of a default. They fell further in Asia on Thursday after a Dutch newspaper quoted ECB policymaker Nout Wellink as calling for a doubling of the European bailout fund.
He said the fund should be increased to 1.5 trillion euros ($2.15 trillion) if politicians want private-sector investors to participate in a second bailout of Greece.
Greek conservative opposition leader Antonis Samaras said the only way out of the crisis was early elections, but analysts said that would only happen in the unlikely event that the government failed to get a vote of confidence.
"I think that Greek politicians are mature enough and will vote for the mid-term plan," said Gikas Hardouvelis, chief economist at EFG Eurobank. "What they don't have is the maturity to implement the hard austerity measures that it includes."
(Additional reporting by Tatiana Fragou and Ingrid Melander; writing by Michael Winfrey; editing by Andrew Roche)