Term Sheet

The latest on private equity, M&A, deals and movements — from Wall Street to Silicon Valley

How to save the euro

May 9, 2012: 10:05 AM ET

The new leaders in France and Greece should reassure the markets that they're willing to work within the existing framework of agreements and that they're committed to the euro.

By Cyrus Sanati

FORTUNE -- The elections in France and Greece over the weekend have created a crisis of confidence that could eventually drown the euro and push the continent into a deeper recession. Talk of tearing up past agreements and a return to profligate spending is not what Wall Street and the markets need to hear right now and will simply serve to encourage further capital flight out of the eurozone.

All this uncertainty confirms that a more concrete solution to the euro crisis is needed, one that involves a much tighter economic union -- something that regrettably looks increasingly untenable. But before a permanent solution could ever possibly take root, market confidence needs to be restored to the eurozone. Wall Street is looking for the new governments to say that they will at the very least work within the framework of the agreements set up by their predecessors and that they are committed to the euro. After that, there can be talk of issuing "eurobonds" and wealth transfers within the zone.

By now the markets have digested the reality that France's next president will be from the Socialist party and that Greece's political system has fallen into total chaos. While the former was expected, the latter was a bit of a surprise. The Greek people voted out of pure frustration (which is totally understandable), giving none of the traditional political parties enough of a majority in parliament to form a government.

MORE: 'Austerity' isn't an evil word

But the chaos in the Greek political system will eventually subside. Greeks will most likely take to the polls again on June 10th once it becomes clear that none of them can cobble up a winning coalition. The election this past weekend will therefore be looked at as some sort of first round vote in which people vote emotionally as opposed to strategically.

The two traditional parties, the center-right New Democracy party and the center-left PASOK party, will most likely pick up enough votes in the next election to form a coalition government, either with a smaller party with a similar ideological leanings or with each other. While both have said they would seek changes to the country's bailout agreement in order to tone down required austerity programs, both are committed to the euro, so they will probably do what is needed to stay in the club.

Over in France, Francois Hollande is getting ready to open up a can of socialism. It has been seventeen years since a Socialist party president resided in the Elysee Palace. Back then there were fears that the president, Francois Mitterrand, would invite the Soviet Army to parade down the boulevards of Paris during his inauguration. Of course, nothing of the sort occurred, and France remained a strong free market economy.

Hollande believes that economic growth is the only way to get his country out of its current economic slump. He is correct on that point. But he also believes that growth can only be achieved through massive government spending and the cancelation of most, if not all, of the debt-cutting austerity measures that French President Sarkozy had agreed to in the "Fiscal Compact" with the European Union.

That would be a mistake. The new governments in France and Greece need to understand that economic growth and government austerity are not mutually exclusive. The type of growth that comes through government spending, especially employment growth, can only be sustained if the private sector grows at a fast enough pace to support it. If not, then any gains would be temporary and just add to the debt load. It is all about the efficient use of resources. Spending billions of euros hiring back thousands of unproductive government workers who produce little value to the country's overall economy isn't the same as spending billions building engines of economic growth that are self sustaining, like a research campus or a fund to seed startup companies.

MORE: After socialist victory, panic in Paris?

But all of this talk of growth versus austerity addresses only the short-term economic woes impacting Greece, France and the rest of the eurozone and skips over the structural problems that created the sovereign debt crisis in the first place. This crisis will never end until the 17 members of the euro fully integrate their fiscal and monetary policies. This, of course, would mean a massive transfer of sovereignty that most of the eurozone governments would find unpalatable.

Yet Hollande says he is in favor of the European Central Bank issuing "eurobonds," to support eurozone members that are having trouble funding themselves in the open market. This would be an alternative to the ECB's LTRO program, which currently works by flooding the banks with cheap cash to buy sovereign bonds as a pass through funding mechanism for many eurozone governments. The LTRO program is the only thing keeping the interest rates on the sovereign bonds of countries like Portugal, Spain and Italy from hitting unsustainably high levels.

But the LTRO program is only a temporary measure, one that cannot possibly continue without eventually triggering hyperinflation. The issuing of eurobonds, backed by all 17 members would be a more lasting solution, but it can never work unless all the members have a joint fiscal regime. That's because it would mean the co-mingling of debt and a transfer of risk across the eurozone. That kind of trust can only occur if all eurozone members were on the same page in terms of spending.

So, Hollande is right to support eurobonds as it would be the first real step to solidifying the currency union, but it is unclear if he has any idea what it would take to make it a reality. He would not only need to convince his own government to give up fiscal control but also convince all the other eurozone members to do so as well, including Germany, which is vehemently opposed to the idea. But before all that he will need to reassure the markets and other eurozone members that France is creditworthy and committed to getting its fiscal house in order. That means France's new president will need to use the national credit card sparingly as he tries to rekindle the fire in country's economic growth engine.

Join the Conversation
Current Issue
  • Give the gift of Fortune
  • Get the Fortune app
  • Subscribe
Powered by WordPress.com VIP.