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S&P to ECB: Pony up

December 6, 2011: 10:07 AM ET

If eurozone members won't pool their debt and taxes, the only way the euro can be saved is if the ECB officially becomes the zone's lender of last resort.

By Cyrus Sanati, contributor

Angela Merkel Nicolas SarkozyFORTUNE -- If the eurozone fails to present a truly viable plan to resolve the long-running sovereign debt crisis by the conclusion of this week's emergency EU summit, all of its members, including triple-A rated Germany and France, could see their credit ratings slashed by one or even two notches, according to Standard and Poor's. One could hear the collective gasps of shock around the world following yesterday's announcement. Markets later tumbled in Asia and Europe in response. Angry politicians and pundits asked: How could S&P do this now, just when the eurozone looks like it is finally getting it's act together?

The reason is simple – eurozone leaders aren't even close to solving this crisis. The "new fiscal compact" that Germany and France plan to reveal at the emergency summit this Friday is weak and will most likely fail to put an end to this seemingly endless crisis. At this point, unless the European Central Bank steps up to become the eurozone's lender of last resort, the compact will be seen as a gun without ammunition. S&P hopes that the threat of a massive downgrade of the eurozone will force this disparate bunch to finally act collectively to solve this crisis.

S&P waited till the end of U.S. trading on Monday to announce that they had put 15 members of the eurozone on negative credit watch. Only Greece, which has a junk credit rating, and Cyprus, which is already on negative credit watch, were spared from a special report from the credit rating agency explaining their move. While a downgrade of some of the eurozone's members was expected this month, most notably France, it came as a bit of a shock that S&P would put the entire eurozone on the chopping block, including fiscally prudent countries like Austria, the Netherlands, Finland and tiny Luxembourg.

The trouble with France

S&P's downgrade on the eve of a critical EU summit this weekend is no coincidence. The threat, hanging like the sword of Damocles over the head of the members, was meant to get their attention.

"We believe that the risks of a deepening and broadening of the crisis have risen markedly and the repercussions of this development will in our view be felt across the monetary union, considering the interconnectedness of the EMU economies and financial markets," S&P wrote in a note explaining its move.

It doesn't get any clearer than that. There have been around 23 high profile meetings among eurozone members since the crisis first broke out in the spring of last year to discuss ways to put this issue to bed. Unfortunately, all this talking has failed to get the members to think collectively as one cohesive unit. There is still an "us versus them" mentality among the eurozone members. The "fiscally prudent" nations from Northern Europe, which have benefitted from a weak euro and expanded trading zone, are unwilling to absorb the consequences of that perk by aiding the "profligate" southern European countries that have racked up tons of debt, due, in part, from buying goods and services from the north.

S&P recognized that the interconnectedness of the eurozone means that their fates are sealed. Further deterioration of the eurozone will mean a recession for all of its members, including those in the north, raising the risk level of their debt.

Germany and France met last weekend to discuss forming some sort of fiscal union. Such a union would be a giant leap forward in solving this crisis. Trouble is, the "union" that was proposed by the two anchor members of the euro doesn't seem to be much of a union at all. Preliminary reports show that the fiscal union proposed would push nations to comply with debt ceiling levels that are already on the books. Those rules, which bar countries that have a debt to GDP ratio of over 60% from running budget deficits in excess of 3%, have been violated by almost all members of the eurozone at some point in the last decade – including Germany. Why? Because there was no consequence in doing so. The "rule" became more of a suggestion and everyone just ignored it, leading up to today's crisis.

The agreement would now levy "sanctions" on those members that fail to adhere to the deficit rules. It is unclear how this will all work. Germany had originally wanted the European Court of Justice to be able to declare national budgets invalid and force nations to comply with the deficit rules, but France objected to that proposal. If the ECJ had that power, then this agreement might have stood a chance of impressing the markets. Taking that provision out now makes this union more a suggestion than a binding agreement. To make matters worse, both nations agreed that the issuing of a common debt instrument, known colloquially as a Eurobond, would not be in their best interest.

Central banks offer aid, but not a eurozone fix

But a true fiscal union would involve the pooling of tax receipts and debt among all members. The fortunes of Germany would need to be shared with that of Greece, while the burdens of Italy would need to be shouldered by stronger members, like the Netherlands. The redistribution of taxes and the harmonization of spending policies would ensure that the eurozone moves in lockstep with the monetary policies of the euro's central bank, the ECB.

Without the pooling of debt and taxes, the only way that the euro can be saved is if the ECB officially becomes the lender of last resort for the eurozone. The ECB would be able to print as much money as needed to buy and support the debt of the southern European nations, until private investors get back in the game. The head of the ECB signaled last week that the bank would become more active in the market if it saw a more meaningful alignment of fiscal policies across the eurozone.

It is unclear if the ECB would interpret the Franco-German plan as meaningful. As it stands now, the plan looks toothless. S&P noted that ECB backing would be critical to solving this crisis and that its support could avoid a mass downgrade. After S&P's announcement yesterday, France and Germany issued a joint statement saying they stand by their agreement. But if the plan isn't beefed up this weekend, then both nations should be prepare to fall together.

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