The Eurozone’s Moment: Why S&P is Turning Up the Heat

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Tony Gentile / Reuters

Standard and Poor’s decision to threaten eurozone countries with ratings downgrades may seem like bad timing. But if it keeps markets on edge, European leaders might be scared enough to crank out some real solutions, rather than the half-baked measures already on tap.

S&P’s threat, which leaves Europe facing a 50% chance of a downgrade in the next three months and a possible downgrade of its bailout fund, came on the heels of some rare optimism in the crisis. Germany’s Angela Merkel and France’s Nicolas Sarkozy had just banged out a deal to give the EU greater control over national budgets ahead of Friday’s game-changing EU summit. Markets were welcoming Italy’s budget-slashing plan. And yields on Italian and Spanish debt were heading south.

But there are plenty of reasons to be skeptical about the days ahead, which is why S&P swooped in. The tentative agreement struck by Germany and France still doesn’t resolve the eurozone’s long term problems, and here’s why: First off, the “golden rule” to cap euro nations’ deficits, a key part of the Merkozy plan, already existed in the EU’s treaty and never worked. The new caveat is that rogue countries would be sanctioned for violating the deficit limit. But that wouldn’t necessarily prevent market panic once a member country falls out of line, mainly because there’s no easy way to enforce the budget rules.

Merkel’s enforcement solution is to have member states transfer their budgeting authority to a central body, but many countries are bound to shoot that down once it comes to actually voting on new rules. That’s why many analysts think Europe’s only route to salvation is to set itself up like the U.S., allowing money to flow freely from strong to weak states, either through common bonds, a bigger bailout, or a lax European Central Bank. The problem there, of course, is that a few weak states might end up running up debt with abandon. But even if those countries defaulted, it would arguably cost less than the two years of global financial turmoil and contagion we’ve had so far.

Another suspect part of the Merkozy deal: “leveraging” Europe’s bailout fund to amp up its firepower. If there is one fool-proof takeaway from the last few years of financial history, it’s that using financial alchemy to solve debt problems eventually leads to disaster. Cooking up insurance schemes and other complex financial beasts to ‘grow’ the size of the bailout fund might only make a revamped eurozone even riskier and more prone to market panics.

Finally, there’s the possibility that private sector bondholders won’t have to take losses on future eurozone bailouts. So much for a new tough-minded Merkel standing up to the banking lobby. As with any investment, banks betting on sovereign debt should be responsible for losses on that bet. So far banks have avoided taking a hit on eurozone losses by convincing politicians that the global economy will tank if they’re forced to pay up. As a result, politicians have saddled indebted countries with that burden, leaving them to sink under the weight of austerity with no room to grow. But the longer the austerity game continues, the more likely that countries like Italy will eventually be forced to default. And the bigger the tab for private banks gets.

As it stands, the Merkozy deal looks like more finagling to avoid political pain. That may fool the markets for another few months. But when the day of reckoning arrives, the bill will be far more expensive.

Roya Wolverson is a writer for TIME. Find her on Twitter at @royawolverson. You can also continue the discussion on TIME’Facebook page and on Twitter at @TIME.