Standard & Poor’s spares no one: the credit rating agency warned on Monday that it may downgrade the credit rating of the entire euro zone if the European Union fails to find a solution to the euro crisis.

The move puts additional pressure on French President Nicolas Sarkozy and German Chancellor Angela Merkel to get down to business at Friday’s European summit. S&P’s threat also affects the strongest euro zone countries: Germany, the Netherlands, Luxembourg, France, Finland and Austria. They will lose their triple-A status unless something changes within the next three months.

The agency followed up its warning to individual countries with a threat to downgrade the zone’s emergency bail-out fund, which also has AAA-rating. S&P warned that the European Financial Stability Fund (ESFS) could lose its top rating if the agency downgraded any of the fund’s guarantors.

Insiders say the warnings are not so much about individual countries, but about the indecisiveness of the euro zone as a whole.

No solution
The warning knocks the ball squarely into Merkel’s and Sarkozy’s court. The two leaders agreed on Monday to draft a new EU treaty with provisions for strict and enforceable budget rules. However, everybody knows that it will be months, if not years, before any such treaty comes into force and it does not provide a short term solution.

In the short term, the ‘Merkozy’ power duo has put its money on the European rescue fund scheduled to start operations next year. Member states will receive support if a qualified majority of 85 percent of the contributing members approve the request.

Euro bonds
Many observers fear confidence in the financial markets will only be fully restored when the euro area starts issuing euro bonds allowing the weaker member states to borrow money against lower rates. In addition, the European Central Bank would have to be granted greater powers to issue loans to those weaker countries. Unfortunately, these are the issues that Merkel and Sarkozy cannot agree on.

Is Friday’s summit really the last opportunity to solve the crisis? ING Bank Chief Economist Mark Cliffe says it’s more a matter of weeks than days:

“It’s certainly true that the panic that we’ve seen in some parts of the financial markets is now beginning to spill over into the real economy. We’re seeing companies themselves beginning to act as if it’s a realistic prospect that the monetary union may break up. Therefore, the pressure is enormous and I think we will need to see some action over the next few weeks.”

It won’t happen because it can’t
However; some people have a different, almost optimistic, view which boils down to: the euro cannot and will not fail because the consequences would be unacceptable. According to Nout Wellink, former president of the Netherlands Central Bank, failure of the monetary union is unthinkable:

“The damage caused by the failure of the euro or a splitting up of the euro zone would be so incredibly big that European leaders, who have undoubtedly realised this, would not allow it to happen.”

And yet even Wellink knows that ultimately it’s the financial markets – not the politicians – that decide whether the euro lives or dies. The saying ‘the market is always right’ may be time-worn, but it’s nearly always true.

Netherlands hit hard
The demise of the euro or a split of the euro zone would deal a particularly severe blow to the Netherlands. Its economy is based on foreign trade (primarily with the EU) and the huge amounts of money Dutch banks have deposited or invested in euro zone countries.

However, we’re not there yet- despite S&P’s warnings. Investors continue to regard German and Dutch government bonds as safe investments. So safe even, that on Monday, investors were willing to pay more for a new issue of government bonds than they were actually worth.

In this unique case, the Dutch government actually made money by borrowing money, instead of having to pay high interest rates like Italy and Greece.

(jric/gsh)