By Greg Peel

In mid 2007, many were concerned over a growing credit problem in the US with regard to subprime mortgages. But the prevailing attitude was that the subprime market was so small that really there was nothing to worry about. The Fed funds rate remained at 5.75%.

By September it appeared there really was something to worry about. The Fed thus responded with a 50 basis point rate cut, branded "shock and awe" by those praising the central bank for acting so decisively to fix the problem. But in January 2008, the Fed was forced to cut again, this time by 75bps. No one used the term "shock and awe" that time. The Fed cut by another 50bps in the same month and by March was organising the bail-out of Bear Stearns. Problem finally solved, many in the market assumed.

The rest is, of course, history. The Fed made another rate cut in April but this time only by 25bps, and did not move again until October. The Fed had to act in October in order to compensate for, in coordination with the US Treasury, allowing Lehman Bros to fail. In between, Fannie Mae, Freddie Mac, AIG and General Motors had all been propped up with taxpayer funds. Global financial markets collapsed and by December the Fed had cut to zero. But not before assisting in the rescue of the entire US banking system via a hastily implemented and near US$1 trillion policy call the Troubled Asset Relief Program, or TARP.

The TARP made the Fed's 2007 "shock and awe" rate cut appear, in retrospect, to be the equivalent of hitting the market over the head with a wet newspaper (with apologies to Paul Keating). Everything is of course, far more obvious in hindsight, but there were at the time plenty of critics suggesting Ben Bernanke was too slow to move. We might however be able to agree that what was occurring in 2007-08 was sufficiently unprecedented, at least in living memory, to expect the powers that be to know exactly how to respond.

Europe, on the other hand, has no excuse.

Those who suggest Greece is potentially "another Lehman" are right on the money, albeit one might also argue Greece is simply the same Lehman in public sector as opposed to private sector hands. The global government and central bank response in 2008 only transferred the problem from one to the other, it didn't solve the problem. Lehman was the smallest and most vulnerable of the five major US investment banks. Greece is one of the smallest and most vulnerable economies in the eurozone. Greece is where Lehman resurfaced.

The Greece issue first hit the radar in early 2010 ? about 20 months ago. If you call July 2007 the beginning of the US credit crunch, it took some 15 months to get from warning bells to TARP, and that has been considered too tardy a response by the history books. Why then has Lehman II taken even longer to sort out?

A simple answer might be that the US was at least allowed to speak with one political voice, and act accordingly in concert with its central bank, while solving the issue of Greece has been hampered by the input of 17 political voices in the eurozone, a total of 27 in the European Union, a central bank of limited power, and an International Monetary Fund hamstrung by the eurozone structure. There has been no decisive policy initiative implemented, only stop-gap measures. The first Greek bail-out fund, which took months to be agreed upon in 2010, was the equivalent of 2007's "shock and awe". The bail-out was broken into payment tranches and Europe is today still arguing about whether Greece should get its next tranche, arguing about whether it should get another bail-out fund in 2012, and arguing about the suggested European Financial Stability Facility (EFSF) which, as everyone knows, is not big enough to cope were Italy needed to be bailed out.

Europe has quite simply attempted to "muddle through" the problem rather than act in any effective manner. Clearly, this approach has not worked or global financial markets would not be once again held to ransom by an ill-thought out monetary union. As Citi analysts put it:

"The 'muddling through' approach is increasingly showing its drawbacks, as discontent with the Greek efforts among official lenders is increasing, contagion to the rest of the struggling [eurozone] countries has not really been prevented, and Greek financial sustainability is not really improving."

In other words, it hasn't worked. The main problem, Citi suggests, is that officials have underestimated the trade-off between deficit cuts and growth. To reduce debt one can either cut spending or improve economic growth, but one cannot improve economic growth by cutting spending. If Greece is not to be allowed to go into bankruptcy, then stimulus, not austerity, is required. So far European stimulus has amounted to no more than some band-aid bank loans and bond buying from the European Central Bank and a couple of insufficient bail-out funds. The next, yet to be agreed upon, step is for Greece's private sector lenders to take voluntary "hair cuts" and stretch out debt maturities. While I am now very sick of the expression "kicking the can down the road", and I'm sure I'm not alone, economists agree that such a move does not solve the problem but simply pushes it further into time with little effect.

As a result there are those who believe Greece should be allowed to default, those who believe Greece should be kicked out of the eurozone, those who believe the eurozone should be broken up and abandoned as a concept, and those taking the opposite tack who believe the eurozone should shift from monetary union alone to both a fiscal and monetary union. The latter argument relies on a common sense idea that you can't have one currency between 17 nations without central fiscal policy and a common bond (of the debt variety).

So we might thus boil down the answer to the question of what to do about the eurozone into three possible answers: (1) continue to muddle through; (2) move to fiscal union; (3) break it up. For as the UBS economists put it, "Under the current structure and with the current membership, the euro[zone] does not work. Either the current structure will have to change, or the current membership will have to change".

Citi's attitude to option (1) is any that further short-term compromise would simply buy more time until the problem intensified once more. Rather than preventing contagion from spreading to the rest of Europe, as has been hoped, "muddling through" simply "maintains a permanent heightened degree of risk aversion and market turbulence across the whole European financial system" and basically has made life for everyone more, not less, difficult. What's more, after all is said and done, Greece's financial position looks no less sustainable today than it did a year ago.

In other words, strike option (1). ANZ Bank economists take it a step further, suggesting that as the "muddle through" continues it is more likely it will be the financial markets, not the politicians or ECB of IMF, which will force a resolution. "A widespread flight of capital from European sovereign debt," notes ANZ, "could make the cost and feasibility of muddling through unacceptable to all Europeans.

Let's thus look at option (2). Last month, German chancellor Angela Merkel and French president Nicholas Sarkozy implicitly decided, after an emergency meeting, that option (2) is the way to go. They spoke of uniform corporate tax rates in the eurozone as a first step. The problem is that they are quite possibly the only two people on earth who think a fully unified Europe is a possibility. Everyone else thinks it's the funniest thing they've ever heard.

If you're Australian, ask yourself: does the Australian federation work as a political system? Consider that in response to the suggestion of Federal mining and carbon taxes, the individually governed states are responding by increasing mining royalties as an offset. That alone should evoke an answer of "no", before we even get to failed attempts to federalise health and education, arguments over GST, and the power of one state to hold all others to ransom under the existing constitution. Yet even with a "no" answer, we all managed to cheer on Samantha Stosur as one nation, even though she's a dirty Queenslander.

Now imagine thousands of years of near perennial war between the likes of Germany, France, Spain, Holland and what we now call Italy (itself a loose union of disparate former states) being laughed off as all of Europe joins as one, before you even get to any of the other eurozone/EU members.

Have you imagined it? Good. We can now strike off option (2).

Option (3) has become a popular call of late, but as far as the UBS economists are concerned "the risk case of break-up is considerably more costly and close to zero probability". The Citi economists concur, suggesting a eurozone break-up "would be very costly, particularly for the weaker, uncompetitive [eurozone] countries exiting or being left behind ? and remains highly unlikely, in our view".

UBS estimates that were a "weak" country to leave the eurozone the consequences would include sovereign default, corporate default, collapse of the banking system and collapse of international trade. And there is little prospect of devaluation of the once again individual currency offering much assistance, the economists believe. They have even modelled the scenario, and decided the exit of a weak country would cost every man, woman and child in that country the equivalent of 9,500-11,500 euros each, equating to 40-50% of GDP.

If things were to go the other way, and the eurozone's strongest country ? Germany ? were to leave the others to their own devices, UBS calculates the exit would cost every German 6,000-8,000 euros in the first year, or 20-25% of GDP. If, on the other hand, Germany alone were to bail out all of Greece, Portugal and Ireland after allowing them to fully default rather than propping them up, it would cost every German a single hit of 1,000 euros, UBS suggests.

So why the hell is Europe fannying about? Surely, assuming the UBS calculations to be accurate, default of all the weak and subsequent bail out by all the strong in the eurozone would solve the whole problem in a trice.

Were it only that simple. Such a policy already seems remote given the number of parliaments that would have to agree, and hence their electorates, but not even economists can agree entirely.

UBS, for example, suggests the "risk case" of a eurozone break-up is close to zero probability but the "base case" of Europe moving toward fiscal integration is of "overwhelming" probability. This despite us already dismissing option (2). Citi nevertheless bluntly disagrees with UBS in saying quite frankly, "fiscal federalism is out of the question".

Citi offers another solution which the economists have dubbed "if you break it, you own it" Europe. The long and short of it is that if a eurozone member becomes insolvent, the problem is settled between the taxpayers of that member and its creditors without any permanent financial support from any other members' taxpayers. Similarly, if a systematically important bank is threatened with insolvency the issue must first be dealt with by that bank's creditors.

Seems fair, but surely such a solution will still set off a domino effect throughout the entire European financial system, would it not? To avoid that, Citi has another part to the plan. I'll get to that in a second.

ANZ Bank perceives that global markets have reached a point of intolerance of the muddling through approach, as previously noted, such that either fiscal union or break-up are being put forward as the only two options. Assuming a fiscal union to be unacceptable, then it seems break-up is the only option. However, ANZ suggests that the two worst case scenarios for Europe are a seize-up of the banking system, a la 2008, or a disorderly break-up. The former may well occur if the muddling through approach continues and it would lead to a severe recession. The latter, as we have decided, is not necessary.

What Citi and ANZ would both like to see is, in essence, a TARP.

ANZ would like to see a broad-based and substantial restructure of the debts or the worst affected eurozone economies which in turn would require European banks to take a hit on earnings and capital. So that complete confidence is not then lost in the banking system, this needs to be backed up by a central government fund to offer temporary capital support to the banking system (rather than the sovereigns), that is, a TARP. In return, the banks must consolidate by merging and selling assets, which is what the US banks did in 2008.

ANZ's solution could also be called "you broke it, you own it". Because it is ostensibly what the Citi plan is implying as well ? that the cost is borne by those at fault, being the taxpayers of the insolvent country and the lenders to those taxpayers (buyers of sovereign debt), and by the banks struggling with insolvency and the lenders to those banks. The additional part of Citi's plan ? that which prevents total collapse ? is what the economists call a "euro-TARP".

Hasn't it always been the best solution? Just throw a tarp over it?

Of course, such a solution is not going to happen overnight, although a resolution to move towards such a solution could. We can dismiss further "muddling through" because the financial markets are about to deliver their own form of justice and it won't be pretty for anyone. We can dismiss a eurozone break-up of any nature at this point on the basis economists agree that would be the most destructive and worst-case scenario. Total fiscal union is out of the question but some fiscal compromise will need to be reached to provide for that which seems the only way out ? the TARP.

There are those who would argue that the TARP of 2008 has not done a lot for the US. But if you consider that the US government has now seen the great bulk of TARP funds returned, in some cases with a profit, and if you contemplate that were it not for the problems in Europe, the US economy would probably be stumbling its way toward recovery with a lot less difficulty than it currently is, then the merit is difficult to argue.

Perhaps Citi can have the last word:

"Europe blunders and Europe stumbles, but it never stays down. This unique hybrid between a federation of nation states and an intergovernmental alliance will likely use the current crises the way it has used all past crises: to emerge stronger and more capable of dealing with future challenges and crises."

Good. But for pity's sake can Europe get on with it please.

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