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A Plan to Save Europe and World Economic Recovery -- By: Larry Kudlow

World and U.S. stock markets are slumping badly as intensified systemic risks from the Greek and European debt-default contagion continue to spread. Disciplinarian markets of stocks, bonds, gold, and currencies are signaling the inadequacy of European Union rescue plans and the global fear that economic recovery will be blunted.

Europe is the main source of the current upheaval. Specifically, the biggest issue right now is short-term funding. Key funding risk indicators, such as LIBOR and various short-term swap spreads, are showing credit and liquidity stress in Europe. Interbank funding looks increasingly sloppy and worrisome. These are dangerous market signals.

The repo market for bank-to-bank loans was the source of the credit freeze back in the fall of 2008. And while today?s funding risks are not even remotely as bad as they were back then, liquidity stresses seem to worsen with the passing of each day. If these funding problems keep worsening, along with stock markets that keep declining, all hell will break loose. Another meltdown is possible.

So I have a thought.

In the autumn of 2008, when financing markets completely froze up during the very worst of the credit meltdown, the FDIC guaranteed all bank debt, from 30 days out to 30 years. In addition, the Fed and Treasury essentially guaranteed overnight lending in the repo market and the commercial-paper market for bank debt. It worked.

At the time, the repo market for interbank loans was about $20 trillion, vastly greater than the $1.2 trillion volume of subprime mortgages. And when the repo market was rescued through the loan guarantees, the financial system gradually started to heal -- although it took several months. (An end to mark-to-market accounting in March 2009 would aid that healing process.)

So it?s my contention that the Europeans must now embark on a similar program. The EU/IMF rescue plan, which consists of $1 trillion in loans and loan guarantees for government sovereign debt, must be expanded to include a blanket loan guarantee for all European bank debt, short term and long term. A Europe-wide, centralized, deposit-guarantee system should also be developed. Right now bank deposits are insured by individual countries, like Greece. This is not credible. (Hat tip to investor David Kotok for this deposit-guarantee thought.)

A loan-guarantee program to backstop the banks in Europe and sovereign debt will put an end to this crazy Greek drama that is pulling down markets everywhere and threatening the economic recovery. As a free-market advocate, I don?t like this sort of government intervention. But we?re talking emergency here. Systemic global emergency.

In the U.S., the loan-guarantee blanket was a vastly more efficient and cheaper way to rescue the financial system than the $700 billion TARP plan to inject money into the banks. Unlike TARP, which still lives on, the loan guarantees were removed in 2009.

So the Europeans must be bolder and more aggressive with their financial safety net. And if a program like this were to be announced, in all likelihood the guarantees would never have to be funded, or wouldn?t really be necessary. In other words, the safety net will be a lot cheaper than simply pouring more loan subsidies into Europe?s welfare state.

These bank-loan guarantees would be temporary, perhaps a year in length. And they would buy time for the essential budget restructuring necessary to slash spending and curb the welfare-state excesses in southern Europe, or perhaps all of Europe. These government-shrinking steps will free up private-sector resources to spur growth.

It may also be necessary to restructure the Greek debt, with creditors taking a haircut. But a big-bang approach to backstop Europe?s banks and its bad-behaving, out-of-control-spending countries is, I believe, a necessary step in halting the contagion threats and restoring calm to the stock markets and financial system.

After several brutal years of recession, the possibility of global recovery must be strengthened by emergency actions from Europe. The world has already suffered enough. That?s why a guarantee safety net -- one that must be conditioned on a radical restructuring of Europe?s sad budget affairs -- is a necessary emergency measure.

And make no mistake about it. The U.S. is part of the budget disarray. Right now, the U.S. government bond market is getting a pass from the European funding crisis. But that pass will not be forever. Even while American corporations have returned to profitability, the sagging U.S. stock market and rise in the dollar/gold price are huge warnings to Washington, D.C., that a radical budget adjustment must be put on the table immediately.

-- Larry Kudlow, NRO?s Economics Editor, is host of CNBC?s The Kudlow Report and author of the daily web blog, Kudlow?s Money Politic$.

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Full post as published by Bench Memos - National Review Online on May 20, 2010 (boomark / email).