Larry Kudlow

U.S and world 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/International Monetary Fund 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.

Larry Kudlow

Lawrence Kudlow is host of CNBC’s “The Kudlow Report,” which airs nightly from 7 p.m. to 8 p.m.