Roadmap for the Coming Greek Default

Moreover, Hussman says a further bailout will only aggravate the situation for both Greece and investors in Greek debt. Because bailout funds are conditioned on austerity measures that produce further economic weakness and revenue shortfalls, such a policy will likely produce more misery and rioting in Greece while pushing Greece's debt-to-GDP ratio higher and the recovery rate for investors lower. A better approach would be to "provide the funds to a post-default Greece, or to use them to recapitalize the banking system after losses that now appear inevitable."

Hussman sees three critical policy responses in the wake of a Greek default. The most immediate priority will be to prevent further contagion, and this can be done by shoring up Italian and Spanish debt. Not just the European Central Bank, but the Fed, too, under the authority of Section 14 of the Federal Reserve Act should purchase Italian and Spanish bonds since, unlike the case of Greece, it is not too late to prevent their default. "The key to stopping a contagion is to delineate which countries absolutely belong behind the firewall, rather than behaving as if all of them do," Hussman says.

The second priority is to preserve the euro by removing unstable members from the monetary union. "The best chance for a durable currency is to restrict its membership to countries with similar macroeconomic characteristics that are actually capable of following a very uniform budget discipline," Hussman says.

The third policy priority is to shore up the banking system and Hussman's solution is to let bank shareholders take losses. "Investors and institutions that voluntarily accept risk in order to reach for extra yield should be prepared to suffer the losses if those investments fail."

Hussman added a warning for U.S. investors in large prime money market funds that remain heavily invested in European bank debt: "It is unclear what level of subordination these debt obligations take, but we can expect that in the event of a Greek default, this concentrated ownership of European bank debt by U.S. money market funds will be less than ideal for investor confidence."