Did you notice something strange over the past two days about the financial markets? The European stock markets actually rallied on the rumour that Greece would be allowed a "ring-fenced" default. Now consider this again because the 'official' position of the Irish and the European political elite is that any default on anything by anyone would be a disaster, leading to huge capital flight and massive financial carnage.

If this is true, how come markets in the past two days have given precisely the opposite signal?

According to the latest financial market move, default actually calms things down for investors. It seems that it makes sense to face up to the reality that a country like Greece -- or indeed a 'bank' like Anglo -- has no money and therefore must default. If you prevent this basic capitalist process from happening (whereby investors pay for their mistakes), you spook the entire system.

If you doubt this, consider the risk perceived by banks in Europe and how they will lend to other banks. The entire banking system is kept liquid by interbank lending, whereby banks lend to each other. Think about it. You go into the bank today and deposit money, but if that money is not lent out to someone else today, the bank will end the day with a surplus of funds in its safe. It makes sense for your bank to lend this surplus money to another bank, which may have lent out too much today. This is how the system works.

But what happens if banks don't trust each other because they are worried about what is on the balance sheets of the banks they are lending to and think that maybe the bank won't be able to pay them back? In such an unusual case, the rate of interest goes up on the interbank lending to cover the lending bank for the risk that the borrowing bank is borrowing precisely because it is running out of money.

Look at the perceptions of risk in the European banking system in the past few weeks. It has skyrocketed. Interestingly, you can see that in the run-up to the Lehman crisis, the perceived risk increased enormously. Then it settled down after the Lehman default and collapse. It is important to see that this happened after the Lehman default.

Things calmed down and even during the various Greek, Irish and Portuguese crises last year, there was a sense that things would settle. Read full article in the Irish Independent...