The folks at The Institutional Risk Analyst sat down with “EU financial mess expert” David Kotok, CEO of Cumberland, to discuss the ECB’s (shoddy) options, the Fed’s lack of credibility, and the looming risk of deflation for the West.
Kotok: The question of credibility is a continuing problem. It all comes back to solvency. We have this idea that sovereign debt does not require a default reserve and that they will pay. And then we have an insolvent issuer of sovereign debt in the Eurozone in Greece that cannot pay, that has no market access. The market is pricing default probability at 50/50 going out two years. You can call Greek debt sovereign debt that will be paid and you can call a duck a frog. But if it walks and quacks like a duck, that’s what it is. So the notion of credibility and the problems facing the ECB are in conflict. Mr. Trichet at the ECB is attempting to restore credibility to his institution, but he is doing so by suggesting the restructuring of the European Union. Mario Draghi will in all likelihood head the ECB next and will have to come in as a very hard line banker because of the baggage he carries to restore his credibility.
The IRA: Well, Draghi worked at Goldman Sachs. What more do you have to say? So it sounds like we are going to see less accommodation in the EU just as the Fed is ending QE2. Why does this sound like a recipie for disaster? People blame President Herbert Hoover for the Great Depression, but FDR and the folks at the Fed actually made the deflation worse from 1932 onward. Global tightening of monetary policy and fiscal policy together sounds like global deflation in 2011 and beyond.
Kotok: If Draghi takes a hard line and the central bank side of the equation in the EU hardens, then they will have to recognize publicly that they cannot cave on inflation and the weakness of the euro because they will destroy the credibility of the Maastricht treaty and everything since. That is what is now at stake.
Hat tip JL for sending this along!