Guest Post: To Dilute or Not to Dilute, That is the Question

Today we have a guest post from Cedric Walter, a new friend from Germany who has written an exceptionally clear explanation of the choices facing the European political and financial leadership headed into this weekend.  I hope you enjoy it and get something out of it as I have. – JB

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Bondholders lent too much at too low rates to the European periphery. They lent unwisely. The key political question for Ms Merkel and Mr Schäuble is: Shall the bondholders be made whole on all their claims? And if they shall be made whole, will it be done in hard, undilluted Euros and their demands satisfied through higher taxes in Germany and France, transferring future purchasing power from taxpayers to bond holders. Or alternatively shall they be made whole through dilluted Euro and the tax on the Euro zone’s savers be levied through inflation.

No other political question is currently of consequence. If the bondholders are not rescued the highly leveraged balance sheets of the European banks will probably not take the stress, the banking system will need a recapitalization and insurers will face sizable writedowns. If bank recapitalization is necessary it needs to be decided where the funds come from. Mr Sarkozy would prefer for the EFSF to play that role. Naturally because French banks are more exposed and their recapitalization needs threaten the French rating and creditworthiness he prefers for Germany to co shoulder this.

This entire debate is about who will bear the ultimate losses and in which way real future purchasing power shall be restored to bondholders claims which have gone bad and cannot be serviced in real terms. Ms Merkel will have to decide if it is politically feasible and equitable to saddle the German taxpayer with the corresponding deduction of future wealth.

The surplusses enjoyed by Germany actually demonstrate a disequilibrium, which indicates an undervalued German currency. Were Germany running on its own currency, it would appreciate, forcing down exports and encouraging imports of real goods, increasing real wealth in the country. In a way, each time a German worker fills up his car at the gas station, he is robbed of a part of the true purchasing power which the value of his compensation should demonstrate in international markets. Consumption is repressed and unemployment exported. Instead the German excess savings automatically go to funding the export surplus, increasing foreign claims and the corresponding risk that those claims cannot be serviced in the future by deficit coutries already on the brink of insolvency.

Calculations as to the economic cost of a breakup of the Eurozone are mostly done by the chief economists of banks, which are not unbiased. They are not watching the political landscape, they are part of the landscape and pushing the agenda of their potentially insolvent banks.

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Thanks, Cedric!