The effects of the bank levy - forcing the non-bank private sector into insolvency

There has been some comment that the bank levy of depositors in Cyprus might, if it does not cause to much contagion, be tried again when, as is inevitable, more banks need to be rescued. This idea makes no macroeconomic sense at all and is incredibly unfair. What it also reveals is a huge logical flaw in the thinking behind austerity.

The bank levy is a default on debt owed by banks to the non-bank private sector. Since it has no effect on debt levels held by the non-bank private sector it improves the solvency of banks by making the rest of the private sector less solvent. This will naturally result a decrease in spending, as attempts are made to increase saving to restore solvency.

What is curious is that the rationale for cutting the government deficit rather than allowing it to remain high with support from central banks is that deficit spending will result in inflation which will effectively reduce the real value of savings. The difference of course is that inflation causes the relative value of debts (which do not increase with inflation) to decrease, improving solvency, so it makes much more sense economically to risk some inflation by deficit spending than to impose huge losses and force large parts of the private sector into insolvency.

Of course not the whole private sector will suffer. Banks will escape by having their debts reduced so that they can be restored to health. Does that not seem just a little unfair?

The student debt bubble

As noted in previous posts growth for the past 40 years has relied on the private sector taking on debt in ever larger amount. This reached record levels before the global financial crisis, and attempts to pay down this debt are responsible for the protracted recession. That is why central banks are desperately trying to convince the private sector to start borrowing again.

While this has not succeeded, there is one group that have increased their borrowing rapidly since the global financial crisis, and that is students. In both the USA and the UK student debt is surging fast. In the USA and the UK this was a result of a rapid increase in University fees and government underwriting of loans to pay for them.

Students are building up debts that they can never repay. Like all bubbles this will end in tears. Already there are signs that this new credit bubble is about to burst in the USA.

Public debt is no more of a burden on your children than a large bank balance.

Those worried about government debt often claim that it is an unfair burden on future generations who will have to pay it back. This is completely wrong. Government debt is a liability to the private sector. It is a claim against government by the private sector. That means it is a private sector ASSET. This is similar to bank deposits. These are a liability of the bank to us, the depositors. It would be accurate to call customer deposits in banks bank debt in the same way that we call government liabilities to us government debt. Similarly, just as we consider this 'bank debt', i.e. the deposits that we have in the bank, to be our assets that we can pass on to our children, government debt represents private sector assets that we can spend in future. Clearly it makes no sense to call this a burden on our children.

The main difference between private sector deposits in banks (bank debt) and government debt (private sector deposits held by the government) is that government debt it far more secure since a government cannot go bankrupt.

Some may argue that government debt eventually has to be repaid and that will require higher taxes in future, which will be a burden on future generations. However there is no reason why a government should ever have to pay back all its debts. Individual debts have to be paid when they come due but total debt need never be reduced. This is similar to banks who have to pay out customers all the time but don't have to reduce the overall level of deposits they hold. These can increase indefinitely.

The only reason that taxes need to go up or government spending needs to drop is to reduce demand if the economy is overheating and inflation is picking up. It is hardly a burden to have to cope with such rapid growth that these measures become necessary. What is absurd is to cut spending and increase taxes when there is no growth and there is unemployment and excess capacity. It just damages the economy further, as has been demonstrated so clearly in Eurozone countries and the UK.