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?