Almost certainly prices for goods in Cyprus will rise as a result of its banking crisis, because the imposition of capital controls will restrict imports, leading to supply bottlenecks. In addition residents will no longer be complacent about keeping money on deposit, but seek other alternatives. Large depositors may be trapped, but smaller local depositors will draw them down for cash to stock up on things needed tomorrow while they are available.
Cypriots will therefore change their preferences from money in the bank in favour of goods. And the lessons from Cyprus are not being lost on ordinary folk across the eurozone, so bank depositors elsewhere are likely to alter their preferences away from bank deposits as well, depending on how they view the soundness of their own banks.
The purpose of this article is to draw attention to the price effect of the likely change in preferences between bank deposits and goods. Prices change either as a result of monetary inflation, which is a gradual process, or as a result of changes in money-preference, which is often substantial and sudden in its effect.
The most recent example of the effect of a change in money-preference was the global banking crisis five years ago, when it went the other way. Banks quickly switched to being risk-averse, and consumers did the same thing. On this occasion it was a change in preference in favour of money, the consequence being prices of goods and services needed to fall significantly to restore the balance between supply and demand. This was why so many manufacturers were in trouble.
When preferences for goods increase, as seems certain in Cyprus, the price effect could also be alarming, exacerbated by those capital controls on import payments. A price boom is created, rapidly driving up local prices against supply constraints.
We must now consider to what extent a decline in money-preference in favour of goods might take hold in other countries in the eurozone, where private citizens become concerned about the security of their deposits. The indications are that depositors are already looking to withdraw deposits in the weaker eurozone states, confirming that a change in money-preference is spreading. This being the case, the surprise for observers will be the sudden strength of price inflation, the root of which is eroding confidence in the eurozone's banks. What is remarkable is the clumsy way in which it is being precipitated, in an apparent desire to punish little Cyprus.
This punitive action is therefore likely to develop into a withdrawal of deposits large and small around the eurozone. With it will go an increasing preference for goods, pushing prices sharply higher, particularly in Spain, Portugal, Greece, Italy and even elsewhere as the effect spreads. The question then becomes how will the ECB respond: will it raise interest rates to curb this unexpected price inflation, or keep them low for fear of precipitating a collapse of insolvent banks and governments?
At stake is an eventual loss of confidence in the euro itself, as larger deposits flee for safety. In the short-term the US dollar and Swiss franc should benefit, but that doesn't get your money out of the banks, because if the eurozone's banks fail no bank and no paper currency is safe and their depositors might be raided. The only safety is in true money that has stood the test of time: gold and silver.