Central Banks Go Green

Central bankers are pondering the climate issue. First, they ought to explain why doing so is consistent with their mandate. Furthermore, they should not put their independence at risk. A column by Barry Eichengreen.

Barry Eichengreen
«Central banks should avoid being tapped as piggy banks by the proponents of a Green New Deal and Green Quantitative Easing.»

Central banks are weighing in on – wait for it – climate change. In mid-April, Mark Carney and François Villeroy de Galhau, governors of the Bank of England and Bank of France, issued a joint statement warning of the risks of global warming. Their statement accompanied the first comprehensive report of the Network for Greening the Financial System, which counts among its members 27 central banks together with a handful of other financial supervisors. That the U.S. Federal Reserve System doesn’t participate will come as no surprise given the Trump Administration’s dismissive approach to climate change.

At first glance, this attention by central bankers to the climate issue might seem peculiar. Climate is not something on which monetary policy makers, unlike natural scientists, have obvious expertise. Global warming unfolds over long periods – it is tempting to say «glacially» – whereas monetary policy is tailored to the ups and downs of the business cycle and inflation.

Moreover, by weighing in on this contentious, politically freighted issue, central banks may be putting their independence at risk. Monetary-policy decisions are delegated to independent central bankers, who serve long terms in office and are expected to take decisions free of political interference, with the understanding that they will be guided by their legally enshrined mandate. Customarily, that mandate prioritizes the maintenance of price stability, which is operationalized as a 2 per cent inflation target, although in some cases the mandate extends also to the maintenance of economic and financial stability.

Risking political backlash  

These are matters on which monetary policy makers have proven expertise. That central bankers are proceeding in good faith can be verified by observing the rate of inflation and closely related variables. This ability to monitor performance and confirm fidelity to the mandate is what makes the delegation of policy to independent technocrats politically palatable.

Whether or not central bank actions are effectively mitigating climate change is more difficult to verify, given how myriad other factors also contribute to atmospheric warming and sea-level rise. Whether the central bank’s actions in this domain are effectively advancing society’s objectives is therefore harder to determine. Under these conditions, the central banker’s typical words of reassurance, which are «trust me, I know what I’m doing,» will be unconvincing.

Given that actions to address climate change are apt to have prominent distributional consequences, they further risk provoking political backlash. The «yellow vests» angered by higher petrol prices will then march not on the Palais de l’Elysée but on the Bank of France. In response, their elected representatives may then insist on exercising direct political control of the central bank.

Climate change as a source of macroeconomic shocks

Before straying into this territory, therefore, central banks need to explain why doing so is consistent with their mandate. The case starts with the observation that climate change can be a source of macroeconomic shocks that directly affects the inflation that is central to their mandate. More frequent cyclones and hurricanes that take agricultural land out of production or destroy coastal property are tantamount to an increased incidence of negative supply shocks. Less supply means more inflation, other things equal. A central bank tasked with hitting an inflation target therefore may have to raise interest rates to keep inflation expectations from becoming unanchored.

Alternatively, if it can convince the public that the effects of the storm are temporary, thereby anchoring expectations, the central may be able to «look through» the increase in prices, in much the same way central banks typically look through fluctuations in commodity and energy prices.

If the problem is sea level rise, then the negative supply shock will not be temporary, as in storm-related cases, but permanent. If this case, potential output and hence the output gap will be affected. The negative economic effects will be ongoing, and the central bank may have to respond even more forcefully to anchor expectations.

Stability of the financial system at stake

In principle, many of the same points apply to carbon taxes and other climate-change abatement policies. Such measures increase the cost of production, for carbon-intensive products in particular but also in general. They are inflationary, other things equal. This is not an argument against their utilization, but it does mean that central banks need to think about how they impact their mandate.

Climate change also matters for central banks in their role as financial regulators. Cyclones, hurricanes and coastal flooding pose immediate risks to insurance companies that are not able to fully reinsure or otherwise diversity away their concentrated exposures to these events, and the failure of important insurance companies can have direct implications for the stability of the financial system as a whole.

Climate-change abatement policies may also undermine the balance sheets of fossil energy companies and mean losses for their shareholders. Economies heavily dependent on companies that have been slow to move away from technologies like the internal combustion engine – here’s looking at you, Germany – may experience balance sheet problems not just in the corporate sector but also in the banks that lend to those corporations.

Green vs. brown assets

What specifically should central banks as regulators do in response? They should apply higher capital requirements on brown than green investments, since brown investments will be more at risk from climate-change abatement policies. In additional to buttressing financial stability, doing so will have the ancillary benefit of discouraging investment in less climate-friendly activities.

In addition, central banks should incorporate extreme climate-change scenarios directly into their financial stress tests. They should require greater disclosure and transparency regarding holdings by financial firms of green and brown assets. Greater transparency will help ensure that regulators themselves are not surprised by problems in financial intermediaries when climate events hit, and those intermediaries will be subject to stronger discipline by the markets.

Finally, central banks should avoid being tapped as piggy banks by the proponents of a Green New Deal and Green Quantitative Easing. In the United States, progressive economists associated with so-called Modern Monetary Theory package together climate-change-mitigation policies – their Green New Deal – with the idea that central banks can pay for such initiatives by printing money, without incurring inflationary consequences. Similar, advocates of a UK Green New Deal have called for the Bank of England to purchase new debt issued by the government to fund energy efficiency in buildings, renewables and local transport systems.

Avoiding industrial policy

In the current environment of low interest rates, there may indeed be more scope for non-inflationary money finance of government budget deficits. But some proponents of a Green New Deal argue that such scope is effectively unlimited. There is no basis for this reckless conclusion in either economic theory or economic history. The reality is that beyond some point inflationary pressure will intensify.

Moreover, central banks preferentially purchasing green bonds will be straying dangerously close to conducting industrial policy. At that point, complaints about their exceeding their mandates will be on firm ground. And the risk to their independence will be back.