Climate change is not only happening, but it also seems to have accelerated in recent years. We have overwhelming empirical evidence that global temperatures are rising, glaciers and poles are melting, and that the process is man-made and caused by Carbon Dioxide and emissions of other greenhouse gases, which have gone way up over the last 50 years, especially in South East Asia where more than a billion people have been lifted out of poverty in recent decades. The fundamental transformation from mostly agrarian economies to industrial powerhouses obviously led to a huge surge in emissions on a global level. As a result of this pollution, global temperatures have already increased by about 1 degree or more over the last century.
Climate change, if not stopped, will also turn out to be extremely costly for the global economy. As temperatures rise, parts of the planet will become close to uninhabitable, and droughts and extreme weather events will intensify.
As it often happens, the most vulnerable will suffer the most. Almost all low-income countries are located closer to the equator compared to many high-income countries located closer to the poles. This means that many Emerging Markets will suffer the brunt of the burden from climate change while being the least responsible.
It is therefore not surprising that many have called for a greening of monetary policy, meaning that Central Banks should take climate change into account. While the idea sounds sensible at first, I actually think that it is a mistake. Let me explain why.
There is no denying that climate change is associated with various externalities of epic proportion that will negatively affect global GDP growth in the decades ahead. These market failures will have to be addressed by governments and the global community to a much bigger extent that what is currently done. However, Central Banks should largely stay out of this.
The greening of monetary policy might not be a great idea
If you have read my blog, you know that I have been a fierce critic of current monetary policy. The Fed has a dual mandate on employment and inflation, and it has mostly failed on both fronts in recent decades. Central Banks should be responsible for aggregate demand management.
Unfortunately, output gaps have been mostly negative for several decades, meaning that the economy has more often than not operated below full capacity. The corollary of this proposition is that monetary policy has been mostly too tight. As market monetarists will tell you, the Central Bank’s balance sheet is not a good measure for the stance of monetary policy.
Things are even worse when you consider the Eurozone. Unfortunately, the ECB has only a price stability mandate, based on the wrong proposition that output gaps and inflation rates move together. The ECB has failed to deliver and inflation has undershot its target for about a decade, never mind the substantial output gaps that Eurozone economies had to endure since 2008 because of misguided macroeconomic policies: austerity plus tight monetary policy.
Given that Central Banks have completely failed on their primary mandate, is it really a great idea to give them more tasks where they most likely cannot deliver? I would argue no.
Furthermore, monetary policy is already distortionary enough. Currently, the ECB can only buy government bonds and corporate bonds. This is a problem for several reasons.
First, the corporate bond market in Europe is not that large, meaning that ECB purchases have larger effects. Second, monetary policy in the Eurozone is geared towards debt. If you want to have a more neutral monetary policy, you should favor Central Banks buying the entire market portfolio of financial assets, meaning that similar to the BOJ, Central Banks should include equity and potentially financial instruments geared towards the housing market in their asset purchases.
Expanding the monetary base by purchasing assets is monetary policy in the classic sense. However, Central Banks, and especially the ECB, have also gotten much more involved in credit policy.
In the Eurozone, the banking sector has suffered enormously as a result of a weak economy. Furthermore, bank credit plays a bigger role than in the US where equity and corporate bond issuance play a larger role for financing conditions. Therefore, the ECB had to become heavily involved in the banking sector and is currently supporting European banks by providing credit subsidies. This is probably the right thing since a banking crisis on top of the current recession would be a catastrophe.
However, precisely because of these distortions, it is not a great idea to make monetary policy even more distortionary by gearing it towards the “greening” of the economy. Central Banks need to deliver on their primary task of AD management first and should not get distracted with scoring cheap points on climate change right now.
An ECB backed European Sovereign Wealth Fund
Therefore, I have an alternative proposal on how Europe can deliver on climate change targets after all. As you might now, the sovereign wealth fund of Norway has a value of roughly 1 trillion USD and is managed by the Norwegian Central Bank, however, under a separate entity that is independent from the monetary policy unit. Furthermore, the wealth fund has also its own ethical guidelines. In recent years, it has largely divested from energy companies and entities in general that have a poor track record when it comes to environmental protection.
While the Euro Area does not sit on oil, we produce something that is in a way just as valuable in today’s global macroeconomic environment: Safe assets. With most of the Eurozone debt having negative yields, financial markets are giving us a clear signal that there is not enough sovereign debt outstanding right now. The Eurozone should take full advantage of this unusual situation and could address two market failures at the same time. First, the safe asset shortage is resulting in a global externality that leads to an insufficiency of aggregate demand across the globe. Second, we have the externalities associated with climate change.
The ECB currently has a balance sheet of about 6 trillion Euros and growing. There is no way that these assets will be sold again any time soon. The ECB could simply transfer some 600 billion of these assets to a sperate entity, a Green Sovereign Wealth fund. This wealth fund would then have sufficient startup capital and based on this collateral it could also issue new bonds that would be eligible for the ECB’s asset purchase program.
Such a green wealth fund can then channel its investments into green equities and the necessary green infrastructure investment that Europe needs to undertake in the near future to address climate change: Green energy, green infrastructure, be that a European train network powered primarily green energy, electric vehicles, green housing and office space, and cleaner/greener cities in general.
But now you ask, isn’t there a gaping hole in the ECB’s balance sheet then and will that be a problem. Well, yes and no! The ECB has the ability to create money out of thin air. It can easily fill any hole in its balance sheet by simply printing new currency. Some crazy traders will probably go bananas and declare the new age of hyperinflation, don’t listen to them, they have been wrong for more than a decade. Where the ECB to “write off“ some of its assets balance sheet, I will give it mere shrug, financial markets will mostly likely shrug, and so should you. The point is that financial markets have priced in low interest rates and low inflation for many years to come, especially in the Eurozone. While removing some of the assets from the ECB’s balance sheet will be slightly inflationary, this is precisely what Central Banks would like to achieve right now.
The distinction between monetary policy and climate change policy is important though and the lines should not get blurred. As outlined above, monetary policy decisions should be aimed at achieving the primary mandate of price and employment stability and therefore be separate from any other undertakings that can be addressed better with tools that are not monetary in nature.
An independent entity such as a Green Sovereign Wealth Fund set up with ECB capital could much more easily gear investments towards the green sector, similar to what the Norwegian Sovereign Wealth fund does. Charging the ECB with another task that it cannot achieve with its current tools would be a big mistake.