Daniel Daianu, 23 October 2019, ISEE conference, Academy of Economic Studies, Bucharest
Financial markets are inherently myopic and misconduct is also frequent. This means that proper regulations have to operate to keep a rein on finance. The Great Recession was enhanced by monumental failures of policy-making and a misleading paradigm, as Alan Greenspan ruefully remarked during Congress hearings in August 2008. Let us recall the Big Bank in the City of London in 1986, the rescinding of Glass Steagall in the US in 1998 and what followed afterwards via other waves of deregulation -the emphasis put on “self-regulation” according to the logic that markets know best, that they can regulate themselves!!.
But finance is not the most blatant case of neglect in policy-making. In 2006, in a famous report, Nicholas Stern, permanent secretary at the UK Treasury at the time, stressed that climate change poses the biggest challenge to economics, that markets can hardly account for climate change and their effects; that public policies need to address this reality sooner than later[i].
Nicholas Stern’s views and those of scientists that think analogously (The Club of Rome being prominent, the UN Intergovernmental Panel on Climate Change and various groups of highly reputed experts have also to be mentioned) have, arguably, been vindicated and there is a wide-spreading wakeup call in this respect;there is mounting evidence that points the finger at an existential threat due to effects of global warming and overall climate change, to environmental degradation. Climate change will foster more migration, massive shifts of population from increasingly inhospitable areas. And one can already see how disruptive such migration can be socially, economically, and politically. Therefore, timely and appropriate measures must be taken to address climate change.
I would like to focus in my short remarks on what the corporate world, regulators, policy-makers, and not least, central banks need to do in order to cope with this existential threat for mankind.
I remember an episode from my life as a Member of the European Parliament (MEP). In 2008 and 2009, climate change was heatedly debated in the EP and action was asked for by many MEPs. Unfortunately, action was stalled, or derailed in advancing legislation and prodding other EU institutions to move resolutely; this occurred owing to the power of vested interests, of car manufacturers especially, and it should be said, due to various EU member states. Ironically, some of those car manufacturer shave been involved in big scandals for obnoxious practices in recent years; they cheated shamelessly on gas emissions they produce. One has to add here disasters caused by the negligence of major oil and gas companies.
Let me say a few words on central banks and their rising concern about climate change. For to see major central banks paying attention to climate change may surprise not a few.As a matter of fact, they have started to pay attention also to income distribution, to new technologies (AI, digitalization, Fintech/block-chain), and cyber-fare.
Central banks realize that their conventional and non-conventional operations do have distributional effects, that income distribution does matter for a fair society, for the stability of democracy. And that, apart from the unknowns that they confront when overhauling their cognitive and operational frameworks, including how to integrate financial markets in their inflation targeting models (which used to think, quite naively, that price stability implies, ipso facto, financial stability), there is a huge challenge posed by climate change. This is because climate change means a different existential territory in view of the threats is poses. A framework for understanding the concerns of central banks when it comes to climate change must consider, inter alia:
– a dramatically changed environment (“low rates for longer with rising vulnerabilities (as the latest Global Financial Stability report of the IMF remarks), demographics, economic stagnation (or secular stagnation, as Larry Summers suggested, and a “regime change” for monetary policy, as Olivier Blanchard put it[ii];
– the exposure banks and other financial institutions have to sectors that are and will be severely impacted by climate change;
– de-carbonization of the economy, which has to happen. Green finance is a catchword in this regard and central banks can and are supposed to do a lot in this respect by, among other things, accepting green bonds as collateral, or purchasing them outrightly.
One needs to highlight a network of central banks that examine climate change seriously and aim at adapting their policies in this regard. This network was initiated by the Bank of England and includes the Fed, the Bank of Canada, Banque de France, the Bundesbank. The ECB has joined in this demarche. And I bet that the National Bank of Romania will become a member of this network.
Reexamining monetary policy neutrality
What about “market neutrality”? Should it be maintained as a central tenet of central banks’ conduct when it comes to climate change?[iii] This is probably the most critical issue to address. Central banks’ stance seems to make sense in view of their central banks’ traditional philosophy not to interfere in markets’ allocation function. But, as it is alluded above, one has reasons to question this stance in view of financial markets’ inherent myopia and, regarding climate change, of massive inter-generational distribution effects that are involved, as well as negative externalities that are not factored in by markets.
As central banks have resorted to QEs, and in doing it, have considered, for instance, how to support SMEs, why not favor sectors that are lesser polluters and green industries? This is the spirit of green finance. It may be that central banks have to broaden their mandate; as they do pay attention to distributional effects of their operations, they have to consider climate change and whether they can do something about it. Not necessarily alone, certainly, but together with other public policy-makers. But I would argue that they have to go beyond considering various risks and banks’ exposure to sectors which are heavily impacted by climate change; they need to think in terms of enhancing a sustainable habitat for people. This may imply a change of philosophy and conduct.
To sum up, three perspectives can one imagine on monetary policy neutrality: one that keeps things unchanged; one that keeps the policy rate neutral, but redefines “neutrality”; one that discards neutrality. Let’s focus on the latter two.
A. Redefining “neutrality”
A “neutral policy rate” (NPR) implies non-interference with market resource allocation. But NPR relies on potential output growth and takes the inflation target as the key parameter; some central banks (Fed for example) consider also unemployment as a policy parameter. Potential output can be redefined in terms of “welfare” (the whole debate on redefining GDP, shifting to Gross Welfare Product).
One can add another dimension to potential output/growth, namely “sustainability”, the extent to which economic activity can harm the environment. Slower economic growth may be better than higher growth, a sort of steady-state economics. This happens when growth produces lots of negative externalities. The bottom line: the policy rate would consider a level of economic activity that takes into account social and ecological concerns. But who would define that level of economic activity? This a fundamental question, for it may cripple central banks‘ independence to the extent “non-harming environment potential growth” would be set by someone else…
Or central banks would not consider environmental concerns in their decision algorithms and governments, instead, would favor less carbon-intensive sectors –as part of an overall industrial/environmental policy. In this case, central banks maintain a monetary policy neutrality stance that would be like option one.
B. Discarding neutrality:
Discarding market neutrality relies on a fundamental assumption: that markets are too myopic to consider ecological concerns. In this respect, I would make a distinction between accepting “green bonds” as collateral and redefining the policy rate as a “green policy rate”.
Discarding market neutrality introduces a clear bias in formulating the policy rate. As Mark Carney said: there could be an environmental Mynskian type moment. Among aspects to consider I would mention:
– heavy exposure of banks, of finance in general, to high carbon emitting (carbon intensive) sectors; the aim is to reduce this exposure, via regulation and preference for green bonds
– central banks need to work together with governments
– transition costs to a new, “sustainable equilibrium” may be high, but unavoidable
– there is a “coordination problem, that regards not only emerging economies…
Akey problem persists: who would set the policy rate? Another cognitive and operational issue: can we have models that, as finance is being introduced in revised new Keynesian frameworks, consider environmental concerns too? I guess it is possible.
There are influential voices (Jens Weidmann, the governor of Bundesbank) who say that monetary policy is already overburdened, that ecological concerns should not additionally constrain monetary policy. This view clashes with other central bankers’ view –for instance Mark Carnery, Villeroy de Galhau, and Christine Lagarde.
Another policy issue is whether one can devise macroprudential policies MPPs) measures that consider environmental concerns by reducing overexposure to high-carbon sectors. Clearly it is possible
Can a carbon tax deal with negative externalities (as a group of eminent economists, including Nobel Prize laureates argued ina Wall Street message of 17 Jan 2018)? I would argue that taxes can help considerably since they influence incentives. But, as is the case with a Tobin tax, taxes may not be enough to change business conduct dramatically. The corporate world, major companies in particular, have to turn into stake-holders, alter their short-termism in pursuing their profit objective. Ethical considerations have to get into the picture as well. Maximizing profits has to be constrained by other goals, by the need to make our life sustainable, by an injection of ethical values.
Business models have to change, as would individual and collective habits have to. But can we change our economic and social models, “reinvent capitalism”? There is an ongoing debate on this topic, that was triggered by the financial crisis and the waking up to the reality of proliferating “winners take all” games, the erosion of the middle class.[iv]
Economics, applied economics in particular, need to overhaul themselves too. Let me mention a few tracks of action:
– changing GDP to other welfare measure; the report produced by a group of economists led by Joseph Stiglitz and Jean Paul Fitoussi[v] comes to my mind, and more recent work by Diana Coyle and Mariana Mazzucato as well;
– focusing on citizens’ life conditions; some suggest that the median-income per capita should be a key measure for policy-makers; that would hook up well the notion of inclusion;[vi]
– how to make “stake-holders’’ concept embedded into firms’ natural temptation to pursue higher profits and be responsive to share-holders primarily; interests remain a big challenge.
A recent statement of the Business Roundtable in the US, that groups 180 CEOs of the most powerfulAmericancompanies[vii] suggests that something may have happened in their collective mindset in view of the natural calamities of recent years. These calamities can no longer be seen as isolated events…as tail events; they have become rather common occurrences and this cannot be looked upon nonchalantly. Things have become very worrisome and we need to provide answers to key questions:
– can we summon the political will to do something significant about it?
– do we have the knowledge and the resources to change business models and society’s interaction patterns in order to make transition to sustainable life?
– can we do it at a time of a new “cold war” between the US and an economically and technologically growing China? When Realpolitik and Geopolitics, Geo-economics are back in action?
– can the EU play a global “coordinating” role in this respect in view of Europeans’ attachment to “green values”?
Can powerful vested interests be overcome? Can all this be achieved within the time span thatit appears we have at our disposal in order to obtain our habitat livable? How can we cope with so many disruptions and ruptures simultaneously?
Central banks have a major role to play not only since they have been regarded, justifiably or not, as “the only game in town” (Mohamed El Erian). Christine Lagarde’s words in the European Parliament, where she indicated empathy with the idea that “market neutrality” needs to be reexamined, were quite refreshing.
Policy-makers, in general, have to be much more attentive to sustainable growth challenges in their decision making.
At ISEE we plan to assign more of our activity to climate change and to work together with kindred spirits, with other groups that have similar concerns.
[i] Nicholas Stern, “The Stern Review: The Economics of Climate Change”, London, LSE, 2006
[ii] Olivier Blanchard, in his presidential speech at the annual AEA meetings of Jan 2019: (“Public debt and low interest rates”)
[iii]See also Benoit Coere, “Monetary policy and climate change”, ECB, 8 November 2018
[iv]I would single out a few thoughtful works: Paul Collier’s “The Future of Capitalism. Facing the New Anxieties”, Allan Lane, 2018; Raghuram Rajan, “The Third Pillar: How markets and the State leave Community behind” Penguin, 2019”; Paul Mason: Post-capitalism: A Guide to Our Future”, London, Penguin Books, 2015, .
[v]Joseph Stiglitz, Amartya Sen, Jean PaulFitoussi, ““Report of the Commission of the Measurement of Economic Performance and Social Progress ”, Paris, 2010
[vi]Klaus Schwab, “Ending short-termism in keeping score”, Project Syndicate, 17 October. 2019