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Climate change and central banks: The case for violating neutrality

Summary:
Climate change is a defining challenge for politicians, policymakers, and financial markets, and it is beholden on each of those to think deeply about the role they can play in limiting the global temperature rise. As the ECB’s strategic review amply demonstrates, central banks are among those institutions increasingly considering their role in meeting climate objectives (ECB 2021). But central banks are unelected, technocratic institutions, operating within strict legal frameworks whose primary task is typically price stability. Any involvement in climate policy must therefore have a sound basis, grounded in the mandate handed to them by elected politicians (Tucker 2019). Motivating central bank action on climate change within existing mandates Therefore, one justification

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Climate change is a defining challenge for politicians, policymakers, and financial markets, and it is beholden on each of those to think deeply about the role they can play in limiting the global temperature rise. As the ECB’s strategic review amply demonstrates, central banks are among those institutions increasingly considering their role in meeting climate objectives (ECB 2021).

But central banks are unelected, technocratic institutions, operating within strict legal frameworks whose primary task is typically price stability. Any involvement in climate policy must therefore have a sound basis, grounded in the mandate handed to them by elected politicians (Tucker 2019).

Motivating central bank action on climate change within existing mandates

Therefore, one justification typically given for central banks to involve themselves in climate policy is that such considerations already fall within existing mandates (Schnabel 2021). Climate change and associated policy responses may impact inflation through its impact on economic activity and very large swings in certain relative prices. Moreover, climate change has implications for financial stability if banks are highly exposed to assets whose value is compromised by physical and transition risks, or if financial markets are failing to price certain climate scenarios (Löyttyniemi 2019).

But these justifications are not without objections. The impact from climate change on inflation is likely to be felt over much longer horizons than central banks operate over – what Carney (2015) has called the tragedy of the horizon. And it is not obvious that central banks will always possess superior knowledge relative to the private sector on how assets should be valued in light of climate risks.

A more fundamental justification

Instead, we argue that the most robust case for central bank involvement in climate change is more fundamentally because the central bank can do some good in furthering a policy priority of government and a challenge of critical importance to the entire polity (Bartholomew and Diggle 2021). The pressing urgency of climate risks means that all public policy levers should be employed in the pursuit of meeting government climate objectives. Or at the very least, central banks should not be acting in a way that pushes against government objectives in this area.

For a central bank like the ECB, which has a secondary mandate that “without prejudice to the objective of price stability, the ECB shall support the general economic principles and objectives of the Union” (one of which is tackling climate change), this falls within existing mandates. To ensure democratic transparency and accountability, central banks with narrower mandates require legal changes or clarifications before they can pursue policy along these lines, as for example has happened with the Bank of England. Indeed, ultimately elected politicians could add an explicit climate mandate to a central bank’s objectives, overcoming objections of technocratic overreach in one fell swoop.

Climate policy is different in this regard from arenas like industrial policy or reducing inequality, which are sometimes added to the long list of things central banks could do, for two reasons. First, climate change is potentially existential – the future survival of the polity itself may be at stake. This is why mobilising central banks to fund total war efforts is a legitimate use of monetary policy, but industrial policy or inequality, for all their importance, are not. And second, central banks do actually have some potentially quite effective tools in the fight against climate change, in a way they do not in other arenas.

‘Green monetary policy’ would violate central bank neutrality

However, this argument typically runs into the objection that it violates the standard commitment to central bank neutrality. Neutrality in this context means the central bank setting policy to affect the aggregate variables of the macroeconomy – nominal growth and employment – rather than to affect the microeconomic considerations of precisely in which sectors or regions economic activity occurs, including whether activity should occur in ‘green’ or ‘brown’ sectors. There are indeed several reasons why neutrality is typically an attractive property of central bank behaviour. 

First, as long as market failures are limited, decisions about how and where production occurs are generally best made by the private sector. Efficiency is best served by allowing market mechanisms to allocate resources within a macroeconomic context consistent with full employment. 

Second, if the public sector does involve itself in questions of microeconomic allocation, perhaps because of market inefficiencies or considerations like equity or economic geography, in a democratic society this is the responsibility of an elected government rather than technocrats.

Third, to the extent to which the central bank starts to involve itself in some allocative issues, it might find itself under pressure from the government to intervene in ever more areas of the economy. This pressure could see the gradual politicisation of the central bank, which may undermine confidence in price stability.  

These kinds of considerations would seem to lean quite heavily against central bank involvement in climate issues, because the entire point of central bank involvement would be to make certain kinds of economic activity face a systematically higher cost of capital (i.e. ‘brown’ industries) and other kinds of activity face a systematically lower cost of capital (i.e. ‘green’ industries). This seems clearly to be microeconomic credit allocation policy and so a violation of neutrality.

But ‘unconventional’ monetary policy already violates neutrality

However, it is hard to see how the full suite of post-crisis tools employed by central banks is neutral in this way. Purchases of government bonds, investment grade credits, and high yield credit; providing liquidity on generous terms; and use of negative rates all impact the economy through quite different channels. For example, buying corporate bonds tends to help those firms who issue bonds, while enhanced liquidity provision helps banks. So the very use of these tools seems to be non-neutral in that they impact some sectors more than others.

And it is not just the tools themselves, but the way they are employed together which is also non-neutral. Monetary tools can be substitutes for one another at the margin – using this particular tool more means this other tool needs to be used slightly less to achieve the same macroeconomic objective. Slightly more asset purchases might mean slightly less use of highly negative interest rates or slightly less liquidity provision. Because those tools work through different sectors of the economy, using more of one tool and less of another will have different impacts on different sectors, and hence violate neutrality. 

None of this is to say that there is anything wrong with the many new tools introduced by central banks after the financial crisis. The point is just that they were not neutral. Indeed as Schoenmaker (2019) notes, ECB policy is already non-neutral in the sense that its policies tend to systematically bias support towards carbon-intensive activities. 

‘Strong form’ neutrality is unachievable, and ‘weak form’ neutrality is rightly violated when existential questions are at stake

It is therefore helpful to distinguish between two concepts of neutrality: strong and weak form neutrality. Strong form neutrality is where central bank actions have no impact on microeconomic allocation within the context of a particular constellation of macroeconomic aggregates. Weak form neutrality is where central bank action impacts microeconomic allocation but this is an unintended and perhaps unavoidable consequence of pursuing optimal policy for the macroeconomy. 

So while corporate QE is non-neutral, it is non-neutral in a rather different way to skewing purchases of corporate QE towards ‘green’ companies to deliberately influence microeconomic outcomes. In other words, corporate QE violates strong neutrality, but not weak neutrality, while green QE violates both forms.  

However, the point still stands that once we accept that strong form neutrality is impossible, the questions stops being about whether this or that policy is strictly neutral and whether the violation of neutrality is justified. And it seems perfectly plausible that even intended violations of neutrality could be justified so long as they were consistent with the broader democratic commitments of the society in which the central bank operates, and are welfare enhancing. This is especially so if continuing with policy as normal, under the pretence that this is somehow consistent with weak form neutrality, is actively biasing policy against achieving governmental climate objectives.

So in those societies that choose to give mandates to central banks to help pursue climate objectives, deliberate violations of neutrality to aid the green transition would be justifiable because of the extreme welfare consequences at stake.

References

Bartholomew, L and P Diggle (2021), “Central banks and climate change – the case for action”, SSRN, 29 July.

ECB (2021), “ECB presents action plan to include climate change considerations in its monetary policy strategy”, Press Release, 8 July.

Löyttyniemi, T (2021), “Integrating climate change into a financial stability framework”, VoxEU.org, 8 July.

Schoenmaker, D (2019), “Greening monetary policy”, VoxEU.org, 17 April.

Schnabel, I (2021), “From green neglect to green dominance?” Intervention by Isabel Schnabel, Member of the Executive Board of the ECB, at the “Greening Monetary Policy – Central Banking and Climate Change” online seminar, organised as part of the “Cleveland Fed Conversations on Central Banking”, 3 March.

Tucker, P (2019), Unelected Power, Princeton University Press.

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