Central banks cannot afford to be casual bystanders in the climate crisis

Is it possible to ignore the winds of change blowing across the rest of the world? Very unlikely, yet central banks seem intent on sheltering from the headwinds battering everyone else by clinging on to a self-determined conservatism regarding their way of “doing business”. Their blinkered focus on maintaining market neutrality (the existence of which is doubtful in the first place) and taking only a very narrow definition of inflation risk might threaten financial stability as well as price stability in a climate constrained world.

Instead, a more nuanced and active approach is needed, in which monetary policy is used to steer economic activity towards more sustainable endeavours, supporting central banks’ mandates as well.

The sanctimonious mantra of the monetary community asserts that a central bank targeting inflation can effectively govern the monetary needs of an open macroeconomy via its interest rate policy, and that it should not deal with anything else but targeting inflation. Indeed, this lofty view that there is one objective, one instrument and nothing else matters has eventually become a convenient excuse for immobility on climate issues.

However, this “casual bystander” approach is currently under scrutiny, as it becomes clear that failing to incorporate the climate crisis into economic analysis might be misleading and even dangerous. This was one of the key messages of the latest report from the Intergovernmental Panel on Climate Change, which explains that “climate change is already affecting every inhabited region across the globe with human influence contributing to many observed changes in weather and climate extremes”.

Climate change is no longer a problem for future generations

So far, central banks have managed to avoid their climate responsibilities as, until recently, visible impacts of the looming climate crisis were largely local and temporary (at least from the perspective of developed nations). Climate-related risks have been conveniently regarded as longue durée problems to be tackled by the next generation, and were simply alluded to as a “tragedy of horizon”.

But this is no longer the case. As the urgency of the anthropogenic climate crisis becomes real and explicit, greening the global financial system has moved up the agenda for everyone, central banks being no exception. Climate change itself poses serious risks to the price and financial stability objectives of central banks. They can – and indeed ought to – steer the global economy towards decarbonised pathways of transition and a greener financial system, while still pursuing stability aims.

So there is clearly an unavoidable need to deepen our knowledge on designing a “green” central bank, one that takes environmental risks, including climate change, into consideration.

There is still a tremendous investment gap to be filled on the way to fulfilling the 1.5°C goals of the Paris Agreement. McKinsey, for instance, reports that the total investment cost of the European Green Deal will likely reach €30tn between 2020 and 2050. The International Energy Agency calculates that the financial requirements of the energy transition are expected to add 1.5-2% to investment-GDP ratios in the developed countries.

It is unrealistic to expect market players to fill this gap on their own. What is more, markets are already skewed to finance carbon-intensive sectors. This could be the result of a lack of information, lack of guidance, or simply a limited supply of green financial alternatives. While provision of credit by banks to socially undesirable activities, as well as underdevelopment of required markets and instruments, are noted as “market failure“, central banks are expected to have a role to play in the development of a securities market to correct this failure.

Interest rates are a poor tool for climate mitigation

In setting the stage for shifting monetary policy towards a green economy, perhaps the key point of departure is to appreciate the role of money “as a hierarchy of promises to pay“. Money is, in essence, a continuum of liquidity, and it is this flexibility that makes central banks the supreme authority over monetary policy, setting the elasticity of the money market overall and banks’ power of credit intermediation in particular.

Monetary policy is, in Mehrling’s words, “about setting the settlement constraint by the banking system”, with the real question being: how can we get elasticity for the projects we favour, and discipline for the projects we oppose?

The cumbersome nature of interest rates as a control instrument in matters of climate mitigation is obvious. Simon Dikau and Josh Ryan-Collins have said that “in advanced economies, central bank mandates are predominantly focused on price stability, and yet many of the central banks in [emerging and developing countries] have a wider remit to support sustainable development and the government’s economic policy agenda”.

Dikau and Ulrich Volz have further argued that higher inflation in less-developed and middle-income countries make them more vulnerable to climate change-related supply side shocks, emphasising the urgent need for taking climate change into consideration in their monetary policy interventions.

In fact, even though climate change is a planetary problem, its effects are not symmetric across the global economy. In its trade and development reports, the UN Conference on Trade and Development describes how the climate crisis is having significantly greater impact in the global south, while Dikau and Ryan-Collins note that “[emerging and developing countries] are more exposed to the immediate challenges of climate change. Many face greater physical risks, including more frequent, climate-change-related, severe weather events. They also recognise the need to rapidly shift their economies on to a sustainable “green growth” path for their future prosperity and energy security.”

Climate impacts mirror existing economic and social imbalances

The climate crisis exposes the uneven character of the global economy in its entirety. The International Labor Organization (ILO) predicts that, by 2030, productivity decline due to heat stress will result in the loss of 280 million jobs and US$2.5tn of global income. Yet, the burden of such losses will disproportionately fall on low-income countries.

Accordingly, ILO expects that over the same time horizon, losses in gross income are projected to rise to 1.9% and 4.4% in low-income and low-middle income economies respectively, while they are expected to stay around at 1% in high-income countries. Job losses are similarly expected to be grossly asymmetric, with South Asia and West Africa being hit the hardest.

Oxfam’s celebrated report on global emissions and income inequality further reveals that per capita CO2e emissions of the richest 1% increased by 25% compared to 1990, and that by 2030 they will be 30 times higher than the level compatible with the 1.5ºC target. On the other hand, emissions created by the poorest 50% will be 20% below the global average. Observers have coined the term carbon colonialism to describe how climate impacts mirror existing economic and social imbalances.

From the perspective of the least-developed countries, the dilemma is real and acute. As the most recent UNCTAD report says, they are “having to pursue economic development while keeping emissions and resource consumption within the ecological limits of the planet”.

Resolving this dilemma calls for decisive interventions in favour of a sustainable growth pathway, one that respects the well-being of our planet as well as the rights of the future generations, while simultaneously enhancing social welfare for the people of today. This will require designing a whole new strategy of structural transformation based on renewable energy and repurposing technologies and institutions dependent on fossil fuels, including central banks.

Central banks will have to shift towards a more active policy stance that is more engaged with eliminating structural bottlenecks, rather than hiding behind market neutrality in their pursuit of price stability.

We need to remind ourselves of an important principle of practicality that, in central banking discourse, what constitutes appropriate policy in normal times and times of crisis ought to be established. Against the unfolding climate crisis, greening central banks is more a question of “how”, rather than “if”.