There is increasing pressure on central banks to take climate change into account in formulating monetary policy. The Bank of England and the European Central Bank have already done so, and the Fed may follow suit. Indeed, the Fed’s move into credit allocation and fiscal policy, as a result of the 2008 financial crisis and the COVID-19 pandemic, has set a precedent for mission creep.
One of those calling for action is Megan Greene, a senior fellow at the Harvard Kennedy School of Government and a columnist for the Financial Times. This article will consider her case for the active use of monetary policy to support a green agenda.
Greene’s Case for Activism
In a recent interview with David Beckworth, on his Macro Musings podcast (September 20), Greene stated:
My thinking on [central banking and climate change] has totally changed over the past I'd say year and a half. I actually wrote a column in the Financial Times [December 12, 2019] that effectively argued that central banks have no business really getting involved in climate change beyond a real supervisory role. You can always get an audience with a central banker if you want to talk about . . . financial risk and climate change. That's easy for most central bankers to swallow. The question is whether monetary policy should really be addressing climate change. . . . And I actually was against it because I thought central banks have a time horizon of two, three, maybe four years where they're forecasting. And the implications of climate change are much further out than that. And so it's really difficult for them to respond to something so far out given that time horizon. I'd say the climate related events of just this summer alone take that argument out at the knees.
Greene now sees climate change as an existential threat requiring immediate action, with a strong role for central banks including the Fed. She argues that the Fed already has the tools to deal with climate change, and that its dual mandate to ensure long-run price stability and maximum employment already gives it the authority to deal with climate change, which could seriously affect both objectives.
Central banks have always picked winners and losers at their own discretion, according to Greene, and they always will. Hence, “they might as well be thoughtful about it and address one of the biggest crises that we're facing.” Moreover, she argues that, “if you think climate change is as existential a threat as a war, then you can argue easily, I think, that central banks should step in again in the face of this threat.”
Greene is concerned that opening the door for the Fed to subsidize green investments could blur the line between fiscal and monetary policy, and further politicize the Fed. Nevertheless, she discounts that risk relative to the grave danger she believes global warming poses for economic growth and price stability.
She also recognizes the knowledge problem confronting central banks in defining a green bond or investment. The European Union provides guidelines, but they are untenable. No one has the time to wade through hundreds of pages of obtuse documents. So decisions will likely be heavily reliant on the discretion of central bankers and politicians. However, Greene believes “you’ve got to start somewhere,” and that learning will occur with trial and error.
In thinking about the next steps central banks should take in addressing climate change, Greene offers the following advice:
So I think [central banks] should continue considering the financial stability side of this, but I think they should also figure out how they might provide finance to retrofit our lifestyles so that they're more sustainable. And there the central banks sort of uniquely have an easy role to play I think by saying we'll subsidize this stuff, go out and do it. And I think people would do it pretty quickly if it were subsidized. I would love to see that happen. And alongside that, I think there's a real reticence on behalf of regular people to recognize that our lifestyles have to change fundamentally if we're going to get on top of this. But if you were to provide finance to help us get there, then people might be more willing to go ahead and adopt new practices and make their houses more green and their transportation more green as well. So I think central banks could have a quick and easy role to play if they could get there.
But why does Greene assign such a duty to the Fed and not Congress? Do we really want to give central banks even more discretion and expand their power? Or would a change of focus—from discretion to rules—provide a sounder framework for reducing uncertainty and dealing with climate change?
The Risks of an Activist Central Bank
Greene sees two key factors in dealing with existential threats: the impact of the threat and its probability. Clearly, climate change could have a substantial impact on the economy, but estimating the probability of that threat is very difficult. There is much uncertainty surrounding climate change.
A prominent scientist, Roger Pielke Jr., who has for many years has argued that human climate change is a problem and something should be done about it, recently testified to the U.S. Senate that:
Unfortunately, key scientific guidance on climate that informs policy—including central bank climate stress testing and U.S. government estimates of the social cost of carbon—has departed from basic standards of scientific integrity. A main reason for this departure is that climate science has increasingly been enlisted in support of policy advocacy rather than to inform policy debates and decisions.
Pielke also argues, and backs this up by discussing the UN Intergovernmental Panel on Climate Change (IPCC) report, that “climate scenarios that underlie much of research on climate, its impacts and policy responses are badly outdated and no longer offer insight to plausible futures.” His testimony should give pause to those who speak with certainty of imminent climate change and the need for rapid central bank responses. Indeed, the IPCC report itself does not paint a dismal picture; it dumps the doomsday scenarios.
The critical question is whether individual behavior is best modified by natural market forces and private innovation in response to price changes, or whether the Fed has a comparative advantage in dealing with uncertainty. Elinor Ostrom and others have shown that the “problem of the commons” can often be resolved by private action, while Karl Brunner and others have shown that a central bank with wide discretion may actually increase uncertainty and exacerbate business fluctuations.
The Case against an Activist Central Bank
Instead of having the Fed and other central banks using their discretion to “figure out how they might provide finance to retrofit our lifestyles,” which would lead to politicization and a loss of central bank independence, proponents of an activist central bank should heed the advice of Karl Brunner:
We suffer neither under total ignorance nor do we enjoy full knowledge. Our life moves in a grey zone of partial knowledge and partial ignorance. More particularly, the products emerging from our professional work reveal a wide range of diffuse uncertainty about the detailed response structure of the economy. . . . A nonactivist [rules-based] regime emerges under the circumstances . . . as the safest strategy. It does not assure us that economic fluctuations will be avoided. But it will assure us that monetary policymaking does not impose additional uncertainties . . . on the market place.
Brunner’s rules-based approach to monetary policy is in sharp contrast to Greene’s approach. Like F. A. Hayek, Brunner sees market competition as a discovery process, dependent on well-defined property rights, a genuine rule of law, and a price system that effectively makes use of decentralized knowledge and relies on the profit motive to spur innovation. In this sense, if climate change leads to higher prices, people will not stand still: they will obey the laws of demand and supply and change their behavior. Buyers will buy less of the relatively higher-priced goods and switch to substitutes, while entrepreneurs will search for better ways of doing things and provide consumers with a greater variety of choices. The Fed’s role in all this would be to provide liquidity in times of crisis and maintain a level growth path for nominal GDP.
This is not to deny that there are externalities and “market failure,” but it is not the role of the Fed to internalize those externalities, and the provision of subsidies is a fiscal, not monetary, function of government.
Free private markets take time to reallocate resources, but the higher the price and the greater the profit expected from increasing market supply—or creating new, cost-effective, goods and services—the faster the adjustment process will be. The long run is not a fixed period of time; it is a theoretical concept that assumes no fixed factors or technological progress. If prices and factors are free to move, and entrepreneurs are free to capture the net benefits from their successful ventures, then climate change is likely to be something the human race can deal with and survive.
In dealing with climate change, it is useful to consider Douglass North’s term “adaptive efficiency,” by which he means discovering institutions that can adjust to “resolve problems associated with fundamental economic change.” He notes four conditions necessary for a smooth adjustment process: (1) “a shared belief system about the legitimate ends of government and the rights of citizens”; (2) a constitution that places “limits on government decision making”; (3) well-defined “property and personal rights”; and (4) a rule of law that protects citizen’s rights “against opportunism and expropriation by public officials.” A society with these types of institutions (both formal and informal) stands a better chance of dealing with climate change and advancing human progress than one based on bureaucratic control. Of course, a “shared belief system” is tough to come by when we’re talking about climate change and other controversial issues. That is why getting the facts right is crucial.
Like North, Charles Plosser, former president and CEO of the Federal Reserve Bank of Philadelphia, recognizes the need for sound institutions or rules to ensure that centralized power is limited and the scope for good policy options is enlarged. In the case of the Fed, he argues:
I fear that the public has come to expect too much from its central bank and too much from monetary policy in particular. . . We have assigned an ever-expanding role for monetary policy, and we expect our central bank to solve all manner of economic woes which it is ill-suited to address.
That statement was made at Cato’s 31st Annual Monetary Conference, in November 2013, when the Fed’s balance sheet was around $4 trillion. Today it is more than $8 trillion and the Fed’s power has grown significantly as a result of the COVID-19 pandemic.
Plosser wants a “limited central bank”—one based on rules—rather than a discretionary central bank with mission creep and no clear rules to guide monetary policy. As he notes,
I believe that the Fed’s aggressive pursuit of broad and expansive objectives is quite risky and could have very undesirable repercussions down the road, including undermining the public’s confidence in the institution, its legitimacy, and its independence.
Before rushing in to make the Fed and other central banks get heavily involved in the complex web of green guidelines, which can be gamed by large law firms, it would be prudent to take account of the limits of central banks to resolve the Hayekian knowledge problem. Making the U.S. economy more resilient by removing barriers to competition, safeguarding private property rights, and making the Fed accountable for long-run price stability would better serve the public interest than placing another burden on the central bank by making it responsible for mitigating climate change.
Radical uncertainty cannot easily be eliminated, but steps can be taken to reduce institutional uncertainty. By adopting a rules-based approach to monetary policy, central banks would be more limited, there would be greater certainty about the course of monetary policy, and public expectations regarding the role of monetary policy would be more realistic. There would also be a sharper line between fiscal and monetary policy, which would increase central bank credibility and independence.
Instead of having the Fed subsidize green bonds or use negative interest rates to steer funds into green investments, it would be prudent to focus on what the Fed can do—namely, control the growth of money and credit, stabilize the long-run price level, and keep nominal GDP on a level growth path.
Greene’s original skepticism about giving the Fed and other central banks a major role in addressing climate change—both in providing carrots and using sticks to reduce greenhouse gases via targeted monetary policy—is warranted. Her earlier advice, in December 2019, should be taken seriously, namely:
While it’s a good thing central bankers acknowledge the dangers of climate change, it’s also important they recognize what they can and cannot do about it. Perhaps they can find ways to finance the fight. But they have no real policy role. Their job is to contain the fallout.
A close look at the difference between a discretionary central bank and one guided by rules in the face of uncertainty raises legitimate doubts about the ability of central bankers to achieve what North has called “adaptive efficiency” in the pursuit of policies designed to taper climate change.
Limiting central banks to simple rules in a complex world, while letting markets and prices perform their function of guiding resources to their highest-valued uses, would be a surer way to address climate change than an activist central bank.
Cato’s 39th Annual Monetary Conference—“Populism and the Future of the Fed” (on November 18)—will consider the case for expanding the Fed’s mandate and the risks it poses to maintaining a bright line between fiscal and monetary policy.