Faced with the pandemic crisis and its economic and financial consequences over the short- and medium-term, central banks have found themselves in a position of guardians of chaos. We have been familiar with the methods they have used since their response to the financial crisis of 2008. The unconventional monetary policies tested ten years ago have become the new normal. But the current threefold health, environmental and social crisis related to the Covid-19 pandemic appears to be an on-going phenomenon, no doubt signaling the start of a new period characterized by the now inevitable ecological tipping points we will be going through.
Central banks can no longer offer a guarantee of financial stability that is clearly speeding up our overuse of the planet’s limits. In this aspect, the crisis is of a very different nature than in 2008 and is thus an argument for a deeper overhaul of the central bank regime.
The principle of market neutrility is being called into question as we face this crisis
There are several clues indicating a growing awareness of the need for a change of regime. Thus we recently heard Christine Lagarde incriminate the notion of market neutrality when discussing the question of climate change.
The rhetorical abandonment of market neutrality as a principle for intervention by the European Central Bank paves the way to a much more proactive regime of intervention for central banks in relation to financial stakeholders. The Central Bank can now officially modify price structures, and therefore put forward an outlook that may reconnect financial stakeholders’ expectations with the long-term goals of public policy.
The recent decision by the Bank of England to recreate short-term lines of credit with the British Treasury and the concerns expressed by the Federal Reserve on the impact of monetary policies on inequalities are further signs of the end of the overriding principle of independence of monetary and policy authorities.
It is now monetarily unsustainable to justify policies of massive financial asset purchases that contribute to perpetuating a carbon economy that the European Commission seeks to eliminate politically through its Green Deal policy. Monetary policy, and notably asset purchases, must not in practice increase wealth inequality among citizens. That is why, now more than ever, we need to question the transmission channels for monetary policy to make sure that it provides support for government responses to the Covid-19 crisis and give a breath of fresh air to business, while ensuring a more sustainable recovery that is equally beneficial to all residents of a given monetary area.
The need for real global coordination
There appears to be a need to speed up closer coordination between public policies (notably in terms of social, climate and biodiversity goals) and monetary policies during this crisis. This coordination is, in fact, an explicit goal of the European Central Bank, enshrined in article 127 of the Treaty on the Functioning of the European Union, but which is seldom applied.
Beyond its health aspects, the Covid-19 crisis first spread through international financial markets. The emerging and developing economies have undergone a spectacular turnaround in their financial cycles even though they have often just been marginally affected by the pandemic. We are currently seeing capital flight from the developing countries, and consequently an increase in their interest rates. In practical terms, this means that the poorest countries will have even more trouble financing their short-term social response or their long-term investments to speed up their ecological transition. The dynamics of financial cycles are now global, and this globalization is also at the heart of the environmental aspects.
As recently indicated again in the analysis by the Central Bank of the Netherlands, Dutch finance is exposed to a number of “biodiversity” risks due to activities undertaken outside the country, either by contributing to the degradation of protected ecosystems, or because it depends on their ecosystem services for its perpetuation.
The alignment of international financial flows with the climate objectives for carbon neutrality in the Paris Agreement (and soon no doubt the objectives for restoring biodiversity at the COP15 in Kunming) requires that we move beyond the simple framework of coordination on a national or monetary union level. The Network for Greening the International Financial System (NGFS) is currently playing this institutional role as a stakeholder in the alignment, although it has not embodied it on a practical level in dealing with the pandemic crisis.
Central banks: international liquidity in the service of the ecological transition
Beyond the alignment of financial flows, the coming decade will require nothing less than a redefinition of international liquidity conditions. Otherwise, it would be difficult to imagine the elimination of oil and other fossil fuels that are key to financing many economies. Concretely, this entails easing up access to financing, including reserve currencies, for countries or financial institutions that implement these shared objectives on a practical level. This will have to replace the restrictive macroeconomic conditions that are currently applied in the wake of the Covid-19 crisis and which, on the contrary, tend to increase social as well as environmental risks.
China, the United Kingdom, the European Union, Switzerland and Japan, i.e. five of the six international currency reserve countries, are already working toward carbon neutrality for the medium term, which they could also support globally. Sustainable currency exchange agreements, or swap lines – called green swap lines here – between a reserve currency country and other countries around the world could take on this new role in international liquidity alignment with these vital ecological objectives.
Essential prerequisites for this would be the definition of a common taxonomy as to which forms of investment are compatible with the timelines adopted and with decarbonization trajectories adapted to each context, as well as a network of public banking institutions as an intermediary able to guarantee their proper application.
At the end of the day, the central banks will have a key role to play in the coming decade to reduce the level of uncertainty surrounding the ecological transition and to create conditions of trust in the private sector for it to adopt the goals of carbon neutrality and the restoration of our ecosystems.
The opinions expressed on this website are those of the authors and do not necessarily reflect the official position of their institutions or of AFD.