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Challenges for central banks.

Summary:
On October 20, I was graciously invited to give a talk at the  ECB Conference on Monetary Policy: bridging science and practice. I survey six challenges facing central banks: 1. Interest rates and inflation; 2. Policy reviews; 3. Financial reform post 2008 4. New challenges to finance post covid; 5. The many risks ahead; 6. Central ...

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On October 20, I was graciously invited to give a talk at the  ECB Conference on Monetary Policy: bridging science and practice. 

I survey six challenges facing central banks: 1. Interest rates and inflation; 2. Policy reviews; 3. Financial reform post 2008 4. New challenges to finance post covid; 5. The many risks ahead; 6. Central banks and climate.  

For the whole thing, go here for a pdf. (The conference website will have video soon.) Items 1-5 are mostly interesting for monetary economists, though general readers might find my summary and distillation of the Fed policy review of some interest. 

Here, I post the section on climate change and conclusion, which are the most novel. And if you like the general approach and want to see it applied to the rest of what central banks are up to, that's another advertisement to read the whole talk pdf. 

In the section leading up to this, I describe risks to the financial system from widespread defaults, sovereign defaults, a US debt and currency crisis, another bigger pandemic, war, political chaos, cyber disaster and a few other unpleasant possibilities. But covid has taught us to prepare for the unexpected.  

....Which brings me to a great puzzle. In this context why are the ECB, BoE, BIS, IMF consumed with one and only one “risk”… climate? 

Challenge 6. Climate, Mission creep, and Politicization risk. 

I think this adventure is a dangerous mistake. 

Disclaimer: I do not argue that climate change is fake or unimportant. None of my comments reflect any argument with scientific fact. (I favor a uniform carbon tax in return for essentially no regulation.) 

The question is whether the ECB, other central banks, and international institutions such as the IMF, BIS, and OECD should appoint themselves to take on climate policy, or other important social, environmental or political causes, without a clear mandate to do so from politically accountable leaders. 

Moreover, the ECB and others are not just embarking on climate policy in general. They are embarking on the enforcement of one particular set of climate policies — policies to force banks and private companies to de-fund fossil fuel industries, even while alternatives are not available at scale, and to provide subsidized funding to an ill-defined set of “green” projects. 

To be concrete, I quote from Executive Board Member Isabel Schnabel’s recent speech. I don’t mean to pick on her, but she expresses the climate agenda very well, and her speech bears the ECB imprimatur. She recommends

"First, as prudential supervisor, we have an obligation to protect the safety and soundness of the banking sector. This includes making sure that banks properly assess the risks from carbon-intensive exposures…"

Let me speak out loud the unclothed emperor fact: Climate change does not pose any financial risk, at the 1, 5 or even 10 year horizon at which one can conceivably assess the risk to bank assets.

“Risk” means variance, unforeseen events. We know exactly where the climate is going in the next 5 to 10 years. Hurricanes and floods, though influenced by climate change, are well modeled for the next 5 to 10 years. Advanced economies and financial systems are remarkably impervious to weather. Relative market demand for fossil vs. alternative energy is as easy or hard to forecast as anything else in the economy. Exxon bonds are factually safer, financially, than Tesla bonds, and easier to value. The main risk to fossil fuel companies is that regulators will destroy them, as the ECB proposes to do, a risk regulators themselves control. And political risk is a standard part of bond valuation. 

That banks are risky because of exposure to carbon-emitting companies, that carbon-emitting company debt is financially risky because of unexpected changes in climate, in ways that conventional risk measures do not capture, that banks need to be regulated away from that exposure because of risk to the financial system is nonsense. (And if it were not nonsense, regulating bank liabilities away from short term debt and towards more equity would be a more effective solution to the financial problem.) 

Next, a pervasive regime essentially of shame, boycott, divest and sanction

"linking the eligibility of securities as collateral in our refinancing operations to the disclosure regime of the issuing firms. …"

We know where “disclosure” leads. Now all companies that issue debt will be pressured to cut off disparaged investments and make whatever “green” investments the ECB is blessing. 

Last, the ECB should print money directly to fund green projects:

"reassessing the benchmark allocation of our private asset purchase programmes. In the presence of market failures, …the market by itself is not achieving efficient outcomes."

Now you may say, “climate is a crisis. Central banks must pitch in and help the cause. They should just tell banks to stop lending to the evil fossil fuel companies, and print money and hand it out to worthy green projects.”

But central banks are not allowed to do this, and for very good reasons. A central bank in a democracy is not an all-purpose do-good agency, with authority to subsidize what it decides to be worthy, de-fund what it dislikes, and to force banks and companies to do the same. A central bank, whose leaders do not regularly face voters, lives by an iron contract: freedom and independence so long as it stays within its limited and mandated powers. 

The ECB in particular lives by a particularly delineated and limited mandate. For very good reasons the ECB was not set up to decide what industries or regions need subsidizing and which should be scaled back, accordingly to direct bank investment across Europe, to set the price of bonds, and and to print money to subsidize direct lending. These are intensely political acts. In a democracy only elected representatives can take or commission such intensely political activities. If I take out the words “green,” you, EU member states, and EU voters would properly react with shock and outrage at this proposal.

That’s why this movement goes through the convolutions of pretending that defunding fossil fuels and subsidizing green projects — however desirable — has something to do with systemic risk, which it patently does not. 

That’s why one must pretend to diagnose “market failures” to justify buying bonds at too high prices. By what objective measure are green bonds “mispriced” and markets “failing?”  Why only green bonds? The ECB does not scan all asset markets for “mispriced” securities to buy and sell after determining the “right” prices. 

Here is another way to put the observation. There are two interpretations of the proposal: 

a) We looked evenhandedly at all the risks to the financial system, like those listed on the last slide, and the most important financial risk we came up with just happens to be climate. 

b) We want to get involved with climate policy. How can we shoehorn that desire into our limited mandate to pay attention to financial stability?  

How do you interpret the proposal? I think it’s pretty obvious that the answer is the latter — or at least that the vast majority of people reading it will interpret it as the latter which is what counts to my point. 

Feeding this perception is the central omission of this speech, and everything else I have read on the subject: any concrete description of just how carbon sins will be measured.

At face value, “carbon emitting” does not just mean fossil fuel companies, but cement manufacturers, aluminum producers, construction, agriculture, transport, and everything else that emits carbon. Will the carbon risk and de-funding project really extend that far, in any sort of honest quantitative way? Or is “carbon-emitting” just a code word to hound the politically unpopular fossil fuel companies? 

In the disclosure and bond buying project, who will decide what is a green project? Already, cost-benefit analysis— Euros spent per ton of carbon, per degrees of temperature reduced, per Euros of 2100 GDP increased, is pretty shoddy in this area.  By what process will the ECB avoid switchgrass, corn ethanol, high speed trains to nowhere, and other past follies? How will it allow politically unpopular projects such as nuclear power, carbon capture, natural gas via fracking, residential zoning reform, or geo-engineering ventures, which all, undeniably, scientifically, lower carbon and global temperatures; or adaptation projects which undeniably, scientifically lowers its GDP cost? 

Actually, where is this analysis for the whole program? Before embarking, I challenge the ECB to calculate  how many degrees this plan will lower global temperatures, and how many euros of global 2100 GDP it will raise in any sort of transparent verifiable and credible way. Never mind the costs, just quantify  the benefits. 

How then will the ECB resist political pressure to subsidize all sorts of boondoggles? If the central bank does not have and reveal neutral technical competence at making this sort of calculation, the project will be perceived as simply made up numbers to advance a political cause. And all of the central bank’s activities will be then tainted by association. 

This will end badly. Not because these policies are wrong, but because they are intensely political, and they make a mockery of the central bank’s limited mandates. If this continues, the next ECB presidential appointment will be all about climate policy, who gets the subsidized green lending, and who got de-funded, what the next set of causes is to be, not interest rates and financial stability. Board appointments will become champions for each country’s desired subsidies.  Watch US Supreme Court appointments for a preview. Countries and industries that lose out will object. This is just the sort of institutional aggrandisement that prompted Brexit. 

If the ECB crosses this second Rubicon — buying sovereign and corporate debt was the first — be ready for more. The IMF is already pushing redistribution. The US Fed, though it has so far stayed away from climate, is rushing to “inclusive” employment and racial justice. There lots of problems in the world. Once you start climate policy, and so obviously break all the rules to do it, how can you resist the clamor to de-fund, disclose, and subsidize the rest? How will you resist demands to take up regional development, prop up dying industries, subsidize politician’s pet projects, and all the other sins that the ECB is explicitly enjoined from committing?

A central bank that so blatantly breaks its mandates must lose its independence, its authority, and people’s trust in its objectivity and technical competence to fight inflation and deflation, regulate banks, and stop financial crises.

A positive piece of advice: Go ask for an expanded mandate. If the EU explicitly tasks the ECB with implementing carbon policies via defunding, bank regulation, and subsidized investment, all of my objections vanish. An explicit mandate to address climate, and only climate, would also help the ECB to defend against the coming demand that it move on to every other problem.

Summary

The western world faces a crisis of trust in our institutions. And that crisis is fed by a not inaccurate perception that the elites who run our institutions don’t know what they are doing, are politicized, are expanding actions beyond the authority granted by  accountable representatives. 

Trust and independence must be earned, by evident competence and institutional restraint.

Yet central banks, not obviously competent to target inflation with interest rates, floundering to stop financial crisis by means other than wanton bailouts, not beginning to address obvious risks lying ahead, now want to determine and implement their own climate change policy? (And, next to move into inequality and social justice?)  

We don’t want the agency that delivers drinking water to make its list of socially and environmentally favored businesses, and start turning off the water to disfavored companies. Nor should central banks. Provide liquidity, period. 

Yes, there is a popular movement that wants all institutions of society to jump in to the pressing social and political goals of the moment, and the heck with boring legalities. But I hope everyone in this room understands those constraints are essential for a functioning democratic society, for functioning independent technocratic institutions, and incidentally for making durable progress on the important social and political goals.

Central banks must be competent, trusted, narrow, independent, and boring. A good strategy review should refocus central banks on their core narrow mission, and let the other institutions of society address big political causes. Boring as that may be.  

*****

Update. A correspondent reminds me that the ECB does not even have a formal financial stability mandate. I left that in as nobody seems to mind, but it might be worth formalizing that mandate as well. 



John H. Cochrane
In real life I'm a Senior Fellow of the Hoover Institution at Stanford. I was formerly a professor at the University of Chicago Booth School of Business. I'm also an adjunct scholar of the Cato Institute. I'm not really grumpy by the way!

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