Fiscal and Macroprudential Policy: Climate Change May Matter…

In July 2022, the ECB is taking concrete steps to integrate climate change into its monetary policy actions (ECB 2022). Amid growing concern and public protests, central banks are beginning to wonder whether the effects of climate change will call for their intervention. In the last few years, this topic has become increasingly common in their speeches and announcements (Carney 2015, Dikau et al. 2019, Schnabel 2021). In most cases, however, this focus has not yet translated into actual policymaking (Masciandaro and Tarcia 2021). Rather, central banks in developed countries have begun a careful inquiry into whether, how, and to what extent they should intervene in climate policy. The ECB’s strategy review is a case in point. And now, with inflation rising, central bankers may face unpleasant trade-offs.

This cautious stance stems not only from the different sensitivities of central bankers on this issue but also from their different interpretations of mandates that they must respect. Historically, such mandates have not directly referenced climate change, although some exceptions have recently occurred in developing countries (Masciandaro and Tarcia 2021). Instead, central bankers typically focus on prices and, since the global crisis, financial stability, often with an outcome on whether or not economic growth is sustained.

Whether the scope of this mandate can be expanded to allow central banks to take climate-related action is an open debate, both from a policy-based and academic perspective (McKibbin et al. 2020, 2021, Bremus et al. 2021, Boneva et al. 2022a , 2022b, Hartman et al. 2022). On the one hand, some claim that the effects of climate change on economic performance may threaten financial stability and that central banks should be held responsible for these effects. On the other hand, many suggest that allowing central banks to take on responsibilities beyond their fiscal and macroprudential obligations would render their overall action ineffective. These actors suggest that climate policy should be left to fiscal authorities (Batten et al. 2016).

…but how can central banks manage this?

Until now, research around central banks’ ‘green’ policies has mostly been directed towards empirical investigations of specific sectors or qualitative analyzes of potential central bank instruments. It has not focused on justifying policy recommendations based on a simple institutional framework that accounts for the interaction and incentives of two main institutions – governments and central banks – and, on top of that, central banks can adopt climate measures through two toolkits. : its financial and/or macroprudential instruments. In our new study (Masciandaro and Russo 2022) we show that, using a principal-agent setting, it is possible to assess whether central banks’ involvement in climate policy would be beneficial, harmful or neutral in terms of ‘greening’. economy, and if this outcome comes at the cost of central banks missing their monetary and macroprudential targets.

The institutional arrangement is such that the government acts as an agent of voters with climate sensitivity and uses the central bank’s own sensitivity to its preferences to ensure that it accounts for climate risk within its pricing and financial stability mandates. In all, four cases have come up. The first, which envisions only government intervention in climate policy, represents the benchmark case. Then, it is possible to consider three other settings where, with monetary tools prescribed by the government, the central bank pursues its price and financial stability mandate under some climate-related constraints. By doing so, it is possible to consider such constraints binding – initially on monetary policy, then on macroprudential policy, and finally on both monetary and macroprudential policy.

The general setting allows us to consider, in a systematic way, the numerous tools of a fiscal, monetary or macroprudential nature that have been proposed so far. In general, one can distinguish between the tools that require government action and the tools that central banks have to put in place. On the fiscal side, the main instrument proposed and introduced is the carbon tax (or carbon pricing), which is levied on firms in proportion to their CO2 emissions (Stiglitz and Stern 2017, Blanchard and Tirole 2021, BIS 2021, OECD 2021). From the financial and macroprudential side, possible interventions relate to the inclusion of climate-related risks in capital requirements, climate stress testing and the integration of ESG criteria in asset-purchase programs (Campiglio et al. 2018, Dafermos et al. 2018, Monday) 2018, De Grauwe 2019, Dikau et al. 2020).

The policy or mix of policies that will be most effective in reducing pollution is a matter of debate (Krogstrup and Oman 2019). While some call for central bank intervention (Campiglio 2016), others claim that any role played by central banks could be harmful (Tirol 2021) or insufficient if not properly matched with government action (Bolton et al. 2020, McConnell et al. al. 2022, Dafermos and Nikolaidi 2021, Hansen 2022).

Good news and bad news

Our general results show that in all cases fiscal and monetary dynamics are anchored to central bank targets, although instruments set under climate constraints depend on carbon emissions. Hence, concerns about the ability of central banks to achieve their core objectives while simultaneously accounting for climate risk do not seem automatically justified.

Nevertheless, two caveats should be highlighted. First, no trade-off arises if the central bank is completely independent in determining its strategy, that is, if it is not subject to external pressures – politicians and/or private lobbies – that might force it to follow a biased level. target variable. Indeed, even if the central bank accounts for climate risk as a proxy for government, such representation is implemented in a way that depends exclusively on the government’s degree of sensitivity to climate preferences. The more the current government can interfere with the central bank’s choices, the less likely is a monetary policy where climate change considerations can be reconciled with fiscal and monetary stability. If the government’s objectives are consistent with the central bank’s objectives, the opposite is true.

Second, in the case of emissions, the results indicate that central banks’ inclusion of climate risk in their policymaking will not necessarily be beneficial to the fight against climate change. Their potential effectiveness also depends on their ability to facilitate ‘green’ – financial and/or regulatory – reductions and perceived levels of emissions. In fact, the only case in which central bank intervention would undoubtedly be beneficial is if it can ensure the full channeling of its resources to reduce deficit spending. At least so far, however, this is unlikely to hold in practice. Central banks only have the mandate, and possibly the power, to monitor financial institutions, not ultimate recipients (eg corporations). In other words, lags and frictions can harm the central bank’s ability to properly calibrate its green action on the actual emissions of non-financial corporations. All in all, preserving their distinctiveness on the one hand, and enhancing their observational powers on the other, seems to be Scylla and Charybdis that the central banker, as Odysseus, should consider in designing new fiscal and macroprudential journeys.


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