Central banks

Jacqueline Best & Matthew Paterson

In the last few years, as central banks have begun to pay attention to climate change, there has been a flurry of academic interest in what central banks are doing and the potential this might hold for climate change action. Yet the crises of the last three years – COVID-19, the return of inflation, and the Russian invasion of Ukraine – have complicated the picture, leading us to look again at central banks and their potential role in climate governance and policy.

The promise of central banks taking a more active role in climate policy was raised by Mark Carney’s 2015 speech, ‘Breaking the tragedy of the horizon’, given while he was Governor of the Bank of England. Carney argued that central banks needed to become active in climate policy because of the threats climate change poses to financial stability, a core area of central bank responsibility. Given this, he argued that these risks – from the physical impacts of climate change, the reputational risks to banks investing in fossil fuels, and the risks to assets ‘stranded’ by climate change policies leading to decarbonisation – needed to be the focus of banking regulation and macroeconomic management.

In the following years, many central banks have introduced policies designed to take account of climate risks, introducing climate stress testing into their financial supervision, and creating the Network for Greening the Financial System, a global network of central banks. A handful of central banks have gone further, moving away from market neutrality in their own asset purchases and issuing green bonds to finance climate-friendly investment.

Many commentators have been optimistic about central banks’ new attention to climate change because of the particular power of central banks to regulate financial institutions, as well as their potential to create credit through their balance sheets. Their hope has been that this could be decisive in shifting investment away from fossil fuels and towards decarbonisation.

But at the same time, it is clear that the over-riding interest of central banks is in financial stability, and thus what has emerged are policies focused on minimising risks of bank failures, through for example stress-testing of banks to climate-related risks. Central banks are inherently conservative institutions, largely unsuited for a more activist role in shaping investment. And when they do, they mostly shape it conservatively, as in enabling fossil fuel assets to flourish in the aftermath of the COVID crisis, and often intensifying existing social inequalities. Perhaps the expectations of central bank climate activism are simply misplaced. Perhaps the most interesting institutional dynamics currently driving climate finance responses are occurring elsewhere—in new forms of ‘state capitalism’, for example, and the recent turn to industrial policy to drive investments in the climate transition.

Yet this story is itself somewhat limited and certainly Eurocentric. A recurrent theme in our conversations regarded the dangers in this story of focusing too much on Europe and North America. Outside that zone, China has taken the lead in more activist policies, pioneering many policies that have later been adopted and standardized by the EU and other western countries.

What effect might the return of inflation have had on this central bank activity on climate change? In most countries, securing price stability – keeping inflation within certain bounds – is the core responsibility of central banks. The period from the late 1980s and the 2008 global financial crisis is often labelled ‘the Great Moderation’, when macroeconomic conditions were remarkably stable and inflation was low. The rapid return of inflation since early 2021 raises the prospect not only of protracted instability and insecurity, but of distracting central banks from any climate activism they have entertained, worried about drifting too far from their core mandate.

But the return of inflation also brings with it the potential for a more fundamental rethinking: while some have invoked older explanations of inflation, centred on ‘wage-price spirals’, others like Isabel Schnabel of the ECB have pointed out that it is natural gas prices, both before and especially since the invasion of Ukraine, that are driving inflation across the economy. This ‘fossilflation’ implies that if governments and central banks want to return to stable and low inflation, then accelerating the shift away from fossil fuels is a key means to do this. Even before the rapid rise of natural gas prices from 2021 onwards, solar and wind were cheaper than gas in most places, so shifting to renewables would have significant effects on overall inflation levels.

Which of these framings will prevail among central bankers depends partly on questions of expertise. Which types of experts within central banks shape their overall approaches? How open are they to the new forms of thinking required to take climate change into account? There is evidence that over the last decade central bankers have been more reflexive about the limits of their models and assumptions—perhaps even shifting to a ‘technocratic keynesian’ paradigm. Yet many of their responses to the recent return of inflation have involved a return to orthodox economic thinking. These epistemic conflicts are in a state of flux and how they will play out is unclear.

Central banks traditionally are, at least in Europe and North America, relatively insulated from the day-to-day turbulence of political life. But both the current crises and the demands placed by climate action itself have generated very significant pressures on central bank independence. Banks have been put under considerable pressure by climate activists to shift investments away from fossil fuels, pressures which occasionally reach central bankers as bank regulators. Even some former central bankers openly consider the possibility of abandoning central bank independence, chiding other more conservative ones for regarding this as a catastrophe commensurate with the potential global devastation of unchecked climate change.

Underlying these specific questions are some much bigger systemic questions about the past and present trajectory of global capitalism and its complex historical relationship with climate change: is the global economy at an inflection point in those patterns with the return of inflation, or is it still defined by the problems of stagnation that have defined the years since the 2008 global financial crisis?

In sum, what our workshop decisively revealed was the indeterminacy of the present moment: while it is possible to trace future paths in which central banks could play a significant and constructive role in climate governance, there are equally many potential paths that would make them significant obstacles to the kind of profound political economic transformations needed to respond to the climate crisis.

This blog post synthesizes a few of the many excellent ideas articulated by workshop participants, including: Ilias Alami, Dan Bailey, Sarah Bracking, Jeremy Green, Eric Helleiner, James Jackson, Paul Langley, Sylvain Maechler, John Morris, Stine Quorning, Adrienne Roberts, Jens Van’t Klooster, Robbie Watt, and Stan Wilshire.

This post was initially published March 6, 2023 by the Sustainable Consumption Institute. The original version can be found here.

As pundits debate whether the US Federal Reserve will raise interest rates again this summer or fall, we are reminded of just how much of the economy’s direction hinges on central bankers’ decisions.

Since the 2008 financial crisis, the power of central banks has grown, as they have used unorthodox tools to stimulate the economy, taken a greater role in financial regulation, and put themselves in more politically sensitive positions, including the tough debt negotiations with Greece.

In spite of this powerful role, central bankers are remarkably insulated from democratic oversight. As a recent “Buttonwood” column notes in The Economist, “Janet Yellen and Mario Draghi are very important players in the world economy, arguably more important than the US President or the German chancellor. And yet they are not elected; if voters do not like the job they are doing, they cannot get rid of them.”

There is a great deal at stake in decisions about monetary policy, as I suggest in a recently published article in Ethics & International Affairs. Central banks not only define the broad direction of the economy but also create winners and losers. Consider, for instance, the disparate reactions of a prospective first-time home buyer and a retired couple living on their savings to the prospect of yet another drop (or increase) in the interest rate.

Central bank independence in its current form is relatively recent. Elected leaders exercised considerable influence over monetary policy in the post-war era, seeking to achieve the right “trade-off” between full employment and inflation. It was only in the 1980s that policymakers moved away from this kind of Keynesianism and embraced the ideas of Milton Friedman, who advocated the creation of an independent monetary authority.

Friedman and other economists believed that if governments were given any discretion over monetary policy they would adopt inflationary policies because these were more likely to be popular with the electorate. They argued that the only way to ensure price stability was to radically limit the government’s influence over monetary policy by making central banks autonomous and requiring them to stick to a simple rule, such as an inflation target. By the late 1990s, central banks in over thirty countries had gone down this path and were using some form of inflation targeting.

The current model of central bank governance does provide for a certain kind of accountability—but only a very narrow one. Ensuring accountability generally involves three elements: broadly-agreed upon standards, information on whether they are met, and sanctions if they are not. Because the principle of central bank independence involves a very limited set of standards—specifically, the achievement of an inflation target—and very few opportunities for sanction, the main mechanism for accountability is provided by publishing information about the bank’s activities. Hence we have seen the rapid expansion of central banks’ commitment to providing more and better information about their models and decisions in recent years.

Unfortunately, while this informational form of accountability may have worked during the stable years of the “Great Moderation” (from the mid-1980s to the 2008 crisis), it is no longer up to the task in the volatile post-crisis era.

Bank of Canada Governor Stephen Poloz and US Federal Reserve Chair Janet Yellen have both suggested that growing economic uncertainty has reduced the effectiveness of simple models and rules. What these bank governors have not acknowledged (unsurprisingly) is the challenges that this growing uncertainty poses for existing forms of accountability.

If uncertainty limits the effectiveness of rule-based policy, then it ultimately requires greater discretion on the part of policymakers. This is not a problem in itself (here I would disagree with those Republican lawmakers who would bind the Fed even further with more stringent rules). More discretion does, however, require a more robust form of accountability.

There are three basic principles that should underpin any such reforms.

1) Fostering more deliberation and dissent

While the informational model of accountability obligates decision-makers to explain their actions, it reduces this process to a simple publication of data. What is missing is the back and forth of question and answer—the process of genuine debate and deliberation. By the mid-2000s, central bankers were being treated like oracles, with Alan Greenspan as the most revered among them. There must be more room for dissent—both among those with the power to set monetary policy and in the wider society that is affected by those policies.

2) Ensuring that central banks are answerable to the wider public

Because financial issues are complex and their impacts are often diffuse, monetary policy questions rarely become salient enough to mobilize public action. In this context, the power of sanction actually shifts away from the two groups to whom central bankers should be accountable—the government and the public—and toward financial actors, who can impose very serious sanctions on central banks if they disagree with their policies. Without overly politicizing monetary policy, we need to find creative ways of ensuring that central banks are more accountable to the wider public.

3) Broadening the objectives against which their actions are judged

One way of ensuring that monetary policymakers are accountable to the public is to ensure that the issues that affect citizens are reflected in the standards that guide bank policy. At present, most of these issues are not officially on the agenda, which is constrained by the goal of achieving a very low level of inflation.

A number of commentators have recognized this dilemma and have suggested that today’s inflation targets may no longer be appropriate. A recent Federal Reserve working paper suggests that increasing the current inflation target and supplementing it with a nominal GDP target makes economic sense. Such moves to broaden the objectives used to guide central bank decisions would also go some way toward increasing their accountability.

As central banks take on an increasingly powerful role in our political and economic lives, it is time to find new ways of ensuring that they are more fully accountable.

This blog first appeared on the Carnegie Council’s Ethics & International Affairs website.

Tag: Central banks

Central banking, climate finance, and contemporary crises

Why we need better central bank accountability