Borrowing from the future for the future’s sake: The role of central banks and debt-based public decarbonization spending

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The argument against market neutrality within a dysfunctional market

The recent ECB podcast “Tackling climate change as a central bank” provides insight into a central bank’s current thinking about its primary mandate (i.e. protecting medium-term price stability and its preconditions) and the possibilities and limitations implied by the principle of “market neutrality”. Given that the market has apparently failed over the past few decades to properly account for the social costs of carbon emissions and continues to do so, it is clear that the rationale for “market neutrality” (similarly EU state-aid regulation) urgently needs to be reconsidered. Absent a carbon pricing that is sufficiently steep and widely applied to effectively drive down real-world greenhouse gas emissions, the current economy represents a market that itself is not neutral but tilted towards fossil fuel projects that are more profitable than they ever should have been allowed to be. The dysfunctionality of capital markets working so clearly against the interest of the human race becomes manifest in the fact, for example, that a recent Saudi Aramco bond issuance was 8x oversubscribed.

The difference between market efficiency and market functionality

In the context of the climate crisis, it is important to distinguish between market efficiency and market functionality:

• “market efficiency”: With regard to capital markets, market efficiency refers to the cost-efficient and normatively agnostic allocation of capital into assets and projects in accordance with their financial performance potential. This ethically “blind” pursuit of competitive financial return seem to work fairly efficiently within developed capital marktes and given pricing structures: Most opportunities offering attractive risk-return profiles are being taken advantage of. Of course, there are instances which lead to relatively inefficient capital allocations (e.g. due to underestimated climate risks/opportunities, excessive speculation/bubble formation etc). Moreover, inefficient capital markets are clearly present in developing economies, where misperceptions of country/currency risk and a profound lack of affordable capital represent considerable obstacles to decarbonization, for example.
• “market functionality”: The primary normative purpose of capital markets is arguably not merely a cost-efficient but more importantly a normatively desirable allocation of resources for the benefit of human societies. A (socially) “cost-efficient” allocation of resources within a functional market could be defined as one that preserves/promotes humanity’s long-term potential rather than destroying/diminishing it. Independently of a market’s economic efficiency, a grave misalignment exists between market prices and the societal benefits and damages associated with production and consumption of goods and services. In the context of the climate crisis, and due to the absence of long-termism and proper carbon pricing, capital tends to be allocated for short-term, temporary economic gains that are far exceeded by medium- to (very) long-term climate damages and risks, especially with regard to fossil fuel/high carbon industries. The idea that fossil fuel based economic value add may serve as a foundation for future sustainable growth has become obsolete by now.

The path dependency between the medium term and the (very) long-term future

As mentioned before, the ECB’s primary mandate is concerned with medium-term price stability and its preconditions. The same applies to other central banks as well. Fortunately, the “medium term” is not clearly defined . The climate crisis has created an unprecedented path dependency between the medium term and the deep future. Due to the existence of climate tipping points, we are finding ourselves in the unusual situation that our climate actions and inactions over the next 30–50 years determine the planetary ecological carrying capacity (which in turn determines economic/price stability) for hundreds of millennia. This is akin to driving with full speed on a highway with the exit ramp to our destination approaching — if we are missing this opportunity, the next exit won’t come for a very long time (by which we will have long run out of gas).

Why the current aspiration gaps cannot be closed in the absence of carbon pricing and/or corporate governance reform

It is frustrating to recognize that the aspiration gaps between current and urgently needed capital allocations for decarbonization (as exemplified by the renewable energy financing gap, the production gap etc) are not nearly being closed quickly enough. Relentless fossil fuel project funding continues to contradict “netzero”/Paris aligned pledges and commitments. I’m afraid it can’t be much different than that for as long as fossil fuel projects are allowed to offer attractive financial performance and/or as long as the de-facto paradigm of shareholder primary is not being replaced by a superceding constraint for sustainable stewardship (e.g. as suggested by Robert Hinkley). Current conceptions of fiduciary duty prevent financial institutions from voluntarily shifting their allocations as soon as this comes at the expense of some (short-term) financial performance that “deep” decarbonization measures — in accordance with the marginal carbon cost curve — often require.

The case for central bank supported debt-based public decarbonization spending

Beyond green asset purchases, carbon pricing, and corporate governance reform, I have been wondering about another powerful but underutilized leverage point for systemic impact. What I believe is necessary at this stage to prevent a global catastrophe that is going to destablize an already fragile human civilization is that governments drastically scale-up debt-based public infrastructure and other decarbonization-related spending, with support from central banks, in order to accelerate the #racetozero, close any funding gaps and ensure a timely and just transition. Private finance can then play a supporting role by following the government’s lead. The rationale is provided by a combination of the following arguments:

1.Central banks have the means to support public debt for decarbonization spending

In a thought provoking article Adam Tooze is making a compelling point regarding central bank’s role in the climate crisis:

“…The problem is not that favoring green bonds would induce bias. The problem is that the bias might still not be sufficient to address the urgency of the climate crisis. If the world is to cope with climate change, policymakers will need to pull every lever at their disposal. Politicians will need to abolish carbon subsidies and replace them with a steep and growing carbon tax. Only when carbon is properly priced will there be a major economic incentive to large-scale private investment. But even that may not be enough. To generate substantial private investment, governments will need to establish a credible commitment to decarbonization. The scale of the leap required is huge. Between fiscal years 1978 and 2018, spending by the U.S. Energy Department on research in renewable energy came to a grand total of $27.65 billion in constant 2016 dollars. That’s less than Americans spent on pet food and treats last year. Accomplishing the necessary transformation will require a huge redirection and increase in public spending on infrastructure, research and development, and assistance to lower-income countries. […] Given the long-term nature of those investments, there is a strong case for funding a large part of this decarbonization drive through the issuance of long-term debt. It is not the business of central banks to issue such loans. The debts should be issued by public investment banks or directly by national governments. But it should be the job of central banks to support this push by acting as a buyer of last resort for those long-term debts. The public discussions of the central bankers have not yet extended this far. But managing the secondary market for public debt is historically the essential function of central banks. It is what makes them one of the most powerful agencies of the state. Like any major financial mobilization, this will no doubt raise fear of inflation. But this is one respect in which the world is fortunate: As advanced economies age, central bankers are struggling not to tame inflation but to ensure that it remains at least 2 percent per year. Acting as a backstop to the issuance of a massive volume of publicly issued green bonds is certainly a novel role for the central banks. But after their exertions in the 2008 financial crisis, central bankers, of all public officials, can’t plausibly retreat into an insistence on the limits of their mandate. When faced with the prospect of global financial collapse, they engaged in extraordinary measures to stabilize the global banking system and flood the world with liquidity. The climate emergency poses a risk that is even more existential…” (https://foreignpolicy.com/2019/07/20/why-central-banks-need-to-step-up-on-global-warming/)

2. The state is the change agent that needs to lead a “moonshot mission” such as the #racetozero

Marianna Mazzucato makes a strong case for a mission-driven leadership role that only states can assume — and have done so in the past — when it comes to a large-scale transformation of the economy:

“…A mission-oriented approach also allows for a new form of targeted fiscal stimulus. The point is to start with a large-scale challenge like climate change and break it down into concrete policy goals, such as achieving net-zero emissions in a given region by a specific date. With targets in place, the full force of government grants, loans, and procurement contracts can be deployed to leverage the combined potential of the public, private, and non-governmental sectors.” (https://www.project-syndicate.org/onpoint/new-fiscal-constitution-job-guarantee-by-mariana-mazzucato-and-robert-skidelsky-2020-07)

3. A paradigm shift in monetary policy indicates a vast amounts of underutilized fiscal space

Modern monetary theory (MMT) has recently evolved from a fringe phenomenon into an increasingly copelling paradigm shift in monetary policy:

“…MMTers go beyond endogenous money theory, however, and argue that government should never have to default so long as it’s sovereign in its currency: that is, so long as it issues and controls the kind of money it taxes and spends. The US government, for instance, can’t go bankrupt because that would mean it ran out of dollars to pay creditors; but it can’t run out of dollars, because it is the only agency allowed to create dollars. It would be like a bowling alley running out of points to give players. A consequence of this view, and of MMTers’ understanding of how the mechanics of government taxing and spending work, is that taxes and bonds do not and indeed cannot directly pay for spending. Instead, the government creates money whenever it spends….” […] The MMT reply to this is simple: No, our approach won’t lead to hyperinflation, because we take inflation incredibly seriously. Taxes are, they concede, sometimes necessary to stave off inflation, and as a consequence, preventing inflation can require cutting back on deficit spending by hiking taxes. But the lower inflation caused by higher taxes is not an effect of “lowering the deficit”; the lower deficit is just an artifact of the choice to raise taxes to fight inflation…” […] “But even when too much demand does result in inflation, Fulwiller, Grey, and Tankus say we shouldn’t necessarily jump to taxes as a solution. “When MMT says that a major role of taxes is to help offset demand rather than generate revenue, we are recognizing that taxes are a critical part of a whole suite of potential demand offsets, which also includes things like tightening financial and credit regulations to reduce bank lending, market finance, speculation and fraud,” they write….” (https://www.vox.com/future-perfect/2019/4/16/18251646/modern-monetary-theory-new-moment-explained)

A fitting quote is provided by Stephanie Kelton:

“What we’ve done to ourselves is to just leave trillions of dollars, literally, on the table, by not taking advantage of the fiscal space that we have, by running our economies below potential, by living below our means as a nation, year after year after year.” (https://www.newyorker.com/news/news-desk/the-economist-who-believes-the-government-should-just-print-more-money)

3. Public borrowing has never been cheaper for developed countries

Independently of what one might think about MMT, the idea of public climate emergency spending is supported by the current (and forseeable) reality of low interest rates:

“…What’s more, many mainstream economists are starting to conclude, given the persistently low interest rates the US and other countries have experienced this decade, that deficits may not be particularly costly, even within a mainstream framework. “The current US situation in which safe interest rates are expected to remain below growth rates for a long time, is more the historical norm than the exception,” Olivier Blanchard, the former IMF chief economist, said in his presidential lecture at the American Economics Association this year. “Put bluntly, public debt may have no fiscal cost…” https://www.vox.com/future-perfect/2019/4/16/18251646/modern-monetary-theory-new-moment-explained

An recent analysis from Worldbank economists looks into the implications of the “new normal” of low interest rates for the climate fight.

“…Since this debate, two major trends have crystallized. The first is that advances in climate science suggest the pace of climate change is more rapid and its impacts more severe than previously projected. Contributing to the rising urgency is a greenhouse gas (GHG) emissions trajectory that has so far shown few signs of abating, despite a succession of global climate agreements, as shown in Figure 1. The second major trend is a continuous fall in the natural interest rate. As Larry Summers and Jason Furman show here, real interest rates have fallen steadily across countries and asset classes in the last 30 years, despite a steady expansion of debt. Long-term real interest rates are now close to zero or even negative in most major economies (Figure 2). We argue that these two trends bolster the case for front-loading climate action both by increasing the social cost of carbon and by lowering the cost of capital associated with investment in decarbonization….” (https://www.brookings.edu/blog/future-development/2021/02/04/secular-stagnation-climate-action-and-the-natural-rate-of-interest/)

4. By itself, state-driven rapid decarbonization offers human societies enormous economic and job-related benefits

A powerful analysis by Saul Griffith further supports the neccessity as well as the positive welfare-effects of accelerated large-scale decarbonization:

“…We don’t begin with the question of what is politically possible, but ask what is technically necessary to make a climate solution that is also the best economic pathway for a country. We need mobilization of technology, industry, labor, regulatory reform, and critically, finance. We tackle the thorny question: “what is the best climate outcome we can achieve?” We prioritize things that are shovel ready, meaning they can be deployed today and don’t require unknown years of research and development to become a reality — we simply don’t have time for that. […] We lean on data and an unprecedented analysis of the U.S. energy economy that allows us to look at the consequences of electrifying everything. Will our lives change? The surprising answer is not a lot. Those things that will change are for the better: cleaner air, cleaner water, better health, cheaper energy, and a more robust grid. We can have pretty much all of the complexity and variety of the American dream, with the same– sized homes and vehicles — and we’ll need less than half the energy we currently use. This is a success story that casts aside trying to “efficiency” or “deprive” our way to zero emissions […] The consequence of getting the technology, financing and regulations right is that we can save every family in the U.S. thousands of dollars a year and create the good new jobs every economy needs. We will need to triple the amount of electricity delivered in the U.S. and we’ll discover that the moonshot engineering project we need is a new grid with new operating rules, more like the Internet. We must have “grid neutrality.” The industrial mobilization required will mean an effort similar to WWII’s Arsenal of Democracy in size, speed, and scope. For a world looking to bounce back from a pandemic and economic crisis, there is no other project that would create this many jobs. An analysis shows that there are tens of millions of good paying jobs that will be created in every zip code, suburb, and rural town in the country…” (https://www.rewiringamerica.org/handbook)

5. The potential damanges and risks of insufficient climate action are far greater than many imagine

Finally, the stakes of insufficient climate action are much higher than many seem to realize. The risk for medium- to long-term regional/global socio-economic stability (which does include price stability) is being severly underestimated. It is as if financial institutions and other economic agents assumed that the collective and systemic long-term risks of rising global temperatures didn’t exist only because they presently cannot be quantified as individual balance sheets risks.

• As global temperatures continue to rise, there is an existential risk of geopolitical conflicts over increasingly scarce and critical resources, especially among nuclear powers:

“…Climbing world temperatures and rising sea levels will diminish the supply of food and water in many resource-deprived areas, increasing the risk of widespread starvation, social unrest, and human flight. Global corn production, for example, is projected to fall by as much as 14 percent in a 2°C warmer world, according to research cited in a 2018 special report by the UN’s Intergovernmental Panel on Climate Change (IPCC). Food scarcity and crop failures risk pushing hundreds of millions of people into overcrowded cities, where the likelihood of pandemics, ethnic strife, and severe storm damage is bound to increase. All of this will impose an immense burden on human institutions. Some states may collapse or break up into a collection of warring chiefdoms — all fighting over sources of water and other vital resources…” (https://www.thenation.com/article/archive/nuclear-defense-climate-change/)

• The economic damage models used in the past (in particular DICE) are characterized by massive failures and shortcomings, as Steve Keen explains:

“…These predictions are absurd. A 3°C increase could trigger, and a 6°C increase would trigger, every “tipping element” shown in Table 2. The Earth would have a climate unlike anything our species has experienced in its existence, and the Earth would transition to it hundreds of times faster than it has in any previous naturally-driven global warming event (McNeall et al., 2011). The Tropics and much of the globe’s temperate zone would be uninhabitable by humans and most other life forms. And yet Nordhaus thinks it would only reduce the global economy by just 8%? Comically, Nordhaus’s damage function is symmetrical — it predicts the same damages from a fall in temperature as for an equivalent rise. It therefore predicts that a 6°C fall in global temperature would also reduce GGP by just 7.9% (see Figure 3). Unlike global warming, we do know what the world was like when the temperature was 6°C below 20th century levels: that was the average temperature of the planet during the last Ice Age (Tierney et al., 2020), which ended about 20,000 years ago. At the time, all of America north of New York, and of Europe north of Berlin, was beneath a kilometre of ice. The thought that a transition to such a climate in just over a century would cause global production to fall by less than 8% is laughable...” (https://profstevekeen.medium.com/economic-failures-of-the-ipcc-process-e1fd6060092e)

• A joint study by several climate research institutes emphasises the risks that are not taken into account by economic assessments.

“…Economic assessments fail to take account of the potential for large concurrent impacts across the world that would cause mass migration, displacement and conflict, with huge loss of life. Economic assessments that are expressed solely in terms of effects on output (e.g. gross domestic product), or that only extrapolate from past experience, or that use inappropriate discounting, do not provide a clear indication of the potential risks to lives and livelihoods. It is likely that there are additional risks that we are not yet anticipating simply because scientists have not yet detected their possibility, as we have entered a period of climate change that is unprecedented in human history. Some advances are being made in improving economic assessments of climate change impacts but much more progress is required if assessments are to offer reliable guidance for political and business leaders on the biggest risks. The lack of firm quantifications is not a reason to ignore these risks, and when the missing risks are taken into account, the case for strong and urgent action to reduce greenhouse gas emissions becomes even more compelling...” (https://www.lse.ac.uk/GranthamInstitute/publication/the-missing-economic-risks-in-assessments-of-climate-change-impacts/)

• It is worth noting that future climate migration trends are likely to strengthen the rise of radical nationalism and geopolitical rivalry. Increasing competition over natural resources will likely lead to an increase of military budgets, siphoning away resources needed for decarbonization, and further hindering international cooperation at a time when it is most needed. As Michael Klare argues:

“…In a world constantly poised for nuclear war while facing widespread state decay from climate disruption, these twin threats would intermingle and intensify each other. Climate-​related resource stresses and disputes would increase the level of global discord and the risk of nuclear escalation; the nuclear arms race would poison relations between states and make a global energy transition impossible…” (https://www.thenation.com/article/archive/nuclear-defense-climate-change/)

The window of opportunity to “invest ourselves out of the crisis” is closing

I think taken together, these arguments allow us to draw this conclusion: Humanity (still) has a historic but closing window of opportunity to “invest its way out of the crisis” and to turn a neccessity into a virtue. The act of “borrowing from the future for the sake of the future” offers a unique chance to leapfrop human progress into a more stable, sustainable world for our children and their descendants. To this end, current public debt ceilings must be suspended specifically for public decarbonization and just transition spending, including decarbonization-related international development cooperation. Of course, taking advantage of this opportunity requires an enormous political will and shifting the overton window. But several recent reports about the potential role of central banks in the climate fight indicate a promising momentum:

• “Net-zero central banking: A new phase in greening the financial system” https://eprints.soas.ac.uk/34895/1/Net%20zero%20central%20banking%20Weds%2010%20March.pdf
• “Aligning Finance to the zero carbon economy: new ideas from leading thinkers” https://static1.squarespace.com/static/5e0a586857ea746075c561a3/t/6075d05564b0627f5c0ae9ab/1618333789073/%236+Financial+Stability+Planetary+Emergency.pdf
• “Adapting central bank operations to a hotter world Reviewing some options” https://www.ngfs.net/sites/default/files/medias/documents/ngfs_monetary_policy_operations_final.pdf

Admittedly, the idea of utilizing public debt to fund the global transition to a climate neutral economy might seem like an unthinkable proposal under the currently dominant paradigms of conventional “wisdom”. But we need to keep in mind that these are truly desparate times that are calling for proportionate measures. Time has already run out. Only few realistic pathways to towards a 1.5 degrees C future remain. We are standing with our backs to a wall — and we can only win (without regrets) if we take this “leap of faith” or lose (almost) everything if we don’t. To quote Saul Griffith’s advice to investors: “Remember that profits mean nothing if the planet is ruined.”