The New Paradigm Papers of the Month of August

Aligning finance with the green transition: From a risk-based to allocative green credit policy regime

Katie Kedward, Daniela Gabor, Josh Ryan-Collins

In this timely contribution Katie Kedward, Daniela Gabor and Josh Ryan-Collins make the case for a more active climate agenda for central banks. Despite the discourse shift in favour of green monetary policy which has followed in the years since the Paris Accord, the extent to which climate risks are influencing investment decisions has remained rather limited. Central banks have pursued a ‘market-fixing’ approach by ensuring that financial institutions disclose their climate risks. In other areas of climate policy such as the carbon contracts for difference, governments are ultimately ‘de-risking’ private capital to correct price signals to favour green investments. While these policy innovations towards ‘greening’ financial markets go in the right direction, they still miss three crucial points as the authors point out.

First, institutional capital remains largely unaffected by central bank asset purchases and collateral frameworks. As many of the insurance companies as well as pension, hedge, and sovereign wealth funds and asset managers are compelled to follow their fiduciary duty of maximizing financial returns and are not subject to the same regulatory pressure as the banking sector, green financial products still fail to compete with the global, dollar-denominated market for fossil fuels. Second, employing risk measures mostly developed by private sector-led ESG initiatives has shown to encourage greenwashing and to underestimate the radical economic uncertainties brought on by biodiversity loss and climate change. Third, bound by the market neutrality principle, monetary policy remains only indirectly concerned with climate change via its effects on financial stability.

These current aspects of the financial system may be addressed by shifting to an allocative green credit policy. To this end, the authors categorise a wide range of incentives and coercive measures – from macroprudential policies to subsidised green loans for households and companies, interest rate controls and credit quotas. In addition, direct price or quantitative restrictions on unsustainable assets could be adopted, affecting not only banks but also institutional investors.

With an allocative green credit policy, central banks and regulators would form part of a wider state-led ‘mission’ to steer the economy towards green transition and directly incentivize credit flows. It would require a reconfiguration of fiscal, monetary, prudential, and industrial policy and a break with the monetary dominance of the last four decades. According to the authors, taking inspiration from some of to the post-war era credit policies could provide impetus for a more coordinated greening of the financial sector and the economy as a whole.

The European Central Bank’s strategy, environmental policy and the new inflation: A case for interest rate differentiation

Jens van ‘t Klooster

A second publication also deals with the very topical issue of green monetary policy. Van ‘t Klooster shows possibilities for the ECB’s new strategy to mitigate climate change and inflation at the same time.

Since 2003, the ECB strategy had mainly been shaped by a short-run perspective. Following the experience of the eurozone crisis, the strategy review in 2021 officially introduced a monetary-financial pillar to assess financial market and sovereign bond market stability. This new pillar now also includes long-run risks to price and financial market stability resulting from climate change. Under the so-called proportionality assessment of the new ECB strategy, the bank is required to consider broader economic pre-conditions for price stability and minimize possible side effects of its policies.

According to van‘t Klooster, the mandate provides sufficient room for aligning the ECB´s refinancing operations with the EU´s broader economic and climate agenda. He argues that the statutes generally allow for any financial market transaction that the bank sees fit. Apart from the ECB´s recent announcement to start considering climate change in its corporate sector asset purchases the bank may also consider steering interest rates. For instance, the criteria used in the Targeted Longer Term Refinancing Operations (TLTRO) programme could be revised so as to benefit green investments under the REPowerEU action plan. It could also consider a successor for the Pandemic Emergency Purchase Programme (PEPP) to counteract fragmentation in government bond spreads across the EU. In his view, a general increase in interest rates could lead to unintended negative and long-term consequences in the real economy. The author therefore recommends that the ECB take into account the economic conditions for much-needed green investments as well as the stability of the Eurozone as a whole when considering upcoming interest rate hikes.

Fighting Climate Change: International Attitudes Toward Climate Policies

Antoine Dechezleprêtre, Adrien Fabre, Tobias Kruse, Bluebery Planterose, Ana Sanchez Chico, Stefanie Stantcheva

A new study looks at which factors are most conducive to winning over citizens in the fight against climate change – be it in their own behaviour or in their support for government policies. 40,000 people were questioned in twenty countries covering the highest emitting economies worldwide in Europe, North America and emerging markets as Brazil, China, and India. The results indicate that public support for climate policy depends on the effectiveness of the respective policy in terms of reducing emissions as well as the distributional impacts on the larger society and the individual itself. Socioeconomic and lifestyle characteristics seem to play a role as more college-educated, left-leaning individuals who can rely on public transportation in their everyday lives generally expressed more support for climate action. The study also identified preferences in terms of sources of funding. Government expenditure for climate policy which is financed through new debt or spending cuts in other areas such as social services or defense spending is generally less popular. Among the preferred funding sources rank higher taxes on the wealthiest and carbon taxes which redistribute revenue to fund environmental infrastructures, to reduce income taxes or to subsidize low-carbon technologies.

Permanent Scars: The Effects of Wages on Productivity

Claudia Fontanari and Antonella Palumbo

A new INET working paper examines the extent to which wage developments in the United States have affected productivity. Using US labour market data from the last seventy years, Claudia Fontanari and Antonella Palumbo show that persistent real wage declines and a falling wage share have had a long-term negative impact on productivity and economic growth. Fontanari and Palumbo explain the decades-long decline in the wage share using a post-Keynesian approach. Among other things, they assume that the flexibilisation of labour markets had a significant impact on stagnating average wages and on labour insecurity. Furthermore, they also concede a role for long-term macroeconomic trends such as automation and globalisation. The study seems to support Sylos Labini’s theory, according to which an abundance of cheap labour can reduce the efficiency and innovation incentives of companies and thus slow down overall economic productivity.

The Financial Drivers of Populism in Europe

Luigi Guiso, Massimo Morelli, Tommaso Sonno and Helios Herrera

According to a new empirical study, the financial crisis has favored the approval of populist parties in Europe even more than previously assumed. Using data from the European Social Survey, Guiso et al. examine voting behavior by employment type, income profile and age since the beginning of the century. According to their analysis, the financial crisis has significantly changed voting behavior and the political landscape in Europe. After the crisis, voter turnout on the left and trust in mainstream parties dropped significantly, especially in countries with little fiscal space at the time, such as Italy and Spain. The authors find that the financial crisis and the subsequent recession led to profound long-term welfare losses for large sections of society. The resulting economic insecurity was accompanied by the rise of populist parties in the immediate aftermath of the financial crisis. Guiso et al. argue that the crisis was a structural break that fostered economic insecurity in large parts of society, including the middle class and high-income earners. The authors conclude that this development could result in either a complete break with the traditional party system or a comeback of the popular parties.