The fact that economists are increasingly waking up to one of humanity’s biggest impending problems can be gauged by the Economics Nobel awarded to William Nordhaus and the resurgence of research in this area.
Two recent statements from central banks on either side of the Atlantic highlight the increasing importance of climate change in monetary policy. On November 8, Benoît Cœuré of the European Central Bank warned that “climate change is not a theory. It is a fact.” A week later, the US Federal Reserve issued a press release encouraging the financial services industry to provide assistance in regions affected by the California wildfires.
One could argue that the California fires are not really a case of climate change. But these fires are becoming quite regular. Such regular fires, floods, droughts etc. are events driven by climate change. The fact that economists are increasingly waking up to one of humanity’s biggest impending problems can be gauged by the Economics Nobel awarded to William Nordhaus and the resurgence of research in this area.
The scale and scope of impact of climate change on economics is large and varied. In this piece, I will discuss it from perspective of central banks and monetary policy. Cœuré gives us a good preview of these challenges. There are two broad categories of shocks: demand and supply (what else!). The demand ones are not problematic as they push the economic indicators (inflation, growth and employment) in the same direction, the so-called “divine coincidence” in economics.
Climate-related shocks fall are supply shocks. Under this, the economic indicators are pulled in different directions. A flood or a fire leads to shortage of goods leading to both lower output and higher inflation. In turn, this pushes energies of policymakers in two different directions. The government will be more worried about falling output while central bankers will worry over inflation. The persistence of the shock matters. A permanent shock is more worrying. Thus, central banks need to figure three things for climate change: identify climate shocks correctly, assess the distribution of these shocks and the trade-off between inflation and output.
Now, supply shocks are hardly new. The world has suffered from plenty. The stagflation episode of 1970s comes to mind when the oil supply shock led to high inflation and high unemployment. Before this stagflation episode, there was little role for monetary economics. Economists believed there was a trade-off between inflation and unemployment leading to policymakers choosing to mitigate the latter leading to even higher inflation.
That’s when the likes of Milton Friedman and Edmund Phelps showed that the trade-off between inflation and unemployment was at best temporary. If one allows inflation to rise, it eventually feeds into inflation expectations and leading to not just higher inflation in future could result in a permanent one as well. In a way, Friedman and Phelps rejected the supply shock and called inflation mainly a demand problem. The central banks, either on their own or egged by governments, keep monetary policy easy in order to fuel demand leading to higher inflation.
This change in thinking defined the role of central banks in terms of price stability or inflation management. They were expected to keep a close watch on inflation expectations and tighten (or ease) monetary policy as inflationary expectations begin to rise (or decline). To fulfil their new responsibility, the central banks first experimented with monetary targets (which did not work as expected) and later with inflation targets which has become the new norm for central banks worldwide.
With climate change concerns, we are again back to revisiting these old ideas. Central banks are unable to address supply side shocks effectively. The onus is usually on governments leading them towards higher expenditure which is usually inefficient and leaky leading to higher deficits and possibly inflation as well.
Developing countries especially India should not just be looking at these developments but even contribute given their wide experience on the topic. The biggest example is the monsoon; its success or failure continues to determine the trajectory of Indian economy. Apart from monsoons, the geography of India keeps springing one supply shock one after the other. RBI and governments have long dealt with this uncertainty over climate shocks. Many RBI assessments and even Budget speeches start with how the monsoon has fared in the year. It also leads to all kinds of political economy developments with expenditure impulses depending on political cycle and so on.
Apart from the monetary impact, the central banks will also have to look at financial stability concerns. In most of these fire/flood affected regions, flow of finance shrinks and collaterals are destroyed. Banks could suffer from NPAs depending on the severity and persistence of the shock. In such scenarios, should the central bank ask the financial institutions to continue lending in adversely affected areas? If it does, it could lead to further NPAs (and insurance claims) and if it does not, then recovery is ruled out apart from obvious questions over morality.
Cœuré and Sweden central bank researchers in a recent note argue for a green monetary policy where central banks support the transition to a low carbon economy and encourage sustainable financial products and investments. This could mean buying green bonds from issuers or providing central bank funds to entities that have a lower carbon footprint. This could provide a signal to others financial entities to follow suit. This approach is not without its criticism; the government should encourage sustainable finance and not the central bank.
To sum up, climate change is emerging as a serious concern for policymakers worldwide. Central banks might have to decentralise their organization and have a dialogue with both experts and citizens (for local knowledge) to understand both climate change and risks that emanate from it. The sooner we get on the problem the better it is, as it will require a lot of preparation against these shocks which happen randomly and can very quickly disrupt everything.
(The author is faculty with Ahmedabad University. Views are personal)For more opinion pieces, click here