Economics and the Environment

Should central banks directly address climate change?

CLIMATE CONTROL: Central banks must be independent of the political process, says Tom Smythe, an FGCU finance professor.

Recently, central banks have announced they will begin evaluating whether banks are adequately managing their risk exposure to firms that could be vulnerable to threats from climate change. Some see this as prudent and welcome. However, there has been additional discussion of whether central banks should actively engage in speeding the process of moving firms to a more climate-friendly state, by using their monetary firepower to subsidize the cost of capital of firms pursuing green enterprise and innovation.

Let’s be clear; humans continue to have a significant negative impact on the environment. However, to suggest central banks further distort capital markets to address the issue is foolhardy and ignores the unintended consequences of such actions. I see four problems with such an approach.

First, while central banks must evolve to changes in the economic landscape, they must do so within the boundaries of legislated mandates. For the Fed, those mandates are to be the lender of last resort, promote price stability and promote full employment. More recently, central banks have taken on the responsibility of financial stability. None of these roles includes providing benefits to any firm that could impede competition with other firms.

Second, the Fed, in response to the 2008 financial crisis, cut target money rates close to zero, where they have remained since. The average effective federal funds rate dating back to 1954 is 5.02%. Since 1990, the average is 3.17%, but since 2008, that average is 0.36%. In addition to keeping short-term rates at unrealistically low levels, central banks have engaged in “evolved” policies such as quantitative easing and—with the onset of the pandemic—direct purchases of corporate and municipal debt in an effort to stabilize markets. However, the distortions caused by these activities have serious consequences. Prior to the pandemic, U.S. stock repurchase activity outstripped investments in R&D and capital investment, often funded with cheap debt.

Additionally, the number of BBB-rated firms was at an all-time high, and these firms have since borrowed more, creating the new class of firms known as “zombies.” In short, the capital allocation process is broken, due in large part to existing central bank distortions.

Third, if central banks engage in selectively influencing the cost of capital for firms, it would constitute “winner picking,” something in which central banks should not engage. History is replete with examples of “government” failing miserably at direct engagement with private business. In the U.S., examples include the Solyndra debacle and the moral hazard created with Fannie Mae and Freddie Mac. Direct government involvement with industry has proven repeatedly to be fraught with problems that do not lead to the best outcomes.

Finally, directing central banks to engage in social policy, even well-intentioned, will irreparably breach central bank independence. Social policy should be left to legislative bodies, where voters can make their voices heard. Asking central banks to choose who to subsidize politicizes one of the last institutions operating with some semblance of independence from the political process.

Instead of asking central banks to undertake such a task, let’s tackle the problem in a reasoned manner. The cost of capital for firms will fall as investment dollars flow to these firms. Announcements by BlackRock, UBS and others that climate change is now a primary strategic characteristic to be used when investing is evidence the market is working. Second, let’s develop and agree on independent metrics that we can apply to all firms when evaluating these characteristics, and require them to be reported for publicly traded firms. Finally, if governments feel compelled to support social issues not being addressed by markets to their satisfaction, do so through legislative bodies, where voters can have their voices heard.

Tom Smythe, Ph.D., is a professor of finance in the Lutgert College of Business at Florida Gulf Coast University.

Photo Credit: Courtesy FGCU, Getty