The view that central banks should be ‘market-neutral’ has a flaw: how can central bankers be neutral about wealth inequality and the climate crisis?
Since the financial crisis, central banks have become the most important actors in economic policy. Their interventions have been essential to stabilise the system. At the beginning of March 2020, the uncertainty triggered by the pandemic threatened quickly to seize the international financial markets once again—refinancing problems troubled companies and governments. With their far-reaching actions that month, central banks prevented the world from experiencing a financial-market collapse, on top of the health and economic crises.
But crisis fire-fighting in this way, however necessary to protect the real economy, has negative consequences. Such interventions also increase wealth inequality, fuel the climate crisis and destabilise financial markets in the long run.
If last March had been a one-off event, the negative effects could possibly be neglected. National governments and the European Commission are however increasingly reliant on monetary policy.
After the financial crisis, central banks were pushed to intervene and their balance sheets grew steadily. The measures taken as a result of the pandemic have however far exceeded even those interventions: the ECB’s balance sheet grew by €813 billion euros from 2007 to 2010 but by €2,261 billion between February and December 2020.
What does permanent intervention by central banks mean for the major challenges of our time, such as climate change and inequality? To meet them, a clear (political) agenda is required. In particular, a progressive agenda is needed for the European Central Bank.
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According to the ECB, its actions should always be ‘market-neutral’. It wants to move prices but without shifting relative prices. In short, no sectors are to be favoured. Yet this claim does not withstand empirical scrutiny.
Already the ECB’s choice of monetary-policy channels is not neutral. Banks, on the one hand, tend to benefit from changes in refinancing conditions, supporting in turn small and medium-sized enterprises. Larger companies active on the capital market, on the other hand, benefit more from the purchase of corporate bonds.
Moreover, these bond purchases by the ECB have distorting effects, as they tend to favour C02-intensive sectors. From March to June 2020 alone, more than €7.6 billion were invested in bonds issued by companies in the fossil-fuel sector. That can hardly be deemed neutral behaviour.
This insight seems to be slowly dawning on the ECB as well. Its president, Christine Lagarde, and the executive board member Isabel Schnabel have publicly questioned the principle of market neutrality, since financial markets do not adequately factor in climate-related risks. That market failure, in this view, could become a problem for price stability in the medium term and should therefore be addressed.
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The fact that the ECB wants to take action is commendable. Yet this should not only be done for the sake of price stability but to contain the climate crisis itself. The secondary mandate of the ECB could serve as a foundation for such efforts: it tasks the ECB to support the ‘general economic policies in the Union’.
An analysis by the Bank for International Settlements shows that the steady rise in stock prices is largely due to loose monetary policy. But what does it mean for wealth inequality when share prices are rising because of central-bank intervention? It mostly benefits high-wealth individuals, as they tend to own more assets. Last year, this was made particularly clear by the pandemic. When the coronavirus spread in Europe in February, stock prices fell as unemployment rose. Since, however, stock markets have recovered—the DAX recently broke through the 14,000 mark for the first time—while the situation in the real economy remains tense.
Central banks are well aware of the effects of their policies on stock markets. The rise in asset prices is intended as a transmission mechanism of monetary policy. But when did we last time hear a central banker talk about inequality?
While monetary policy helps to stabilise the economic and financial system in the short term, it thus also reinforces the socio-ecological challenges of our time. Reliance principally on monetary policy is insufficient to bring about the transformation of our economy. A progressive agenda for the ECB can address these issues.
Clearly, the ECB cannot bring about that transformation on its own. It crucially needs expansive fiscal policy, to finance the transition to a low-carbon economy and as an instrument for stabilisation in times of crisis. We need a just tax policy and a consistent C02 price, which takes into account effectively the external costs of fossil fuels. In addition, we need stable financial markets which do not require continuous stabilising interventions by central banks.
To this end, shadow banks must finally be regulated. In contrast to banks, which are required to hold higher reserves by the ‘Basel 3’ framework, an immediate collapse due to illiquidity is still a major problem for shadow banks, such as money-market or hedge funds. Much of the turmoil on the United States government bond market last March was due to highly leveraged trades by hedge funds. Once central banks began purchasing bonds, they not only stabilised the government bond market but bailed out a number of hedge funds at the same time.
Central banks have powerful tools at their disposal. Should they support policy objectives beyond their traditional, price-stability mandate—and, if so, how? They need to draw attention to the negative effects of their policies and proactively manage them. They should not exacerbate existing challenges, such as climate change and wealth inequality, but instead support their resolution.
Concrete proposals on how to make the ECB’s refinancing programmes more sustainable or how to decarbonise ‘quantitative easing’ are already on the table. Digital central-bank money could contribute to financial stability and combat wealth inequality through targeted monetary policy.
Are these new tasks compatible with central-bank independence? Perhaps not but they might confer democratic legitimacy on these powerful institutions. The first strategic review of the ECB in 17 years shows even central bankers are well aware of the challenges.
Questions such as these will be discussed during an online conference, Next Generation Central Banking: Climate Change, Inequality and Financial Instability, on February 3rd to 5th