Many of the measures governments can take to address climate change fall under the headings of taxing and spending—in other words, fiscal policy. But fiscal policy is often steered by politics, which can lead to slow progress on a polarizing issue such as climate change. Some politicians and voters have begun to look to central banks to help make climate-oriented policies, but Chicago Booth’s Lars Peter Hansen warns that monetary policy is far more limited in its capacity for environmental goals.
Narrator: Melting icecaps, hurricanes, tornadoes, droughts, famine—climate change is affecting our lives every day. Some governments are passing legislation to address the threat, though many are not. Even central banks are throwing their hats in the ring. But just what can central banks actually do? Chicago Booth’s Nobel laureate economist Lars Peter Hansen wrestles with this very question in an essay published in the Journal of Monetary Economics.
Lars Peter Hansen: I wrote this essay because I was curious or struck or trying to sort out why central banks are jumping into the climate-change arena. I’d been very interested in climate change as a problem. I thought about it primarily as being like a fiscal challenge. Taxes, subsidies, and the like. So why should central banks be involved? And I’d been doing a lot of research on uncertainty. And so I thought perhaps the most interesting angle is because the financial sector faces uncertainty connected to climate change. Might there be a role?
I don’t really want to put myself in the heads of central bankers. I haven’t been a central banker. On the one hand, I think there’s probably a feeling of wanting to do something. Lots of the public has a sense that climate change is an important problem. There’s been frustration that other entities within the government have been slow or not really meeting the needs to address climate change. So maybe central banks should get involved in it.
But the question is: What is in their so-called arsenal to do? What can they do that’s really effective and productive? And so in writing this essay, that’s really the type of issues which I wanted to probe. What can central banks do that’s productive? And where is it overstepping? What is really in their power to do productively?
Narrator: Hansen points to fiscal policies such as a carbon tax and subsidies for new green technologies as possible ways to combat climate change, none of which are in the hands of central banks.
Lars Peter Hansen: Governments are not always the best people at kind of figuring out how to spend wisely because the political arena can distort the expenditures in unproductive directions. But potentially this is a policy lever that’s certainly worthwhile considering. But that’s, again, fiscal policy. What’s the right amount of subsidies we should give to research and development of new green technologies? So those are potentially powerful levers going forward to address climate change. And ones that I think are certainly worthy of very serious consideration. What central banks can do to address this is much more subtle or secondary.
Central banks regulate financial institutions, including banks. In order to do that effectively, it’d be good to have a common way, agreed-upon, sensible way to measure exposures to climate change. Climate change is different than other risk faced by financial institutions because we’re potentially pushing economies into places that they haven’t experienced in the past. And so you can’t just look at historical data and just immediately figure out what those exposures are. So that makes us want to think about uncertainties a little bit differently. And some of my research has been trying to delve into exactly that question.
To my view, what would be productive is for the regulator and the regulated, along with academics’, potentially, input to agree on how to measure exposures to climate change in sensible ways. If the central banks and the private sector are on the same page here, it can be productive to both. And it would make the role of the central bank as monitor much more direct and straightforward. So to my taste, that’s a very productive first step and one that I would like to see more effort devoted to.
Narrator: Hansen argues that there are three ways that central banks can get involved.
The first two would come naturally to central banks: focusing on financial stability, and regulation of the banking sector. Having experience with the financial crisis, central banks may feel emboldened to help banks prepare for the uncertainty of climate change. Hansen also considers the issue of whether central banks should somehow help steer investment toward green technologies.
Lars Peter Hansen: So in thinking about the role of central banks, perhaps three things might come to mind. One is the overall stability of the financial system, financial stability. The second one is regulation. Central banks regulate the banking sector in making sure the institutions in the banking sector are well-prepared for uncertainties attached to climate change as they unfold. Of course, those two are interrelated.
A third one that there has been some attention paid to is maybe central banks should look at the financial institutions and in order to support economies with their kind of zero emissions plans going forward, they should be in the business of trying to figure out how to slant or make sure that financing goes to green technologies. Yes, central banks should make sure that the financing is available to develop new green technologies, but they don’t really have the expertise to be green venture capitalists. That expertise, in my view, lies elsewhere. And so their main role ought just to be to make sure that there’s financing available for productive ventures.
Narrator: Another problem central banks face is adapting a long-term strategy as the effects of climate change will unfold beyond the next five years.
Lars Peter Hansen: If we’re talking about events that play out over multiple decades, then we really do have to start thinking in some sense more probabilistically. We can’t just say, “Well, here’s this scenario that plays out over 30 years, what will you do?” First of all, that’s not the type of environment they’re going to face. Second of all, if you give me the ability to know what’s going to happen in 30 years, then I can do lots of intelligent things, but that’s not very useful to give that type of answer.
So how you can get reasonable responses to stress tests is a very interesting and important challenge. And right now, if you take our knowledge base about the uncertainties attached to climate change and how they might unfold over multiple decades—right now they’re thinking about stress tests in terms of three decades—how to pose those uncertainties remains an intellectual challenge and a practical challenge facing decision-makers. So the naive approach of just imitating the stress-test mentality played out for three decades would not be productive.
Narrator: For central banks, Hansen concludes that while monetary policy can support climate change goals, it’s a weak substitute for sensible fiscal policy. Central bankers need to beware of overstating their ability to contribute and providing false hope for tackling the challenge.
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