Climate Finance

Climate change is the topic of the day. The World Meteorological Organization tells us that the 2011-20 decade was the warmest on record. Earlier this year, the U.S. government re-joined the Paris Accord, and is proposing a range of new programs to mitigate the long-run impact of climate change. Now that a warming planet has made the Arctic increasingly navigable, national security specialists are concerned about geopolitical risks there. Thousands of economists have endorsed a carbon tax. Even central banks have joined together to form the Network for the Greening of the Financial System—a forum to discuss how to take account of climate change in assessing financial stability.

Against that background, last month, NYU Stern’s Volatility and Risk Institute (VRI) held a conference on finance and climate change. Speakers addressed issues ranging from the modeling and measurement of climate risk in finance to assessing its impact on the resilience of the financial system. In this post, we primarily focus on one of the central challenges facing policymakers and practitioners: what is the appropriate discount rate for evaluating the relative costs and benefits of investments in climate change mitigation that will not pay off for decades? We also comment briefly on several other issues in the rapidly growing field of climate finance research.

Past responses to the discount-rate question vary widely. Some observers call for a discount rate matching the high expected return on long-lived, risky assets—a number as high as 7%. This would imply a very low present value of benefits from investments to mitigate climate change, consistent with only modest current expenditures. Others postulate that climate change could lead to the extinction of humanity. For plausible discount rates, the specter of a nearly infinite loss means that virtually any level of mitigation investment is warranted (see, for example, Holt).

Recent climate finance research that we summarize here comes to the conclusion that over any reasonable horizon, the appropriate discount rate for computing the net present value of investments in climate change mitigation should be relatively low….

Fiscal Space Has Limits, Too

In the battle against the economic impact of COVID-19, governments around the world are pulling out all the stops. In advanced economies, leading central banks have pushed interest rates to zero or below. And, a recent IMF estimate puts the combination of discretionary spending and automatic fiscal stabilizers (including unemployment insurance and progressive income taxation) at $9 trillion―more than 10 percent of global GDP.

With bond yields low or negative, the limits to monetary policy are clear (see our pre-COVID post). How large is the scope for additional countercyclical fiscal policy? With sovereign yields so low, the cost of additional financial expansion looks to be minimal, at least for now (see, for example, Blanchard).

Nevertheless, each time public debt-to-GDP ratios ratchet higher—as they did in the 2007-09 crisis and are now doing again—the question of “fiscal space” reemerges. When the next economic shock hits, will governments again be able to provide relief and stimulus on the scale required to meet society’s needs?

In this post, we highlight recent fiscal developments in advanced economies, and review the factors affecting the sustainability of their high and rising levels of debt. To foreshadow our conclusion, the fact that many countries’ fiscal positions were precarious even before the COVID crisis does not weaken the current case for stimulus. But, doubts about fiscal space are growing. So, it is important that governments find a way to make a credible commitment to future fiscal consolidation when their economies have returned to full employment. Failure to do so could threaten confidence both in government finances and in economic performance….

Relying on the Fed's Balance Sheet

Last week’s 12th annual U.S. Monetary Policy Forum focused on the effectiveness of Fed large-scale asset purchases (LSAPs) as an instrument of monetary policy. Despite notable disagreements, the report and discussion reveal a broad (if not universal) consensus on key issues:

In a world of low equilibrium real interest rates and low inflation, policymakers could easily hit the zero lower bound (ZLB) in the next recession.

At the ZLB, the Fed should again use a combination of balance-sheet tools and interest-rate forward-guidance to achieve its mandated objectives of stable prices and maximum sustainable employment (see our earlier post).

Yet, significant uncertainties about the impact of balance-sheet expansion mean that LSAPs may not provide sufficient stimulus at the ZLB.

Fed policymakers should undertake a thorough (and potentially lengthy) assessment of alternative policy tools and frameworks—ranging from negative interest rates to a higher inflation target to forms of price-level targeting—to ensure they remain as effective as possible.

The remainder of this post discusses the challenges of measuring the impact of balance-sheet policies. As the now-extensive literature on the subject implies, balance-sheet expansions ease financial conditions. However, as this year’s USMPF report emphasizes, there is substantial uncertainty about the scale of that impact....

Fire, fury and the national debt limit

During the 2016 campaign, then-candidate Donald Trump discussed his broad experience with debt. He would bring the skills and sensibilities of a real estate mogul to government debt management, and the result would be a better deal for the American public. He even broached the idea of renegotiating the obligations of the U.S. Treasury.

Well, the day of reckoning has arrived. The Treasury has announced that by the end of September, it will face a shortfall. Without the authority to issue additional debt, the government will not be able to pay all of its bills—including the interest on the outstanding debt. In response, President Trump has threatened the Congress: either fund the wall along the Mexican border, or he will shut down the government.

If the U.S. government fails to meet its obligations for any significant period, we will all be big losers. A government that cares about the people—both now and in the future—would never willingly inflict such a wound.

Regulatory Discretion and Asset Prices

The Federal Reserve’s annual stress test is the de facto capital planning regime for the largest U.S. banks. Not surprisingly, it comes under frequent attack from bank CEOs who argue, as Jamie Dimon recently did, that “banks have too much capital…and more of that capital can be safely used to finance the economy” (see page 22 here). From their perspective, this makes sense. Bank shareholders, who the CEOs represent, benefit from the upside in good times, but do not bear the full costs when the financial system falters. As readers of this blog know, we’ve argued frequently that capital requirements should be raised further in order to better align banks’ private incentives with those of society (see, for example, here and here).

A more compelling criticism of central bank stress tests focuses on their discretionary character. To the extent feasible, central banks should minimize their interference in the allocation of resources by private intermediaries, allowing them to direct lending to those projects deemed to be the most productive.

But the painful lessons that have come from large asset price swings and high concentrations of risk provide a strong case for the kind of limited discretion that the Fed uses in formulating its stress tests. This blog post highlights why it makes sense for regulators to use this year's stress test exercise to learn how well the largest U.S. intermediaries would fare if the recent commercial real estate price boom were to turn into a bust....

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