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….

Black Monday: 30 Years After

On Monday, October 19, 1987, the Dow Jones Industrial Average plunged 22.6 percent, nearly twice the next largest drop—the 12.8 percent Great Crash on October 28, 1929, that heralded the Great Depression.

What stands out is not the scale of the decline—it is far smaller than the 90 percent peak-to-trough drop of the early 1930s—but its extraordinary speed. A range of financial market and institutional dislocations accompanied this rapid plunge, threatening not just stocks and related instruments (domestically and globally), but also the U.S. supply of credit and the payments system. As a result, Black Monday has been labeled “the first contemporary global financial crisis.” And, a new book—A First-Class Catastrophe—narrates the tense human drama that it created for market and government officials. A movie seems sure to follow.

Our reading of history suggests that it was only with a great dose of serendipity that we escaped catastrophe in 1987. Knowing that fortune usually favors the well prepared, the near-collapse on Black Monday prompted market participants, regulators, the lender of last resort, and legislators to fortify the financial system.

In this post, we review key aspects of the 1987 crash and discuss subsequent steps taken to improve the resilience of the financial system. We also highlight a key lingering vulnerability: we still have no mechanism for managing the insolvency of critical payment, clearing and settlement (PCS) institutions....

The China Debate

China’s rapid credit expansion is worrying. Will Chinese policymakers be able to contain the growth of credit without undermining economic growth and without triggering a banking or currency crisis? Aside from the consequences of Brexit, this is probably the most important issue facing global policymakers and investors today.

As it turns out, there are powerful arguments on both sides. The positives—high national savings and returns to investment, combined with the government’s broad tools for intervention—must be measured against a set of negatives—growing loan losses, the spread of shadow banking, large capital outflows, falling investment returns, and declining confidence in the government’s financial policy management. Against this complex background, it is no wonder that concerns and uncertainty are both high. What one can say confidently remains conditional: things are very likely to end badly if the credit buildup continues amid slowing economic growth...

Is China's devaluation a game changer?

Since 1978, China has engaged in an unprecedented and wildly successful experiment, moving gradually from a command economy to one based on markets; in small steps transforming a system where administrators controlled the goods that were produced to one where prices allocate resources. There were surely miscalculations along the way. But, even big blunders could largely be concealed. Until now!

What has changed in recent months? The day has come for China to become more closely integrated into the global financial system, and this has a number of implications. The most important is that as prices and quantities of financial assets (rather than goods) are determined in markets, bureaucrats lose a great deal of control. But, as recent events very clearly demonstrate, Chinese authorities are reluctant to let go....

China's stock market boom and bust

Ask a well-educated person which country boasts the largest equity market and you’ll usually get the right answer: the United States. Ask which country has the second largest market and you’re likely to get a range of answers: Japan? Britain? Germany?

The answer is China. In terms of annual trading volume, China's equity market has been #2 since 2009. Measured by total market capitalization, it has been #2 for seven of the past nine years....

Why should this matter now? First, because it highlights the extraordinary spread of market-based finance in a country led for more than 65 years by its communist party.... Second, because the growth in Chinese equity markets comes with sizable risks. Recent experience drives home this point....

It's the leverage, stupid!

In the 30 months following the 2000 stock market peak, the S&P 500 fell by about 45%. Yet the U.S. recession that followed was brief and shallow. In the 21 months following the 2007 stock market peak, the equity market fell by a comparable 52%. This time was different: the recession that began in December 2007 was the deepest and longest since the 1930s.

The contrast between these two episodes of bursting asset price bubbles ought to make you wonder. When should we really worry about asset price bubbles? In fact, the biggest concern is not bubbles per se; it is leverage. And, surprisingly, there remain serious holes in our knowledge about who is leveraged and who is not.

Steve Cecchetti and Kim SchoenholtzNovember 17, 2014Leverage, Stock market, Real estate, MBS, ABCP, SIV

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Money, Banking, and Financial Markets