April 30, 2019

We need to talk about the economy, but the jargon trips up even our best and brightest. Remember when David Cameron was accused of getting ‘debt’ and ‘deficit’ mixed up?

Another pair of terms that can get confused is ‘fiscal’ and ‘monetary’. Fiscal policy is all about how a government raises and spends money; monetary policy is about the management of the currency – and especially how much of it there is in circulation, which is primarily controlled through interest rates and which has a big influence on inflation.

Being about spending and taxation – i.e. what the government giveth and what it taketh away – fiscal policy tends to be more political than monetary policy. The latter typically goes unnoticed, unless something goes badly wrong. In fact, the whole subject is so esoteric that situations that we ought to be concerned about – such as the impact of persistently low interest rates – fail to excite much debate. Indeed, it suits the politicians to depoliticise the whole issue, handing over key decisions to an ‘independent’ central bank as if some of the most fundamental features of the economic system had nothing to do with them or, by extension, us – the voters.

Further reading
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However, monetary policy is becoming re-politicised. In fact, it’s become the subject (and sometimes the cause) of some of the most radical developments in politics of our time. The most obvious example is the ongoing consequences of the European single currency, which was supposed to be the ultimate in turning over political decisions to the technocrats, but which has unleashed forces that are slowly tearing the EU apart while at the same time driving efforts towards further integration.

Then there’s the debate stirred up by the use of monetary instruments like quantitative easing (QE) – when central banks create money and use it to buy back government bonds and other assets from the market, thus boosting the money supply and reducing the cost of borrowing. As well as being controversial in itself, QE is drawing attention to things that governments would prefer the public not to notice – such as the fact that private banks are allowed to literally create money out of thin air before lending it to us.

Once people start focusing on the weirdness of monetary policy, they start having weird ideas of their own. For instance, there’s the proposed alternative/supplement to QE known as ‘helicopter money‘ i.e. money that is created by the central bank and then dropped directly into consumers’ bank accounts. Then there’s Modern Monetary Theory, which turns conventional economic policy on its head and is gaining influential converts.

Another radical departure in monetary policy is proposed by Dirk Schoenmaker in an article for VoxEU. He argues that Eurozone monetary policy should be “tilted” in favour of investment in low carbon technology – by lowering the cost of capital for such investments relative to investments in polluting technologies.

Further reading
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But are central banks supposed to get involved in such things? Surely if the state wishes to channel investment towards certain sectors it should do so by non-monetary means, like tax breaks and subsidies. And if a central bank were to pick favourites, how would that even work? Doesn’t a change in base rates apply to the economy without differentiation?

To answer the last question first, Shoenmaker explains that as well as setting interest rates, the institutions of the Eurosystem (i.e. the European Central Bank and the central banks of the Eurozone member states) have other means of influence:

“The Eurosystem manages about €2.6 trillion of assets in its Asset Purchase Programme, which includes corporate and bank bonds in addition to government bonds. In its monetary policy operations, the Eurosystem provides funds to banks in exchange for collateral, which currently amounts to €1.6 trillion. A haircut is applied to the value of collateral, reflecting the credit risk.”

In finance, a ‘haircut’ is the discount that creditors apply to the value of an asset as a item of collateral compared to its value on the market as an investment item. The more extreme the haircut, the greater the reduction in general demand for the asset:

“Applying a higher haircut to high-carbon assets also makes them less attractive, reducing their liquidity. Early estimates indicate that this haircut could result in a higher cost of capital for high-carbon companies relative to low-carbon companies of four basis points.”

A basis point is a hundredth of one per cent, so four basis points amounts to a 0.04% difference in interest rates. That might not seem like very much, but when it’s applied to the vast sums of investment that will be needed just to stop Europe’s energy infrastructure from crumbling, it adds up. Furthermore, it sends yet another signal to the money markets that investing in fossil fuels is risky – and that the climate change commitments that governments enter into come with teeth.

It would also demonstrate that central banks, though not directly responsible for climate policy, realise that anything that destabilises the global climate ultimately destabilises everything – including the financial system for which they are responsible.

Schoenmaker makes a persuasive case, then. And yet I wonder if EU member states might not see any extension of monetary policy as economic integration by the backdoor. While monetary policy has been federalised by the single currency, fiscal policy remains, for the most part, in national hands (though subject to the Stability and Growth Pact). If, however, we start using monetary policy to do things previously the exclusive province of fiscal policy, then within the EU that would represent a further erosion of national sovereignty – and that could be subject to a further populist backlash.

Ironically, it may be non-members of the Eurozone (and indeed the EU) that find it easier to use monetary policy in new ways.

Further reading
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By Peter Franklin