Central bankers remain stuck in the myth of ‘market neutrality’

Monetary policy is never neutral. The recovery must not follow financial markets but rather reflect a shared vision of a green future.

Central banks today struggle with the climate impact of their asset-purchase programmes. The solution is not just their buying more green bonds—but democratising monetary policy.

The Bank of England announced earlier this month that it would be the first major western central bank to abandon its strategy of ‘market neutrality’. Instead of indiscriminately buying from all issuers in the market, disproportionately benefiting companies such as Shell and BP, the bank would review its Corporate Bond Purchase Scheme, to ‘account for the climate impact of the issuers of the bonds we hold’. It would thus seek to offset the bias of its existing programme, which benefits the most polluting economic sectors.

The European Central Bank is contemplating a similar move—‘tilting’ towards less carbon-intensive sectors. Others are sure to follow.

Having written an article a few years ago entitled ‘The myth of market neutrality’, you might imagine we would support this move. Although a step forward, the key lesson however remains to be learned.

Faith in the market

The question we asked in that paper was: why do central banks support the fossil-fuel industry with their monetary policy? Until the 1980s most central banks had a key role in a broader industrial policy. Accordingly, they sought to guide credit within the economy through a range of regulatory measures. The allocation of credit was part of economic policy, with government regularly weighing in.

As faith in the market grew over the course of the 1980s, central bankers increasingly came to present their role as much more narrow. They focused increasingly on one simple objective—to keep annual inflation at around 2 per cent. Being a largely technical exercise of using one tool to achieve one objective, monetary policy could thus safely be entrusted to an independent central bank.

After 2008, the world of central banking changed again. ‘Free’ markets had led to an opaque and largely unregulated global financial architecture, which crumbled under its own weight. The deflation of a large debt bubble and governments gripped by the fear of public debt drove western economies into a deep and long recession.

Central bankers pursued new experiments to revive the flagging economy. Buying shares and bonds became a key policy tool. In 2010, the Bank of Japan started buying its way into the Nikkei stock exchange. Now the largest single owner of Japanese shares, the BoJ has a portfolio worth around €2,700 per citizen. And that is peanuts compared with the Swiss National Bank’s diversified portfolio of shares and corporate bonds, which comes in at €33,000 for each Swiss.

Last year, the United States’ Federal Reserve was the last major central bank to announce corporate-bond purchases. They were—pun intended—a carbon-copy of the earlier European Central Bank corporate-share purchase programme. All these programmes copy the same ‘market-neutral’ specifications, which in turn replicate the carbon-intensive composition of capital markets.

Different impression

When we wrote our article in 2018, corporate security purchases were still mostly of academic interest. Economists at the Grantham Institute in London and elsewhere had, though, documented something strange. Central banks presented their purchases as designed explicitly to let the market work without disturbing the relative prices of assets. Despite being ‘neutral’ in this sense, however, a quick look at the bonds actually purchased gave a very different impression. Shell, Total, Ryanair, arms manufacturers—almost exclusively multinational companies—emerged in a virtual ‘who’s who’ of an old economic model very much out of sync with 21st-century climate policy.

What had happened? Central banks, we argued, had sought to follow the market because doing so was meant to be less political. But the outcomes were far from neutral. To this day, firms often refuse to disclose key information about the impact of climate change on their business model. Inertia leads investors simply to assume that that world is not coming—but it is. Because bond markets are crucial for capital-intensive sectors, such as energy and manufacturing, bond-purchase programmes are particularly biased: they benefit the most polluting sectors.

The deeper insight of the paper was more basic: monetary policy is always political, so attempts to be ‘neutral’ are doomed:

No attempt to replicate market structure will ever succeed in removing the political dimension from security purchases. As critical political economists, sociologists and anthropologists have so frequently argued, markets embody a specific, political vision of society, which is not shared by every member of the polity. Consequently, even if central bank purchases perfectly reflected the structure of the corporate sector, they would still reflect specific political views.

This argument holds still. The Bank of England may seek to correct the bias of its bond purchases towards carbon-intensive firms. But seeking to avoid bias is to remain stuck in the myth of apolitical markets.

Accepting responsibility

What then is the way forward? Moving beyond market neutrality requires accepting responsibility for the climate impact of monetary policy. Old polluting companies such as Shell and BP lack a strategy which fits the emerging vision of a green future. They should not receive public money.

But the choices that central banks face are often not that simple. Energy-intensive raw resources such as concrete and steel fit that future but not all ways of producing them do. Emissions from the UK’s vastly outdated housing stock need to drop by 24 per cent by 2030 to meet the Paris-agreement targets. Better insulation can only be installed during refurbishing, but to this day banks provide generous cheap funding without any concern for energy efficiency. This locks in decades of future emissions. Which renovations should still be funded by banks?

Central banks cannot, and should not, make these choices alone. Rather, they should find new ways to again make monetary policy part of economic policy—as it always was. Monetary policy should be conducted in fine-grained co-ordination with a broader climate agenda.

Democratic vision

The UK finance minister, Rishi Sunak, has explicitly asked the Bank of England to make sure that its operations reflect ‘environmental sustainability and the transition to net zero’. The bank should act on this. In doing so, it should follow not just the Paris agreement but also the fine-grained regional and state-level policies that build on it. These spell out a democratic vision of an economy constrained to a 1.5C rise over pre-industrial temperatures.

Companies which lack a good story about how their business model fits such an economy should be banned from the Bank of England’s Corporate Bond Purchase Scheme and the list of eligible collateral. They should also no longer benefit from the broader low-interest rate environment created by central banks. Banks which lend to such companies should themselves be struck with high borrowing costs when they seek to access the Bank of England’s super-cheap Term Funding Scheme. Credit-rating agencies which fail to take that vision into account should lose their elevated status.

At the end of the day, central banks cannot drive the climate transition. Giving up on ‘market neutrality’ creates space for democratic politics—for a global Green New Deal, where climate policy takes over the driver’s seat from the financial markets.