Usefulness of the article: Ten years after the global financial crisis, monetary policy has certainly reached the limits of its effectiveness in the eurozone. Green cooperation between different economic policies (fiscal, monetary, and structural) could respond to technological and environmental challenges and provide much-needed support for growth.
Summary:
· Monetary policy in the eurozone has certainly reached the limits of its effectiveness in stimulating the economy on its own. Furthermore, if maintained for too long, the European Central Bank’s (ECB) unconventional monetary policy is likely to have adverse effects on the economy and destabilize the financial system.
· The persistence of low interest rates is mainly due to the slowdown in productivity since the global financial crisis. However, the lack of investment in Europe will become even more of a handicap to potential growth in the face of the challenges posed by global warming.
· A judicious combination of fiscal, monetary, and structural policies (policy mix) could provide a solution to the economic and environmental challenges facing the eurozone. Real interest rates below economic growth rates currently offer an opportunity to pursue accommodative fiscal policies while preserving the sustainability of public debt.
· The ECB could align itself with the « green » objectives of the new European Commission, in particular by ensuring that green projects benefit from advantageous financing costs. As part of the « green policy mix, » green bonds could become the central financing instrument and the European Investment Bank the true financial arm of the Green Deal.
Ten years after the outbreak of the global financial crisis (GFC), key interest rates and nominal government bond yields in advanced economies remain at historically low or even negative levels. With rates already close to theireffective lower bound, there is little room for monetary policy to combat a future economic recession.
In 2019, global growth slowed under the combined effect of increased trade and geopolitical tensions between the world’s major powers and persistent uncertainty over the terms of Brexit. The significant decline in manufacturing activity in Germany, but also in the eurozone, risks spreading to other sectors such as services and construction. At the same time, inflation in the eurozone remains low (estimated at 1.2% in 2019) and market expectations are moving away from the 2% inflation target set by the European Central Bank (ECB). Moreover, in response to weak economic activity and inflation, the ECB announced new monetary stimulus measures in September 2019, further reducing the deposit facility rate (to -0.5%) and relaunching its net asset purchase program. Monetary policy in the United States has also become more accommodative, with the US Federal Reserve cutting key interest rates three times in 2019.
When rates are already close to their floor, the effectiveness of resorting to even more accommodative monetary policy becomes questionable. In the wake of the financial crisis, the expanded toolkit available to central banks[1] made it possible to combat the threat of deflation and ease government financing conditions. It should be remembered that these so-called « unconventional » monetary policy measures (UMPMs) were intended to be « temporary » in nature, with the aim of restoring the « normal » functioning of the economy.
Discussing the negative effects of low interest rates is no longer taboo
Ten years after their introduction, the undesirable economic effects of low interest rates are being openly discussed by a large group of stakeholders, including financial institutions such as the ECB and the International Monetary Fund. If maintained for too long, these UMPs risk having adverse effects on economies and destabilizing financial systems.
First, low interest rates over many years could encourage excessive risk-taking by agents seeking returns. Similarly, the excess liquidity resulting from quantitative easing could fuel asset price bubbles (e.g., real estate or stock markets) whose values would gradually become disconnected from economic fundamentals. A sudden price correction in certain overvalued markets could have systemic implications.
Second, historically low interest rates pose a challenge to the profitability of financial institutions. The reduction in net interest margins[2] erodes the profitability of the banking sector and creates a risk of insolvency for institutions that are unable to adapt to this new operating environment. Last but not least, NIRB would have negative repercussions on society in terms of wealth redistribution and income inequality. NIRB could widen wealth inequality through revaluation gains on certain types of assets (stocks and real estate). Furthermore, the current low yields on fixed-income assets (e.g., bonds, Treasury bills) held by pension funds and life insurance companies will certainly lead to a reduction in future payments and fuel intergenerational income inequality.
Persistently low interest rates are due to weak productivity
How can we explain the persistence of extremely low interest rates despite their potential undesirable effects?
First, a supposed decline in neutral interest rates[3] is believed to be the cause of low rates in advanced countries. According to this hypothesis, excess savings (particularly precautionary savings), linked to greater risk aversion after the financial crisis and the aging of the population, have caused real equilibrium interest rates to fall.
Another factor explaining low rates is the decline in expected returns on investment. According to the hypothesis put forward by Larry Summers, since the GFC our economies have been stagnating in a secular manner and their growth potential has been reduced due to the slowdown in total factor productivity (TFP) and weak population growth.
This helps us understand why productivity has been so low in advanced countries since the crisis. Underinvestment in the face of the imperative for governments, but also the private sector, to reduce debt would be the usual suspect to explain limited productivity gains. Stanley Fisher (Blackrock 2019) points out that underinvestment in infrastructure, education, renewable energy, and digital technologies would limit potential growth and prevent TFP from returning to its pre-crisis levels. In fact, in the European Union (EU), nearly half of all corporate investment decisions are reportedly held back by inadequate transport infrastructure and lack of access to digital infrastructure (Boone and Buti 2019).
This investment shortfall in Europe will become even more debilitating in the face of the challenges posed by global warming. Indeed, reducing CO2 emissions across entire sectors such as energy, industry, and transportation will require more investment and, above all, different types of investment.
A vicious circle between low interest rates and weak productivity
A study by the Banque de France (Bergeaud et al. 2019) shows that low interest rates are not only a symptom but also a cause of low productivity. The authors highlight a circular relationship between interest rates and productivity. According to this hypothesis, the prolongation of low interest rates has artificially made a large number of low-productivity companies and projects « profitable, » leading to a secular slowdown in productivity. Moreover, Gopinath et al. (2017) empirically validate this vicious circle between low interest rates and slowing productivity in Spain, Italy, and Portugal since the early 1990s. In light of these analyses, a technological shock leading to considerable productivity gains would enable advanced countries to break out of this negative spiral.
Furthermore, it is now unthinkable to envisage a solution to structural productivity weakness without taking environmental constraints into account. If no action (or insufficient action) is taken, the consequences of climate change and the energy transition will weigh more heavily on our economies. Climate change is likely to affect potential growth through two main mechanisms:
- A slowdown in labor productivity as average temperatures rise, and
- The destruction of productive capacity due to more frequent and intense natural disasters.
In short, the ecological challenge requires a massive mobilization of public and private resources to stimulate innovation and the transition to low-carbon technologies. Mark Carney, Governor of the Bank of England, already sounded the alarm in 2015: without an appropriate policy response, the damage caused by climate change to economic growth, public finances, and the financial system would lead to a new global economic crisis.
A European green policy mix as a response to climate and economic challenges
Faced with the « explosive cocktail » of these economic and environmental challenges, a judicious combination of fiscal, monetary, and structural policies (policy mix) could prove decisive. Monetary policy has certainly reached the limits of its effectiveness in stimulating the economy on its own through bank credit. Moreover, the ECB has repeatedly called on governments to pursue expansionary fiscal policies to boost growth. As Mario Draghi has repeatedly stated, significantfiscal space is available in certain eurozone countries with low levels of public debt, such as Germany, the Netherlands, and Austria. More generally, real interest rates that are lower than economic growth rates offer a unique window of opportunity to pursue an accommodative fiscal policy while preserving the sustainability of public debt.
In light of recent announcements by European economic policymakers, we could even talk about a « green policy mix . » On the fiscal and structural policy front, the new President of the European Commission, Ursula von der Leyen, has presented her » Green Deal, « a green pact consisting of strong measures to achieve carbon neutrality by 2050. To be effective, however, the European Green Deal will need to mobilize budgetary resources at the EU level that are commensurate with the challenge, both at the European level and at the level of the member states.
With regard to monetary policy, Christine Lagarde, the new President of the ECB, stresses that climate objectives should also be integrated intothe institution’sstrategic review. Supporting EU economic policies is part of the ECB’s mandate, insofar as this does not prejudice the primary objective of price stability. Although the subject involves many technical issues, the ECB could already align itself with the new Commission’s green objectives, in particular by ensuring that green projects benefit from advantageous financing costs. Even though green bonds have already been purchased as part of the ECB’s asset purchase programs (CSPP and PSPP), their volume remains very limited for the time being.
Green bonds would thus become the central instrument for financing green projects as part of the « green policy mix. » At present, the European green bond market remains in its infancy, accounting for less than 1 percent of the total bond market. The French Treasury led the way in the eurozone with its first issue in January 2017. In addition, development banks such as the European Investment Bank (EIB), the French Development Agency and its German counterpart, KfW, have been issuing green bonds for some time. The EU could increase the depth of these markets by making the EIB the European « green » bank, the financial arm of the Green Deal.
At the same time, for the Green Bond market to develop, it is crucial that major issuers, such as Member State governments, supply this market with regular, large-scale issuances. In this way, the ECB will be able to become a major player in the green bond market, notably through purchases on the secondary market (as part of its PSPP public securities purchase program) or by granting liquidity to commercial banks in exchange for green securities provided as collateral. Greater depth in the secondary market for green bonds would enable the ECB to increase its purchases of green securities and thus lower their yields, while respecting the imperative of market « neutrality. » More importantly, the massive purchase of these assets will gradually green the ECB’s balance sheet, which is currently far from CO2 neutral. The NGFS (the network of central banks and supervisors for greening the financial system) recommends that central banks integrate sustainability considerations (i.e. , Environmental, Social, and Governance (ESG) Criteria) into their capital management. We could well imagine this recommendation being extended to the rest of central banks’ assets held for monetary policy purposes.
Conclusion
Finally, to ensure the effectiveness of this green policy mix, it is essential to define a time frame in advance. The duration of this expansionary policy should therefore be announced as soon as it is put in place, so that it can be factored into the expectations of private agents. Of course, in the medium term, it is essential that the private sector take over and play a central role in the energy transition of our economies. This greening, through the investments in infrastructure and innovation that it induces, is likely to stimulate technical progress and productivity gains (Porter’s hypothesis). Overall, this « green » cooperation between different economic policies could lift our economies out of secular stagnation by responding to the technological challenge and providing long-awaited support for growth.
[1] Extremely low or negative interest rates, large-scale public and private asset purchase programs, and forward guidance.
[2] A bank’s interest margin is the difference between the interest rate at which it lends and the interest rate at which it refinances itself on the various capital markets.
[3] This corresponds to the long-term equilibrium interest rate that allows the economy to maintain full employment without creating inflationary pressures.
[4] Article 127(1) of the Treaty on the Functioning of the European Union states: « Without prejudice to the objective of price stability, the ESCB(European System of Central Banks) shall support the general economic policies in the Union with a view to contributing to the achievement of the Union’s objectives as laid down in Article 3 of the Treaty on European Union. »
