For more than a decade, economists around the world have been broadly in agreement. To stimulate the economy (hit by shocks ranging from the 2008 financial crisis and Great Recession to the COVID pandemic), it is good for central banks to pursue an unconventional monetary policy anchored on asset purchases. Initially this policy was instrumented by central banks buying sovereign bonds – those issued by states –  from commercial banks, allowing the latter to strengthen their balance sheets and ratios. This, in turn, would enable them to charge lower interest on loans, and by this means stimulate the economy and boost investment. After buying government bonds on a massive scale, central banks moved on to corporate bonds, i.e., those issued by firms. When deciding the mix of its asset portfolio in this sector, the ECB opted from the start to follow a “market neutral” policy to avoid interference or favoring some companies over others. 

In recent months, however, several voices, some within the ECB itself, have questioned whether this is the right course, and whether it might now be time to factor in other variables like sustainability. 

This is the research that Monika Piazzesi presented on Tuesday, 29 June at the 16th JEEA–Fundación BBVA Lecture – “How Unconventional is Green Monetary Policy?”.

Neutral but inefficient

Prof. Piazzesi asks in her paper whether this “market neutrality” is truly efficient. And the answer, it seems, is no.

“What we did – explains the Professor of Economics at Stanford University – was to look at the microdata on the individual bonds the ECB has bought in conducting its unconventional monetary policy, to determine the sectoral make-up of its portfolio (what share has gone to the automobile industry or to oil and gas, etc.). Then we looked at the emissions of each company and added them up to calculate the percentage weight of each sector in total pollutant gas emissions, so we could then compare both rates. So let’s say the ECB has ten percent of its portfolio invested in oil and gas, we can now see how that compares to the share of total emissions that these companies produce. And what we found is that this ‘market neutral’ policy has led to the most polluting firms being overrepresented in the ECB’s debt portfolio.”

The largest sector in the European economy is the services sector, so it has the highest market value and the biggest share of assets. However, a study of the ECB’s bond portfolio shows that it is underweight in services and overweight in others such as manufacturing, when the service sector has very low emissions compared, for instance, to oil and gas. So what the ECB is in fact doing is to build a browner portfolio, because it owns more corporate bonds issued by relatively high-emission sectors. 

“One of the problems – Piazzesi continues – is that the companies producing the highest emissions, in oil and gas for instance, have lots of productive machinery that they can use as collateral (assets that serve as security for borrowings), so can issue more bonds than sectors like services.” And the ECB purchasing system, designed not to distort the market, ends up investing more heavily in the companies that issue most debt. But, according to Piazzesi’s analysis, “buying a firm’s bonds in proportion to the amount of bonds outstanding is a bad idea in a world where only a few firms issue bonds at all, and tend to do so on a major scale. Many other companies, conversely, finance themselves through equity, and as the ECB does not buy equity, its portfolio will never be proportional to total market value. From an economic standpoint, the ECB is trying not to distort the market, but if you really analyze how companies finance themselves, they use a range of instruments. So buying only in proportion to outstanding bonds is by no means neutral.”

Piazzesi points to some alternative models. That of the Swiss central bank, for instance, which is “currently buying the equity of green companies that are coming up with new, innovative technologies, and is thereby enabling them to lower their cost of capital. That is another policy the ECB could be discussing. I believe monetary policy should be looking for ways to finance firms, in the awareness that it is harder for the green players because they necessarily innovate more. So I think the big question the ECB must ask itself is what kind of infrastructure can I create to help these green firms raise finance?”

So, firstly, “the ECB should rethink whether buying in proportion to bonds outstanding is genuinely neutral. It certainly doesn’t seem so. Because it depends on the bond financing used by individual firms as opposed to equity financing. The next question is: in a world where we have not agreed on a carbon tax that can take care of carbon emissions, should the ECB take steps to bring down the cost of capital of firms that have greener technologies? This is particularly crucial in the present transition phase to a new greener economy, with lower emissions. The question is how can we move more quickly to an economy with a lot of green innovation and new green technologies. In that case, it might be worth having corporate bond purchases that focus on green firms.”

The carbon tax

Piazzesi wonders aloud what monetary policy can do in a world where we do not yet have a good carbon tax. “What we should do as an economy is have a carbon tax, so the negative externalities associated with emissions are incorporated into firms’ decisions, which will have to factor the cost to society of any increase in production. Europe is doing better than the United States in that regard, because it has a lot more environmental regulations, but we still don’t have agreement around an optimal carbon tax.”

For Professor Piazzesi a carbon tax is the obvious step for modern economies. But on what scale should emissions be taxed? “William Nordhaus – the 10th edition Frontiers of Knowledge laureate in Climate Change – is one of the people who has most contributed to the quantitative question of how high the carbon tax should be, and we should follow his models in making that decision. Any other policy, like the kind that I’m suggesting (that of monetary policy influencing the cost of capital to favor green firms in a way that mimics the effect of a carbon tax) is going to be worse than the carbon tax, which is the ideal tool to take care of the problem of carbon emissions. Any other policy is going to be a weaker instrument, but ways must be sought. A few years ago, there was a debate about who should receive the revenues from a carbon tax. One proposal, which has the support of most economists, was to take the tax receipts and distribute them per capita to households, so there is no negative redistribution effect, you give it to everybody equally, helping to create wealth.” 

A legacy of problems for future generations

On the topic of the post-pandemic economic crisis, Prof. Piazzesi admits that things have developed in a way she did not anticipate: “If you had asked me five years ago what would happen if everyone stayed at home for several months, without producing, I would have said the world would just collapse. And that didn’t happen. It is true that effective policies have been put in place, and governments have spent huge amounts of public money to counteract the crisis. But still I am impressed by how well working from home has functioned. There are whole sectors that are suffering tremendously, like bars and restaurants, tourism and entertainment. But I would have imagined the world ending in a situation of lockdown, and it didn’t. We are already seeing a recovery, and stock markets valuations are at a record high. I would never have thought that we could come out of this so quickly.”

In her view, however, policymakers have based their decisions on the survival of their own generation. “In the future we will need to think about all the debt we are accumulating in order to overcome the COVID crisis. We have created problems for future generations. During lockdown, children stayed at home with no school, we failed to address the climate crisis and we increased debt a lot. So we are leaving these three issues for the next generations. The people in charge have solved problems thinking mainly about themselves, and now we have to think more about the wellbeing of younger generations. I don’t think it’s sustainable, in terms of political economy, to go on legislating without regard to their needs.” 

About the speaker

Monika Piazzesi is Joan Kenny Professor of Economics at Stanford University, and a Professor (by courtesy) at the Stanford Graduate School of Business. She studied economics at the universities of Heidelberg and Bonn (Germany), then went on to earn a PhD from Stanford University. For the last thirteen years, she has been on the faculty at Stanford, after holding teaching and research positions at the University of California, Los Angeles and the University of Chicago. At the start of her time in Chicago, she received the Elaine Bennett Research Prize, awarded every other year by the American Economic Association for outstanding research by a woman not more than seven years beyond her PhD. That same year (2006), Piazzesi was appointed co-editor of Journal of Political Economy, and would continue in this role until 2014. Prior to that, she had been associate editor of the Economic Journal and the American Economic Review.

Piazzesi is a Research Associate at the NBER, where she was the director of the NBER Asset Pricing Program from 2007 to 2009. She is also a Research Fellow at the American Center for Economic Policy Research (CEPR), a Senior Fellow of the Stanford Institute for Economic Policy Research (SIEPR), and a Fellow of the Academy of Arts and Sciences and the Econometric Society.  A former Monetary Advisor to the Federal Reserve Bank of Minneapolis (2007-2008), she currently serves on the Research Council of the Bundesbank and the Academic Advisory Council of the Chicago Federal Reserve. Holder of a Guggenheim Fellowship 2015-2016.

JEEA–Fundación BBVA Lecture 

The BBVA Foundation supports the generation of knowledge and its transmission to society in the socio-economic field through its own programs and in conjunction with leading institutions. Since 2005, the Foundation has hosted the annual JEEA-Fundación BBVA Lecture in partnership with the European Economic Association (EAA). This international scientific body promotes the development of economic science throughout Europe, as well as communication between teachers, researchers and students, the links between university and research centers and relations between theoretical economists and policy-oriented economists.

The JEEA (Journal of the European Economic Association) is one of the leading scholarly publications in the field, known for the high scientific quality of the articles it carries and the prestige of its collaborating editors. Since 2017, publisher Oxford University Press has brought out six issues each year, one of which contains the text of the JEEA-Fundación BBVA Lecture.