Green Money Without Inflation

This post was first published on Ivory Tower, Paul De Grauwe’s personal blog here.

To what extent can the money created by the central bank be used to finance investments in the environment? This is a question that is often asked today. The green activists respond with enthusiasm that the central bank, and in particular the European Central Bank (ECB), should act and stimulate the financing of environmental investments through the printing of money. The ECB has created 2,600 billion euros of new money since 2015 in the context of its quantitative easing (QE) program. All that money has gone to financial institutions that have done very little with it. Why can’t the ECB inject the money into environmental investments instead of pouring it into the financial sector?

Most traditional economists react with horror. The ECB should not interfere with the environment, they say. The government should do that. If the ECB jumps on the environmental bandwagon, it will be obliged to print too much money. This will fuel inflation in the long run, with terrible consequences. Ultimately, the environment will not be served.

Who is right in this debate? To answer that question, it is good to recall the basics of money creation by the ECB (or any modern central bank). Money is created by the ECB when that institution buys financial assets in the market. The suppliers of these assets are financial institutions. These then obtain a deposit in euros at the ECB in exchange for relinquishing these financial assets. That is the moment when money is created. This money (deposits) can then be used by the financial institutions to extend loans to companies and households.

There is no limit to the amount of financial assets that the ECB can buy. In principle, the ECB could purchase all existing financial assets (all bonds and shares, for example), but that would increase the money supply in such a way that inflation would increase dramatically. In other words, the value of the money issued by the ECB would fall sharply. To avoid this, the ECB has set a limit: it promises not to let inflation rise above 2%. That imposes a constraint on the amount of money that the ECB can create. So far, the ECB has been successful in maintaining the 2% inflation target.

There is also no restriction on what types of assets the ECB can buy. Since 2015 when it started its QE-program, the ECB has mainly bought government bonds, but also corporate bonds from financial institutions. The ECB could, however, also purchase bonds issued to finance environmental investments. The only restriction on these purchases (again) is that they do not endanger the 2% inflation target.

What are the options for the ECB? The ECB has bought 2,600 billion of government and corporate bonds since 2015. These purchases have not fueled inflation, which has remained below 2% in the Eurozone. The ECB has now stopped making new purchases. It has announced though that when these government and corporate bonds come to maturity, new bonds will be bought in the market so as to keep the money stock (money base) unchanged. This creates a “window of opportunities” for the ECB. It could replace the old bonds with new “environmental bonds”, i.e. bonds that have been issued to finance environmental projects. In doing so, the ECB would not create new money. It would only reorient money flows towards environmental projects. As the total amount of money would remain the same there would be no risk of additional inflation..

A possible objection is the following. If the ECB buys these “environmental bonds”, it will be involved in the decision-making process about which environmental investments should have a priority. For example it would have to answer questions such as: How much public and private investments must be made? Should it be renewable energy or nuclear energy? Should the priority be given to public transport? These are all questions that have to be settled by political authorities, and not by the central bank.

One possible way out: The European authorities give a mandate to the European Investment Bank (EIB) to finance, for example, 1000 billion of environmental investments. These political authorities add guidelines for the EIB about environmental priorities. The EIB issues bonds to obtain the resources necessary to fund these investments. This is the moment the ECB can step in by buying the EIB-bonds at a pace dictated by the expiration of the old bonds on its balance sheet. This way the ECB creates “green money” without fueling inflation. At the same time, as the ECB buys EIB bonds, it creates the possibility for the EIB to increase its borrowing in the capital markets without endangering its AAA-status.

The bottom line is that it is perfectly possible for the ECB to use the instrument of money creation to favour environmental investments without endangering price stability. Of course, one could also argue that the ECB could use its monetary instrument to favour other worthwhile projects, e.g. poverty reduction. This is certainly true, and if a majority of the population were to desire this, it should be done. Nevertheless, I am rather reluctant to go in this direction, as it would create the risk that the ECB is loaded with too many social responsibilities that it cannot handle properly.

That’s why I conclude that given the existential nature of the degradation of the environment, including climate change, the priority should be to use the ECB’s money creation capacity towards the support of environmental projects. This can be done without creating inflation.