Never Two Without Three: Will the World Listen After the Global Financial Crisis, COP21 and the Pandemic?

By | August 7, 2020

This post is the latest in our special issue: “Climate Change and Financial Markets – Risk, Regulation, and Innovation.” To learn more about the special issue and the work of the Global Financial Markets Center around climate change and financial markets, please read the special issue’s introduction here. And to review all The FinReg Blog posts that touch on climate change, go here.


The most systemic risk ever

In order for a war to be just, three things are necessary. First, the authority of the sovereign. Secondly, a just cause. Thirdly, a rightful intention – Thomas Aquinas

The unprecedented is necessarily unrecognizable – Shoshana Zuboff

2020 started as a fairly quiet economic year: the world economy was performing well, with stable growth, decreasing unemployment, and well-functioning financial markets. Then, in a matter of weeks, the COVID-19 pandemic changed the course of world history. We have already experienced macroeconomic uncertainty unknown in contemporary history and the beginnings of political and social upheaval. An example is the unprecedented raise in unemployment claims (graph 1).

Graph 1 – US initial claims 2000-2020,

 “This crisis is like no other,” because it involves literally the entire world. Although unprecedented, the pandemic has exposed weaknesses that were already there. This is especially true as far as financial stability and environmental issues are concerned. A few years ago, the Paris Agreement sparked a mass interest in climate change and triggered a discussion on how to fulfill the breathtaking task of funding the green transition. COP 21 also implied a discussion on green financial rules in the middle of a general process of financial re-regulation in response to the 2008 global financial crisis. The pandemic, climate change, and the 2008 global financial crisis; three very different emergencies with a common consequence – global financial instability.

These worldwide problems require worldwide solutions and coordination. However, the appetite for international coordination seems to have diminished in recent year, as exemplified by the vagaries of the Trump administration.

The pandemic took shape as the third side of a triangle that depicts the future of the world economy. Many links among the three have already emerged, as the pandemic has abruptly changed the determinants of both financial stability and of transition to a green economy. In this article, we succinctly describe these connections and how the third side of the triangle can arouse a reappraisal of the policies proposed for the other two.

Links between the virus and the environment are manifold. First, there is the issue of pollution. Polluted areas are more affected by the virus, and because global warming destroys bio-diversity, thus making it more convenient for viruses to “specialize” in infecting human beings. Second, due to the dramatic reduction in economic activity, the energy demand contraction is the strongest ever, with an estimated impact that is more than seven times larger than the impact of the 2008 financial crisis. This has already produced a collapse in energy prices, with the price of oil (futures contracts) falling below zero at one point, and will have consequences on energy prices for years, thereby influencing the speed of transition to renewable energy.

The connection between climate change and financial stability was well established before the pandemic. For instance: “The projected increase in the frequency and severity of disasters due to climate change is a potential threat to financial stability.”. The connection between the pandemic and financial stability is obvious. Financial markets have been dramatically upset by the emergency. In a single day, on 23 March, at their lowest, global equity markets were losing some $26tn, forcing a public intervention to tackle the collapse. More generally, the pandemic has affected the whole of economic activity, interacting with pre-existing financial vulnerabilities. An immediate consequence of the emergency has been a colossal increase in public sector intervention in the economy. Given that public sector involvement was also a major discussion point around the transition to a green economy, will resources simply be diverted from green projects to the health emergency?

A world of debt

Global debt was rapidly increasing before 2008 and its growth has continued ever since. For instance, the OECD reported that at the end of 2019, the stock of non-financial corporate bonds stood at $13.5 trillion, double the level of 2008. In the following graph we can see both the rise of debt and the connected collapse of interest rates:

Graph 2 – BIS, “87th Annual Report,”(2017), p. 19

Many commentators believe that excessively loose monetary policy is to blame for this situation, but it is not clear what alternative they have in mind: letting financial markets collapse during the crises, bringing down the world economy with them? Preventing banks from providing “too much credit” would push borrowers elsewhere (shadow banks, for instance). In this picture, the distinction between private and public debt is very thin. In order to maintain financial stability, governments and central banks have been forced to intervene, buying assets (as with quantitative easing), buying banks, or offering different forms of guarantees on private debts.

With the pandemic, public debt is set to explode with the direct growth in state expenditures combined with a collapse in state revenues. This will result in the substitution of private debt with public debt, as the former ECB President explained: “Much higher public debt levels will become a permanent feature of our economies and will be accompanied by private debt cancellation.”  How this debt explosion will be managed – in terms of the mix of financial instruments, fiscal policy and so on— is not only important for financial stability, but also for green finance. This raises several important points.

First, central banks have acted rapidly and in innovative ways, overcoming old taboos and entering new territories. All this is in stark contrast to the extreme prudence used by public authorities in funding the green transition. Second, international institutions deemed the task of funding the green transition to be immense. For instance, in 2014, an official report put the overall need of the transition at $90 trillion before 2030. Now, almost a third of that sum has been spent in a matter of weeks. Third, economic theory has long discussed the different ways by which a central bank can fund the State. In some institutional set-ups, such as the Eurozone, some of these methods are legally forbidden. The pandemic forced a more pragmatic outlook. Currently, “[t]he difference between QE and direct monetary financing is mostly one of presentation.”. Once again, this pragmatism can be important for green finance. For instance, proposals have been made for issuing irredeemable bonds to tackle pandemic – the extension to perpetual green bonds seems natural.

Prices, leverage and central bank independence

The fear of QE-induced inflation was common after 2008 but it never materialized. Now, once again, there are similar fears due to the enormous monetary stimulus in response to the pandemic. In reality, deflation is not only rooted in the pandemic induced economic collapse, but also in an excess of supply in many sectors before the virus. The risk of deflation is worsened by the fact that the collapse of consumption also comes from well-off families that are reducing their shopping not for a lack of money, but for the wealth effect (people spend less as the perceived value of their personal assets decreases). This means that the usual measures employed by the government to tackle consumption collapse will not work.

For now, it is difficult to assess what prices are doing since it is difficult to measure inflation during the pandemic. But the massive public intervention creates an even bigger dislocation for the price mechanism than monetary instability: it risks destroying its signaling function altogether. Whatever happens, “you would never know it from the markets.” How can prices in real and financial markets represent an effective signal to economic agents when they are so distorted? This is especially true for financial markets, where risk-free rates, the base for every asset yield, are anchored to zero for the time being. Who will buy bonds, including green bonds, that pay so little interest? This will also hurt banks’ profitability, worsening financial fragility. And yet, central banks are forced to keep rates low because financial leverage is very high and growing: debt has increased since 2008 and is going to increase even more because of the pandemic.

In a situation where monetary and financial stability are so precarious and intertwined, the distinction between fiscal and monetary policy and the independence of central banks are largely gone. It is the State, as a whole, that must keep the system on its feet, but how – be it using monetary, fiscal, direct or indirect stimuli— is a question that must be dealt with concretely. Already, with unconventional monetary policies, the discussion on the independence of central banks has entered a new era (“the divorce is over”) and the osmosis between fiscal and monetary policy is complete. This is especially true for U.S. economy that “is now dependent on asset bubbles for survival,” forcing the Fed to continuously intervene in the markets. But can the mechanism go on for long? What happens if markets doubt the efficacy of the intervention, or if  bigger and bigger interventions are needed for markets to survive? More public money is the only cure because any other policy measure is making no difference. For instance, the strong re-regulation of the banking sector after the 2008 crisis (“Basel 3”) was considered effective in improving the situation such that “the global financial system is more resilient and better placed to sustain financing to the real economy as a result of the G20 regulatory reforms in the aftermath of the 2008 global financial crisis.”. And yet, a few weeks of COVID-19 were enough to bring banks to their knees and force the authorities to intervene. The growth of financial markets and leverage went hand in hand with an increase in social and wealth inequalities that made the world less resilient to crises and even to pandemic. These developments, if unchecked, will reduce the financial and political space for the green transition. Something different is needed.

A new role for the State

Although there remains some support for economic policies that support the traditional recipe of cutting wages and social benefits, it is widely acknowledged that the situation calls for a different approach. Inevitably, “[g]overnments will have to accept a more active role in the economy.”. The question is what this looks like. There have been discussions around public capital, nationalization, and the like. In the U.S., there has even been a discussion on the use of the Defense Production Act to effectively take over firms temporarily.

These trends have been in the works for some time. The IMF noted that in the past decade, “state-owned enterprises (SOEs) have doubled in importance among the world’s largest corporations where now they count for the 20% of the total assets. This development is important in many ways for the green transition. For instance, SOEs are essential players in power generation and hence in the transition itself (see graph 3).

Graph 3 – IMF (2020), p. 53

Should the State decide what is produced, in spite of ownership? Presently, there is general agreement that the state should ensure the production and distribution of essential goods to tackle the pandemic. But, these “essential goods” intersect many economic sectors. Besides the immediate production of goods that are already there, there is an issue of R&D investment, for instance, in vaccines. One way or another, the State will have to fund them and there are proposals to nationalize the pharmaceutical industry. The issue of production chains brings us to a last point, connected to world trade and global value chains. In such a dramatic situation, supply chains that depend on China and other Asian nations seem too fragile. The shortening of supply chains and reshoring will require a stronger role for the state, including the option of outright nationalization.

These developments also entail a fierce competition among different state models. The Chinese example is an obvious starting point, not in its wholeness, but for peculiar aspects. For instance, a situation where private investors, for all their importance and wealth, are junior partners of the government could become attractive. Risks of unpleasant political developments are undoubtedly part of the picture, as influential government actors can use the situation to reshape the institutional and political landscape for their own purposes.

Conclusions: What a Green New Deal should look like after the pandemic

The bulk of the discussion around the green transition has focused on how to help financial markets create green products (green bonds, green mortgages, and so on), which seemed the only way to fund the gradual transformation of the productive system. The pandemic has changed the situation: it has shown that immense resources can be rapidly mobilized by public authorities, if deemed a vital need.

Combating climate change is also a vital need. The problem is that while the health emergency has spread (and is still spreading) everywhere, climate change affects different countries or economic sectors in very different ways, and the urgency of the issue is perceived differently in every country. On the other hand, by forcing an unprecedented increase in public and private debt, the pandemic will make the financial system even more fragile. Is it really a good idea to finance the transition with more bonds?

In Europe, as well as in the U.S., there is a discussion of a Green New Deal. The 2008 crisis and the pandemic, for different reasons, show that we live in a world that relies too much on finance. In order to be effective, the green transition must be based on different foundations. The original New Deal is a good start: financial reduction, social equality, public investment. This has served  the U.S. and the rest of the world well for decades. But, the health emergency is pushing the world in exactly in the opposite direction, exacerbating financial leverage and poverty. These effects have already provoked social unrest and could lead to political upheaval. The conventional model of growth is increasingly ineffective, as visible from the slowing down of productivity. The consequences of stagnant income are visible in the Gini coefficient trend, which is a measure of income inequality (see graph 4).

Graph 4 – US Gini coefficient, 1974-2016,

The pandemic is only worsening a preexisting situation. As the IMF noted: “In the past year, there were numerous protests in many parts of the world. Although the underlying causes of this social unrest are multifaceted and country-specific, some similarities reflect deep-rooted issues, such as poverty, inequality, erosion of trust in established institutions, and perceived lack of representation,”. Pandemic-induced economic crisis is likely to create an explosive mixture of financial and social instability.

With the pandemic, the world has turned away from international coordination. In a situation where many states violated the International Health Regulations adopted by the WHO in 2005, the feeling was that every country was left on its own, even within the EU. The usual controversy among Northern and Mediterranean EU countries has mapped onto how to tackle the pandemic, but we have seen similar quarrels in the U.S., for instance, California declaring its independence from the federal government’s efforts to fight COVID-19.

The virus has shown that we are all connected as residents on the same sick planet. The mantra of public policies for health and environmental emergencies should be “everyone’s health depends on everyone else’s health. We are all connected in an interdependent relationship” ( our translation). A different role for the State, a truly Rooseveltian Green New Deal, are still uncommon ideas in economic science right now. However, 2008 forced a retrenchment on many aspects of economics and the green transition may further push the Overton window of economic policy. Yet, we have known about the catastrophic impact of climate change for a while now. Perhaps the pandemic, as painful as it has been, will be the third and final sensational event that ushers in long awaited new economic ideas.


Lorenzo Esposito is a financial supervisor at Banca d’Italia, Milan Branch and a Professor in Economic Policy Department at the Università Cattolica del Sacro Cuore, Milan. The views expressed are those of the author and do not involve the responsibility of the Bank of Italy.

Giuseppe Mastromatteo is a Professor in the Economic Policy Department at Università Cattolica del Sacro Cuore, Milan.

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