The twin revolutions in our money and energy systems

“Most revolutions are explosions,” D. H. Lawrence once wrote, “and most explosions blow up a great deal more than intended.”

Two of the major systems underpinning the global economy - money and energy - are facing changes so significant that they could well be considered revolutions. And the potential for sudden and unexpected flare ups is playing on minds right across the globe.

The low interest rate and low inflation environment that supported our economies through the major crises of the past two decades is under strain as we emerge from the pandemic. Meanwhile entirely new systems of trade have emerged, such as cryptocurrencies and decentralised finance initiatives supported by distributed ledgers rather than traditional institutions. The resulting changes in supply chains, employment patterns and end user demand are combining to put upward pressure on prices and force a rethink of long-standing monetary policy orthodoxy.

At the same time, the urgent need to move away from the fossil fuels which have propelled human development for several centuries, is overturning long-established methods of energy production, pricing and distribution.

This backdrop only increases the risk of a monetary policy mistake. The agonising of central bankers on the likely persistency of higher prices and labour shortages shows that most are out of practice when it comes to dealing with inflation. We have to track back to the early 1980s to find a time when prices rose as quickly as they have done recently.

The Federal Reserve is indicating a swift tightening cycle, involving an end to asset purchases in Q1 and three to five rate hikes this year. But this rapid systemic shift in monetary policy risks lighting the fuse on a global debt pile that has ballooned during the years of ultra-low rates. If, as rates rise, growth collapses, defaults rise and markets panic, central banks will be forced into a dovish pivot.

Meanwhile, when it comes to finding ways to meet ambitious global climate pledges, policymakers have so far leant heavily on the supply side, including attempting to use the transmission mechanism of the financial system to push through changes in the real economy.

While this is a good place to start, it’s very unlikely that supply side changes alone can achieve the pace and scale of change needed to meet climate targets. Policymakers will have to turn their attention to the demand side, which will include some necessary changes in behaviour by the consumer, something that politicians seldom embrace with open arms.

There are three broad sets of tools at their disposal: more product transparency to enable consumers to make better choices; direct tax incentives (and disincentives); and regulatory mandated change such as enforcing certain product standards or even outright bans.

Although this may sound intimidating, there are already some effective precedents, such as the prominent nutritional information on processed foods. Anyone aiming for a healthier lifestyle can pick the yoghurt with less sugar or sauce with lower salt. In a similar way, consumers may benefit from more and clearer information on the carbon cost of their purchases, directing the unseen forces of demand towards greener products.

Tax incentives and product subsidies, although more controversial, can direct consumers towards green alternatives. So far, this approach has been focused on big purchases, such as grants for electric vehicles, but could be expanded to cover more of the daily spend.?

And finally, we may have to be bolder about banning carbon intensive or highly polluting products altogether. While this sounds more extreme, it has been done effectively in the past in a whole range of areas, including lead in petrol, CFCs and more recently with the banning of halogen lightbulbs last year.

Central banks have centuries of history to draw on to work out how to manage the growth and inflation challenges of our current environment, including the lessons learned from some painful policy errors. But no textbook exists for the roadmap through the current climate challenge.

We are far behind where the science says we need to be to minimise long-term harm from carbon emissions. We need a revolutionary approach, one that pulls multiple levers - both carrot and stick, both demand and supply side, both nudges and compulsion - if we’re to prevent the environmental timebomb from going off.