Climate Minsky moments and endogenous financial crises

Summary

Focus

Does the transition to net zero decrease financial stability and, if so, by how much? Answering these questions is crucial for financial regulation over the next decades, which may be characterised by a shift away from emission intensive technologies. Ambitious carbon taxes would negatively affect the macroeconomy and asset prices by causing a sharp and permanent drop in the productivity of emission intensive assets. Climate policy could then give rise to climate Minsky moments, in which a sudden reduction in asset prices raises the concern that financial intermediaries are unable to repay depositors, triggering a financial crisis.

Contribution

We assess the impact of climate Minsky moments on financial stability, the macroeconomy and welfare. Specifically, we develop a new quantitative macroeconomic model using historical moments for the financial sector and incorporating carbon taxes and endogenous financial crises. Using our non-linear framework, we evaluate how a climate policy that reaches net zero carbon dioxide emissions by 2050 – consistent with the Paris Agreement – affects financial and economic outcomes in the short and long runs.

Findings

We show that climate policy consistent with the Paris Agreement initially substantially increases financial fragility. However, carbon taxes enhance long-run financial stability as a buildup of excessive financial sector leverage is prevented by lower asset returns. Quantitatively, the net financial stability effect is only negative for higher social discount rates. Even then, the welfare effects of climate Minsky moments are, at most, second order relative to the real costs and benefits of an accelerated transition. Our results challenge the notion that financial stability concerns justify delaying the net zero transition.

Abstract

How does a shift in climate policy affect financial stability? We develop a quantitative macroeconomic model with carbon taxes and endogenous financial crises to study so-called "Climate Minsky Moments". By reducing asset returns, an accelerated transition to net zero initially elevates the crisis probability substantially. However, carbon taxes enhance long-run financial stability by diminishing the relative size of the financial sector. Quantitatively, the net financial stability effect is only negative for higher social discount rates. Even then, the welfare effects of "Climate Minsky Moments" are, at most, second-order relative to the real costs and benefits of an accelerated transition.

JEL classification: E32, E44, G20, Q52, Q58

Keywords: climate policy, financial stability, financial crises, transition risk, non-linearities