Atif Mian: Fixing the Imbalance of Global Macrofinance

Today’s guest is someone of great personal significance to Tiger – his senior thesis advisor and one of the most important mentors in his student career. Atif Mian is the John H. Laporte, Jr. Class of 1967 Professor of Economics, Public Policy and Finance at Princeton University, and the Director of the Julis-Rabinowitz Center for Public Policy and Finance, which has graciously supported this podcast since day one. Prof. Mian studies the connections between finance and the macro economy, and his book House of Debt became an instant international bestseller when it was published in 2014 and kicked off a critical line of research related to debt forgiveness and risk sharing mechanisms. He is the first person of Pakistani origin to rank among the top 25 young economists of the world by the IMF. 

The following is from Tiger’s 2/5/21 Substack email "Piecing together the secular trends in macro-finance...", the topics in which are discussed in this interview with Prof. Mian:

The frontier of macro-finance

The field of macro-finance seeks to bring finance back to our understanding of the macroeconomy. Conventional macroeconomic models like the New Keynesian model doesn’t really incorporate finance, which no doubt has had a huge impact on the economy.

Macro-financial economists seek to link together inequality, credit, r*, asset prices, productivity growth, market concentration, secular stagnation, etc.

• How does the source of credit influence inequality? What is the source of the ongoing credit?

• Is there a feedback between finance and real productivity? Does the discrepancy between interest rates and credit spreads lead to undesirable outcomes in corproate market concentration?

• How does the redistribution of wealth through the boom/bust cycle in finance impact the aggregate economy?

• …

These topics are closely studied by my own thesis advisor Atif Mian, one of the world’s most prominent financial economists. The charts below are from his recent graduate macro-finance course lecture slides. I think he pieced together the large trends in an artful way that would be nice to share with you. Many of these phenomenon don’t have readily available answers yet, so the charts are more for the purpose of showing the overarching framework and hypotheses:

Rising debt and falling r*

We have been seeing a dramatic rise in debt level as measured by debt-to-GDP ratios across the world, which will only further blow up after Covid. Meanwhile, no matter how you measure it, the expected return r* has been declining.

One way to think about it is – the quantity of credit has been rising, so the price of credit has been falling. We shall come back to the idea of “credit” soon.

Global liquidity trap

In the chart above, the red dots are the US interest rates, and the orange bars are the interquartile range of similar developed countries. Not only have the rates in the US been falling, the range of interest rates across developed countries has become much narrower around that decline. Interest rate is low everywhere.

This is what is commonly referred as the “global liquidity trap” – after the interest rate has fallen to a certain level, liquidity preference may become virtually absolute in the sense that almost everyone prefers holding cash rather than holding a debt which yields so low a rate of interest.

Discrepancy between interest rate and credit spread

The graph shows credit spread in basis percentage points terms. The interest rate has really fallen off a cliff, but the spreads have not gone down and in fact even risen a bit. This could have dramatic impact on market concentration and productivity growth.

Rise of household and government debt

Not all credit is created equal. The long-run growth in credit is mostly driven by the rise of household and government debt, and not corporate debt.

Even this graph is slightly misleading because the recent uptick in corporate debt is mostly used to buy back equity in recent years, so the corporate debt trend should actually be even flatter than the graph shows.

Why is one kind of credit favored more than the other? It likely has more to do with the demand side than the supply side (see the next chart).

Falling investment and productivity

We also observe falling investment (left) and productivity (right) at the same time. The way we can interpret this is – the credit boom is not on the supply side because firms aren't investing more with the borrowed credit, yet we still see this huge growth in credit, so it is very likely that the credit growth is demand-driven.

The ongoing question is: what are the forces driving up finance but not real investment?

Inequality and r*?

One element to link everything together is inequality, which has a clear correlation with r*. Wealth-to-income ratio is actually just the inverse of r* (which is intuitive since wealth being the present discounted value of future income). The dramatic fall of interest rates and expected returns have driven up inequality through many systemic factors.

“Why did nobody notice it?”

Recall when the Queen of England asked a room of economists “Why did nobody notice it” referring to the 2008 financial crisis. Well, there is some truth to the Queen’s observation as for many years we've not been able to predict the decline of r*.

The forecasting errors on interest rates tend to be one-directional – to overestimate how high interest rates will go and end up seeing interest rates actually go much lower.

The charts below show huge forecasting errors from both the central banks and the market professionals. Remember, the central bankers set the rates themselves, and even so they're not able to predict the long-term decline! Everyone's systemically underestimating some underlying force that turns out to be more dominant than predicted.

The dotted lines are projections, and the solid line the actual development. Dotted lines are consistently above the solid line – meaning there’s been systemic “optimism” that led to constant underestimation.

Secular trends vs. business cycles

All the charts above are showing something very systemic and long-term (secular).

Both from a statistical and intuitive standpoint, all the shocks within business cycles might have high variance in the short run but will eventually cancel each other out in the long run. Hence, the reason why we see these persistent trends above is not because of short-term incidents, but because of the long-run forces that may have a small variance in the short term but will add up to be significant in the long run.

There's something deeper happening that doesn't appear in the day-to-day news. It is much more theoretically and empirically challenging to isolate out these long-run forces. These charts are only the tip of the iceberg but should hopefully provide some overarching framework to your thinking on today’s macro-financial issues.

Atif Mian