Fischer Uses the E Word

"The exit has begun."

The new Vice-Chair at the Fed has confirmed the long slog out of extreme measures has started. None of our astute leaders took the opportunity to remind Mr. Fischer that No CB had ever successfully completed the trek.

If I were Fischer (or any other Fed staffer), I would highlight that the monetary system we will be attempting to exit to is NOT the one that developed from 1980 to 2008. The old system was an unregulated counter-party system of un-securitized and un-collateralized LIBOR (money) agreements. Base rate levels declined markedly then oscillated between 6% and 1% for some time. The targeting of the base rate was the primary focus of policy makers despite its poor track record of determining financial conditions.

The financial system the Fed hopes to exit to is a completely new and different animal. The system is heavily regulated. Capital is sequestered for most activities. Fees, charges and paper work are heaped on simple arrangements. Everything is on the balance sheet. Most importantly, collateral transactions are now the foundation of the former "money system."

I have long suspected that financial system 2.0 is less elastic and more rigid than the old one. The exit, without offsetting increase elsewhere, amounts to a significant reduction in system size and capacity. The Death Star is a massive safe counter party for the shadow banking system to get sucked into. The Fed's hope to return to a "rates regime" may  prove difficult to calibrate to the new landscape. (The money system was very volatile in the early years. I recall 20-30bp moves on TT&L calls ! GIK)

"System Stability" is now the third mandate of the Fed and coveted by CBs around the globe. There is a fine line between stable and comatose. The old system, for all its flaws, was a Faith based system whose flexibility ushered in the greatest economic advance the globe had ever seen. Financial System 2.0 has some pretty big shoes to fill. According to Fischer, we are on our way to finding out if its up to the task.

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