QE2 craziness: the missing logic of this strange approach.

• Author: Steil, Benn

Imagine that you get in the shower, turn on the water, and nothing comes out. You call a plumber, who tells you that there are holes in the pipes, and that it will cost you $1,000 to repair the holes. You tell him to turn up the water pressure instead.

Sound sensible? Well, this is the logic behind the U.S. Federal Reserve's second round of "quantitative easing" (QE2), its strategy to keep flooding the money pipes until credit starts flowing freely again from banks to businesses.

You wouldn't expect this to work in your shower, and there is little reason to expect it to work in the commercial lending market. The credit-transmission mechanism in the United States--and elsewhere-has been seriously damaged since 2007. Small- and medium-sized businesses in the United States depend on small- and medium-sized banks for access to vital credit, yet too many of these banks remain zombies, unable to lend because their balance sheets are littered with bad commercial and real estate loans from the boom years.

The U.S. Troubled Asset Relief Program was an opportunity to force banks to disgorge bad assets--and thus repair the credit pipes. Instead, banks were obliged only to take equity injections from the government, which they consider politically toxic. As a result, the banks have been focused on returning the bailout funds at the earliest opportunity, rather than using them to boost lending.

The net result is that, even though the Fed has pushed its short-term lending rate down to zero, most banks will only lend on the basis of vastly greater collateral, and at much higher real interest rates, than before the bust. So now America plows on with the cheap option: flood the pipes and see what comes out.

Make no mistake: something will come out, though not necessarily where it should. We have already seen the liquidity intended to boost U.S. bank lending instead leak through the cracks into markets as diverse as agricultural commodities, metals, and poor-country debt.

What ms remarkable about this is that some of QE2's most prominent cheerleaders actually think that wherever new demand shows up is fine and dandy. After all, it is only "aggregate demand" that matters to the Keynesian faithful. To worry about the composition of demand is silly; it only complicates the algebra.

Nobel Prize-winning economist Paul Krugman, who berates the Fed for not opening the monetary sluice far wider, showed the follies of the crude Keynesian approach nearly a decade ago...