In Offense of Ben Bernanke, Part III: Bernanke, Blinder, and Underpants Gnomes

Part I: The Fed is Competent?
Part II: The Natural Rate of Unemployment
Part III: Bernanke, Blinder, and Underpants Gnomes

Professor Blinder writes:

Here’s the first Economics 101 question: When central banks seek to stimulate their economies, how do they normally do it? If you answered, ‘by lowering short-term interest rates,’ you get half credit. For full credit, you must explain how: They create new bank reserves to purchase short-term government securities (in the U.S., that’s mostly Treasury bills). Yes, they print money. [Italics added]

But short-term rates are practically zero in the U.S. now, so the Fed wants to push down medium- and long-term interest rates instead. How? You guessed it: by creating new bank reserves to purchase medium- and long-term government securities.

I’m afraid that’s only partial credit, though. What the Federal Reserve has yet to elaborate on is why this “stimulates” the economy. You should know, Professor Blinder, that investment appears to be interest-rate inelastic. You wrote this in your journal article, “Is There a Core of Macroeconomics That We Should All Believe?”

The claim that QE2 is supposed to “stimulate the economy” bothers me. For those of you who watch the TV show, South Park, it reminds me of the underpants gnomes episode. The gnomes collect underpants and give the following explanation for why:

Underpants Gnomes:

Phase 1: Collect underpants.

Phase 2: ???

Phase 3: Profit!

Bernanke and Blinder:

Phase 1: QE2.

Phase 2: ???

Phase 3: Economic recovery!

I still want a better explanation for Phase 2… from the Fed. They say they want to be clear and explain their thinking, but I have yet to hear an explanation other than that.

If you want a more sane explanation for QE2: one could point out that many of the Fed’s current assets are maturing. This means that cash will be flowing back into the Fed and they want it out. Thus, the Fed is trying to keep its balance sheet steady rather than expand it per se.

I surmise that they intend to raise the opportunity cost of holding Treasuries, thus making private sector debt and equities relatively more enticing to hold. Then banks go back to private lending, commercial paper, corporate bonds, etc., and investment expands. So it looks like the people at the Fed have discovered a free lunch. But as ECON101 teaches us, Professor Blinder, There ain’t no such thing as a free lunch!