I think this is a false argument. Surely, the first approach would mean all parts of the economy suffer together. But it is the wrong assumption to say that the second approach does not have side effects either. In fact, unless sectors of the economy “not in over-capacity” can be clearly identified and capital funneled directly to those parts of the economy or allocated to such by banks, then the injection of capital would simply flow to all parts of the economy, including the parts ostensibly in over-capacity. Look at this complaint:

What really struck me in Skidelsky’s account, however, was the extent to which conventional opinion in the 1920s viewed high unemployment as a good thing, a sign that excesses were being corrected and discipline restored–so that even a successful attempt to reflate the economy would be a mistake. And one hears exactly the same argument now. As one ordinarily sensible Japanese economist said to me, “Your proposal would just allow those guys to keep on doing the same old things, just when the recession is finally bringing about change.”

This is exactly true. As we see over and over, human nature is such that, without pain, we do not learn from mistakes (in general) — since by some definition of “mistake”, things that do not cause pain are not mistakes. Without austerity and pain, it is optimistic to assume the injected capital will not be used to go back to the old investment schemes… and delay restructuring. It is also optimistic to assume politicians beholden to populist wishes will make painful cuts to those sectors in over-capacity, at the same time as they are doling out fresh capital to those deserving capital, both of which are necessary actions for a shortened recession and sustained recovery.

On top of that, what if in the economy, whether due to its interconnections or otherwise, there is over-capacity in every sector? Imagine the world built everything that anybody would possibly want for 10 years, then what, besides unemployment for 10 years? And so what, it isn’t such a bad thing then, is it? Japanese aren’t doing badly, are they? So what if they haven’t been fully productive for 10 years, who cares? If they are happy with their standard of living, they can all work half-time for all I care.

Is this printing money? It isn’t any different than normal bank credit creation if you simply view the Fed as another bank. The only difference is the Fed isn’t subject to reserve ratios or capital leverage requirements (e.g. it’s extremely levered), so it can, not necessarily will, create credit much too imprudently.

The Fed can acquire bad assets no matter what asset it takes. US debt may be one such bad asset but is it really worse than the rest of the stuff? By definition, the Fed is buying all of them at rates above what they are worth when marked to market. But the idea is this is for longer term benefit and hence not imprudent.

I think the outcry about the Fed buying government bonds rather than other assets is the Fed’s special relationship with the Treasury and the potential for abuse. The Fed has a chummy depositor who will never participate in a run on it, and that is the Treasury. And such a depositor will get any amount of money it needs to deposit with the Fed by issuing debt that even if nobody wants, the Fed will happily buy. The metaphorical printing press is in two pieces, mediated by the accounting trick that is permanent debt issuance. So if the two collude, they can put the printing press together and make it work. Whether such collusion is or is not happening is debatable, as there is no sharp line to cross. Everybody is still happy to leave their deposits with the Fed and presumably still believes the Fed (or the government) that the Treasury means to retire these debts eventually, to unwind these positions.

But if this economy doesn’t turn better soon, these assumptions will become untenable.