Niall Ferguson and Kevin Phillips are the latest to join the fiscal expansion is contractionary bandwagon. While they argue in favor of massive liquidity injections (as advocated by Milton Friedman) to avert a banking crisis, they reject Keynesian stimulus spending by running up massive fiscal deficits. They claim that the stimulus spending will increase the public debts and fiscal deficits and thereby trigger off inflationary pressures and force up interest rates. The fiscal expansion then ends up being a contraction.
Both Paul Krugman (and here) and Brad DeLong have argued that when the economy is facing a liquidity trap this view is incorrect and both Monetarist liquidity injections and Keynesian fiscal stimulus are necessary. They claim that when the interest rate is near zero monetary expansion and deficit spending do not offset but reinforce each other.
Their arguement is based on the reality that the banking system has stopped performing its natural role of buying bonds from corporations, which in turn uses the proceeds to invest in their plant and equipment. In the circumstances, the only alternative is for Government to step in. As Krugman writes,
"By buying a lot of private securities, the Federal Reserve is... playing the role the private banking system is no longer playing properly... debt-financed spending on infrastructure by the Obama administraition is filling the hole left by the collapse in business investment... It gives some of those excess savings a place to go — and in the process expands overall demand, and hence GDP. It does NOT crowd out private spending... until the excess supply of savings has been sopped up... [and the interest rate consistent with full employment rises above zero]".
In other words, there is no excess demand for savings to drive up interest rates. Scott Sumner weighs in here. Excerpts from the recent PEN World Voices debate on how to deal with the crisis is available here.