Why fiscal expansion will not lead to higher interest rates and inflation?

Conservative critics of fiscal (and monetary) expansion in the US have been arguing that government borrowing to meet stimulus expenditures is likely to put upward pressure on interest rates and thereby crowd out private spending. In other words, they claim, fiscal expansion actually ends up being contractionary. They also claim, in a reflection of Milton Friedman's "inflation was always and everywhere a monetary phenomenon" arguement, that such expansions expand the money supply and thereby stoke inflationary pressures.

This reading of fiscal expansion glosses over the importance of the context in which the expansion takes place. Apart from other things, the present recession is characterized by two features - interest rates touching the zero-bound and counter-party risks forcing banks to shut their lending taps. The US economy is therefore facing a liquidity trap. The Fed's aggressive pumping of liquidity through TAF, TALF, and TARP, have left the banks with sufficient liquidity, which they are unable or unwilling to lend in the face of high risk perception.

Further, as seen by the appreciating dollar, despite the devastation in the US financial markets, the "global savings glut" is still driving capital to the US Treasuries and other dollar denominated assets. In other words, though the economy is awash with savings and investible funds, both the supply (credit institutions) and demand (businesses put back by expectations of bleak economic prospects) sides are constrained. In the circumstances, anybody coming forward to borrow money at the prevailing rates, will only eat up the surplus savings without putting any upward pressure on rates. And the government is the only agency capable (and willing to) of shouldering the burden.

Paul Krugman makes an excellent illustration of this using the principles of Econ 101 to argue that the global excess of desired savings "means that fiscal deficits won’t drive up interest rates unless they also expand the economy" (which is desirable). Krugman argues that government borrowing sucks out the "incipient excess supply of savings even at a zero interest rate" (the real rate is in negative territory), and in the process expand overall demand, lower unemployment, and hence GDP.

Allan Meltzer (and here) feels that the enormous increase in bank reserves — caused by the Fed’s purchases of bonds and mortgages — will surely bring on severe inflation if allowed to remain. This concern is fuelled by the perception that the Fed's complicity in the bailouts has scarificed its independence and made it effectively a monetary arm of the Treasury, thereby raising questions about its ability (not its knowledge or willingness) to fight inflationary pressures (by raising interest rates) in the face of soaring deficits.

While the source of concern is valid, the inevitability of inflation may be misplaced. The economy suffers from both excess credit availability (though not the willingness to lend or borrow) and idle production capacity, and is operating at much below its optimum potential output. In the present circumstances, any decision that seeks to take up the savings and production slack would only have the effect of taking the economy to its full employment equilibrium and potential output frontier. It is only then that the inflationary pressures take hold.

Krugman draws attention to the Japanese brush with "enormous budget deficits, rapid growth in the money supply and the prospect of a sustained currency devaluation" in the 'lost decade' of nineties, which instead of sparking off an inflation spiral, pulled the economy into a deflation trap. He therefore feels that the danger facing the US economy is deflation, with its attendant danger of depressing wages and causing economic stagnation. Joe Nocera and Mike Moffat follows the debate here and here.