When deficits are good

Conservative opposition to fiscal stimulus spending financed by government borrowings has gone along these lines. The burgeoning government borrowing driven deficits will have the effect of driving down bond prices (buyers will be willing to buy only at low prices), unleashing inflationary pressures and driving up interest rates. Further, they claim that large deficits now will generate expectations of future tax rises leading to the "Ricardian equivalence" of increased savings and postponement of spending and investments, which in turn depresses aggregate demand. And finally, the large government borrowings will "crowd out" private investment spending by shrinbking the pool of available investible resources.

But supporters of the stimulus have argued that contrary to the standard neo-classical assumption of the economy being always near full employment, the economy is today so far away from its production frontier that there is ample space for large Keynesian spending stimulus. Further, the weak economic environment and demand conditions have put off business investments and the wide-spread counter-party risks have forced banks and lenders into turning off their credit taps. The result is that banks are sitting on piles of liquidity for which the only demand is from the safety of government.

In an excellent blog post, invoking John Hicks, Brad De Long explains why an economy faced with a liquidity trap does not face interest rate pressures. Hicks had argued that a financial crises causes a "sudden flight to safety that greatly raises interest rate spreads and as a result diminishes firms' desires to sell bonds to raise capital for expansion and at the same time leads individuals to wish to save more and spend less on consumer goods". De Long writes,

"In Hicks's model, the immediate consequence is an excess demand for (safe/government) bonds in the hands of investment banks: bond prices rise, and interest rates falls. As interest rates fall, (a) firms see that they can get capital on more attractive terms and so seek to issue more bonds, and (b) households see the interest rate they can get on their savings fall, and so lose some of their desire to save. The market heads toward equilibrium. But as the market heads toward equilibrium, something else happens as well: the fall in interest rates and the rise in savings is accompanied by a greater desire on the part of households and businesses to hold more of their wealth safely - in pure cash. And so the speed with which cash turns over in the economy, the velocity of money, falls. And as the velocity of money falls, total spending falls, and workers are fired, and as workers are fired and lose their incomes their saving goes from positive to negative

Thus the process of return to equilibrium takes two forms - interest rates fall, boosting investment and curbing savings; spending and thus employment and production fall, further curbing savings.

In normal times, the correct policy response is for the Federal Reserve to inject more money into the economy: through open-market operations it should buy bonds for cash, thus increasing the amount of cash so that even at the lower velocity we still have the same volume of spending, and thus transform the adjustment process from a fall in interest rates, spending, employment, and production to a fall in interest rates alone.

A little thought, however, will lead us to the conclusion that such open-market operations may fail. In them, the Federal Reserve is buying bonds, shrinking the supply of bonds out there - and thus pushing up their price and pushing down interest rates. For each amount that the Federal Reserve expands the money stock, therefore, it puts downward pressure on interest rates and thus on monetary velocity. In the limit where interest rates are so low that people don't really see a difference between cash and short-term government bonds like Treasury bills, open-market operations have no effect because they simply swap one zero-yielding government asset for another.

It is in this situation that a government deficit can be useful. A government deficit means that the government is printing and issuing a lot of bonds at exactly the same moment that private investors are looking for a safe asset to hold. As these bonds hit the market, people who otherwise would have socked their money away in cash--thus diminishing monetary velocity and slowing spending--buy the bonds instead. A large and timely government deficit thus short-circuits the adjustment mechanism, and avoids the collapse in monetary velocity that was the source of all the trouble.

Thus a Hicksian analysis last fall would have said--did say--"don't worry: a large flood of government bond issues won't push up interest rates; it will stem a collapse in monetary velocity instead as people who want to hold their wealth in safe form and would otherwise be holding money find themselves happy holding government bonds instead."

And Paul Krugman writes,

"A weak economy both drives up deficits and drives down the demand for funds, while a strong economy does the reverse. Thus the surpluses of the late Clinton years were associated with high interest rates, while the current recession has depressed both rates and revenues.

And what about the bounce in interest rates over the past few months? It reflects a gradual reduction in the end-of-the-world discount: interest rates have risen along with stock prices as investors have gradually become convinced that we’re avoiding a second Great Depression."

Update 1
Paul Krugman has this elaboration of why the deficits are not elading to higher interest rates.