Will additional so called “borrowing” by government drive up interest rates? No it won’t: because central banks have decided that interest rates will remain at about 0.5%. That is, central banks have undertaken in most countries to print and lend to banks whatever amount of money is needed to keep rates at 0.5%. I.e. if government borrowing DID drive up rates, central banks would just print more money.

Put that another way, if governments do “borrow”, they are borrowing money which the “government – central bank machine” has created. Bit of a farce. I don’t call that borrowing. I call it printing money and spending it.

Thanks again! I agree with you that there is an opportunity cost of deficit spending, but it is probably just not crowding out in this economy (notice question #3 above). Krugman also acknowledges this in the end of his blog post: “Now, there are real problems with large-scale government borrowing — mainly, the effect on the government debt burden. I don’t want to minimize those problems;”

The long-run issues associated with a large debt burden are a real concern and one that we should be teaching our students about when they learn about expansionary fiscal policy.
Thanks again. Jason

Thanks for the response, I am still trying to understand all of the debates about Keynesianism that have resurfaced with this recession. I believe Krugman and others would say being close to the zero-bound makes this different than the normal recession. At the same time he treats his analysis as if it is self-evident for any reasonable economist. But as I understand it not all economists accept the idea of a liquidity trap and its relevance as he does.

I also think the idea that credit markets are “frozen” is problematic, particularly now that we are past the worst panic period in the banking system and financial markets. Are we really seeing credit-worthy borrowers being completely unable to obtain credit? We should expect the availability of credit to be lower.

Finally I think what I’m calling the “simple Keynesian story” completely ignores the need for the re-allocation of resources. Because of that, I’m not convinced that there is virtually no opportunity cost of government spending, which seems to be what this analysis entails. I teach AP economics, so I realize that’s basically what we are teaching as a first approximation, but we need to be aware of its limitations (as I’m sure you are).

Great site by the way.

With the federal funds rate effectively at 0% and credit markets still frozen, what conclusion are we to draw other than that equilibrium ir must be below 0%. Negative interest rates, were they possible, would create the incentive to borrow and spend, but without the ability to lower commercial rates below the zero bound, there is room for government borrowing and fiscal stimulus without the fear of crowding out.

I am not sure what you mean by a “normal” recession. By the textbook definition, the current recession is a normal one… caused by a fall in consumer spending, investment and exports, a reduction in aggregate demand, falling output and employment, and downward pressure on the price level. In fact, as an econ teacher, the current recession is a perfect example of a normal one, because it has been accompanied by all the predicted outcomes that our AD/AS model predicts should occur during a recession. Certainly, if it were a much milder recession, one in which investment demand had not plummeted as low as it has and in which “liquidity preference” (i.e. the supply of loanable funds) had not increased as much as it has, and if nominal interest rates were still above zero, then we (and I assume Krugman) would expect deficit financed government spending to decrease the supply of loanable funds, drive up interest rates and crowd out private investment.

I had my students read the chapter from “The Worldly Philosophers” about Keynes last week. Heilbrunner summarizes the Keynesian view of recession as such:

“A thrifty community will always attempt to save some part of its income. But business is not always in a position to expand its operations. When the business outlook is poor… the impetus to invest will wane. Why should businessmen expand their facilities when the look to the future with trepidation?

“And therein lies the possibility of depression. If our savings do not become invested by expanding business firms, our incomes must decline. We should be in the same spiral of contraction as if we had frozen our savings by hoarding them.”

My interpretation of this is that Keynes believed expansionary fiscal policy was necessary to unfreeze the idle savings tied up in frozen credit markets. If private households and firms are not borrowing, and instead prefer liquidity, the “spiral of contraction” will only drag us into depression. Public spending is needed to fill the “recessionary gap” between equilibrium national income and full-employment national income.