One potentially-important case outside the standard framework for thinking about fiscal policy in a depressed economy is the following: What if interest rates remained depressed not just for the short but for the long term as well? Call this case one of "voluntary financial repression". In it, the risk tolerance of investors is so low and the ability of private-sector investment banks to create safe assets is so impaired that investors are willing to pay the government to move their purchasing power forward in time. The economy is not dynamically sufficient in any standard sense, but the interest rate r on Treasury debt is lower than the growth rate g of the economy. There is then no binding government budget constraint. And the math then tells us that the government should borrow and spend--and then borrow and spend some more until it has pushed the interest rate on its Treasury debt back up above the growth rate of the economy and there is a binding government budget constraint once more.
Note that this case of "voluntary financial repression" is profoundly different from other episodes of financial repression. In the past situations in which Treasury bonds have carried negative real interest rates have arisen because of government policies that require financial intermediaries to hold excessive amounts of Treasury debt. The standard argument is then that the apparent free lunch of government borrowing offered by financial repression is really the collection of an inefficient tax on banking customers. The ultra-low interest rates on Treasury debt are a regulatory tax ultimately paid by banking customers and collected for the government by the banks. The policy recommendation is then not that the government should take advantage of low interest rates to borrow and spend. The policy recommendation is then, instead, that the government should reform its bank regulatory system so that it no longer imposes an inefficient tax on banking customers and financial depth.
This time, however, appears to be different. High demand for Treasuries at even ultra-low interest rates is not the result of legal requirements to hold Treasuries imposed by the government. Rather, it is the result of an extremely high degree of effective risk aversion on the part of investors and financial intermediaries. No argument can be made today that the government is levying excessive taxes on the banking sector. It has, instead, provided the banking sector with enormous benefits in terms of bailouts that provide free insurance against macro financial risks. It has not burdened the banking sector with excessive requirements that they hold reserves in the form of Treasuries. It has, if anything, done the opposite: burdened the reast of the economy by not imposing large enough reserve requirements on banks.
There is some lurking underlying market failure here--trusted financial intermediaries that can create safe private-sector assets for investors to hold appear to be absent. The natural fix for this market failure is for the government to create the safe assets that investors seek to hold: the government needs to borrow and spend, and keep borrowing and spending until the benefits from repairing this failure on the part of the private market to supply safe assets are exhausted--which will certainly not be the case until, for Treasuries r > g.
