Is the government's deficit spending causing problems?

Many politicians are worried that the huge increase in government deficit spending is causing problems because it will:
1. raise interest rates as demand for borrowing exceeds savings. This would hurt investment spending and reduce economic growth.
2. cause foreigners to stop loaning the US money. Foreign governments (mostly, but also private investors) have been loaning the US hundreds of billions of dollars every year (graph) and that has helped keep the dollar strong so that we can buy more imports than we export.

However, interest rates have been really low which indicates a surplus of savings over investment. How could the government dramatically increase borrowing without driving up interest rates?

Brad Setser: Follow the Money » Blog Archive » More government borrowing doesn’t necessarily mean more total borrowing: "The United States is borrowing less from the rest of the world than it was. That is true even though the US Treasury is borrowing more from everyone, including more from the rest of the world.

The amount the US borrows from the world is the gap between the amount that Americans save and the amount that Americans invest at home. That turns out to be equal to the current account deficit. And for the US, it so happens that the current account deficit is about equal to the (goods and services) trade deficit. The trade deficit — at least in the first quarter of 2009 — was way down. In dollar terms, it was about half as big as it was in the first quarter of 2008. That implies that the US is borrowing far less from the world now than at this time last year.

Why hasn’t the expansion of the fiscal deficit pushed the amount the US borrows from the world up? Simple. American households and businesses are borrowing a lot less, so the total amount of money that Americans are borrowing isn’t rising.

A picture is generally more effective than words. The following chart shows borrowing by various sectors of the economy — households, firms and the government.** All data comes from the Fed’s flow of funds, table F1.

As the chart shows, the rise in government borrowing came even as other sectors of the economy were borrowing a lot less. Household borrowing peaked in 2006. Borrowing by firms actually peaked in 2007 — remember all the leveraged buyouts then. Borrowing by both households and firms fell precipitously in 2008. As a result, total borrowing by households, firms and the government fell in 2008.
...And since Treasury rates now (even after last week) are well below Treasury rates back when private borrowing was far higher, it is pretty clear that the rise in Treasury borrowing didn’t induce the fall in private borrowing (crowding out). Rather, the rise in Treasury borrowing came in response to a crisis-induced collapse in private borrowing.

From 2004 to 2007, net borrowing by American households and firms averaged over $1.8 trillion. In q4 2008, it was less than zero. That is a rather large swing.

* Technically, a current deficit can be financed by selling equity rather than debt, so equating the current account deficit with the amount the US borrows from the world isn’t quite right. But in general the US has financed its deficit by selling debt not equity, so it isn’t a bad rough approximation.
** Firms are defined as non financial corprate businesses and nonfarm noncorporate businesses in table F1 of the flow of funds data. government includes state and local government.