Understanding the Effects of Fiscal Deficits on an Economy

Financing a Deficit
All deficits need to be financed. This is initially done through the sale of government securities, such as Treasury bonds (T-bonds). Individuals, businesses, and other governments purchase Treasury bonds and lend money to the government with the promise of future payment.
The clear, initial impact of government borrowing is that it reduces the pool of available funds to be lent to or invested in other businesses. This is necessarily true: an individual who lends $5,000 to the government cannot use that same $5,000 to purchase the stocks or bonds of a private company.
Thus, all deficits have the effect of reducing the potential capital stock in the economy. This would differ if the Federal Reserve monetized the debt entirely. The danger would be inflation rather than capital reduction.
Additionally, the sale of government securities as a way to finance the deficit has a direct impact on interest rates. Government bonds are considered to be extremely safe investments, so the interest rate paid on loans to the government represent risk-free investments against which nearly all other financial instruments must compete.
If the government bonds are paying 2% interest, other types of financial assets must pay a high enough rate to entice buyers away from government bonds. This function is used by the Federal Reserve when it engages in open market operations to adjust interest rates within the confines of monetary policy.
FDR's Deficit Spending
Upon entering office, Franklin Delano Roosevelt (FDR) was intent on balancing the federal budget. In this, he was supported by the U.S. public, which like him, felt deficits were bad. However, due to the Great Depression of the 1930s, the need to get people back to work, and the influence of economist John Maynard Keynes, the government under FDR engaged in massive spending on public works.11
Federal Limits on Deficits
Deficits seem to grow with abandon and the total debt liabilities on the federal ledger have risen to astronomical proportions. However, there are practical, legal, theoretical, and political limitations on just how far into the red the government's balance sheet can run, even if those limits aren't nearly as low as many would like.
As a practical matter, the U.S. government cannot fund its deficits without attracting borrowers. Backed only by the full faith and credit of the federal government, U.S. bonds and Treasury bills (T-bills) are purchased by individuals, businesses, and other governments. All these purchasers are agreeing to lend money to the government.
The Federal Reserve also purchases bonds as part of its monetary policy procedures.12 Should the government ever run out of willing borrowers, there is a genuine sense that deficits would be limited and default would become a possibility.
Total government debt has real and negative long-term consequences. If interest payments on the debt ever become untenable through normal tax-and-borrow revenue streams, the government faces three options. It can cut spending and sell assets to make payments. It can print money to cover the shortfall. Or, the country can default on loan obligations.
The second of these options, an overly aggressive expansion of the money supply, could lead to high levels of inflation, effectively (though inexactly) capping the use of this strategy.