In what ways are the government deficits harmful to the economy? The Bad
The main worry about deficits is crowding out. Crowding in was just described ?€" it occurs when deficits cause output to go up and business confidence is increased. Crowding out comes about when deficit spending raises interest rates. There is a limited amount of funds available for investment, and when government competes with the private sector for a share of these funds to finance its deficit spending, it drives the cost of these funds ?€" interest rates ?€" higher. The increase in the interest rates causes investment to fall, and lower investment translates into lower output and lower economic growth. In addition, to the extent that the private sector is more efficient than the public sector, crowding out, i.e. more government spending and less private investment, can result in a less efficient use of resources (though in the case of public goods government can be the more efficient provider, and hence it is not always the case that efficiency falls).
Another worry about deficits is that they will be monetized leading to inflation. Debt monetization occurs when the Fed prints new money and uses it to purchase government bonds help by the private sector. This removes debt from the private sector and replaces it with money, and if the money is used to purchase goods and services, as it's likely to be, this can be inflationary (though when there is an excess supply of goods, as in a deep recession, inflation is unlikely to be a problem).
The worst outcome would be for the deficit to get so bad that the government chooses to default on debt payments (which could also lead to some other currency, or a basket of currencies, replacing the dollar as the vehicle and reserve currency). I don't expect this to happen, particularly since we can always print money to pay off our debts. But printing money to pay off debt could be highly inflationary, it could lead to high interest rates as foreigners refuse to lend to us for fear we'll inflate the obligation away when it comes due, and the government could still choose to default if it is the least costly option among bad alternatives. Thus, it needs to be mentioned as a possibility.
Which of these concerns is most important? Notice that in the short-run, the consequences of deficits are mostly positive when the economy is in a recession. Deficits allow us to stabilize the economy (though it's important we pay the bills when times get better), deficit spending can stimulate investment through crowding in, and there's little danger that the spending will drive up interest rates or be inflationary due to the large amount of slack in the economy.
But in the longer run deficits are mostly problematic. As the economy nears full employment deficits can lead to higher interest rates, crowding out, less investment, and slower growth. Inflation can also be a problem, and if the debt burden gets bad enough, outright default is a possibility.
That's why economists who have supported the use of monetary and fiscal policy to ease the effects of the recession are recommending that we continue the stimulus for now, or at least that we don't make things worse by reducing spending or raising taxes before the economy is on better footing. We do have a deficit problem, and it must be addressed over the medium and longer term in order to avoid the negative effects described above. But reducing the deficit before the economy is on solid footing can be counterproductive ?€" it could slow the recovery or even cause a setback.
If we are smart ?€" if we continue to help the economy now and implement a credible deficit reduction strategy over the longer term ?€" the good can triumph over the bad and the ugly. Unfortunately, the way things look presently, with the deficit hawks demanding immediate action to stave off invisible bond vigilantes, and the inflation hawks pushing for interest rate...
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