This is part two of a series on the economics of debt, deficits, and today’s high interest rates—and how policymakers should respond. Read part one here. 

The effects of deficits and debt on the broader economy are largely straightforward—with one big exception: They differ radically depending on whether the economy is operating near its productive potential or is instead operating well below it (which occurs most notably during recessions).

The main economic effects of deficits in these two states of the world are essentially as follows:

• Large deficits during times when the economy is operating near its productive potential (or during times of full employment) put upward pressure on either interest rates (more likely) or inflation (less likely).
  • The higher interest rates in turn can “crowd out” productive private-sector capital investments. If this happens chronically, this can shrink the size of the capital stock U.S. workers have available to them—with the capital stock being factories and other buildings, equipment, software, and research and development efforts. This smaller capital stock in turn reduces productivity, or the income generated in an average hour of work in the U.S. economy, hence shrinking the growth of potential living standards.
• Large deficits when the economy is operating well below potential actually stabilize the economy and aid its return to potential.
  • Economies start operating below full employment when aggregate demand—spending by households, businesses, and governments—falls short of what is needed to fully employ productive resources. By increasing spending and lowering taxes (hence boosting private-sector disposable income that can be spent), higher deficits boost aggregate demand and push the economy closer to potential.
  • Because private-sector investment responds to income growth as well as interest rates, deficits run during times of less than full employment can actually “crowd in” productive private-sector investment.

The one noncontroversial effect of budget deficits: They raise aggregate demand

If there is one noncontroversial statement about budget deficits, it is that they raise the economy’s aggregate demand. Whether this increase in aggregate demand is good or bad depends on the broader economy.

Deficits when private spending is strong

When private-sector sources of demand are strong—consumers are buying a lot, businesses are demanding lots of new capital goods to undertake production, and imports and exports are roughly balanced—all available productive resources (like workers) are fully employed and the economy does not need the public sector to inject extra demand into circulation with larger deficits; additional increments to demand will not bring forth more output. Instead, additional demand sent into a full employment economy will bid up prices rather than cause more output to be produced.

If the Federal Reserve is determined to not let strong demand bid up prices and push inflation above its preferred 2% target, it will respond to this excess of demand by raising its short-term policy rates to try to tamp down private sources of demand. Higher interest rates are generally effective in reducing demand through lower consumption, business investment, and larger trade deficits.

Besides the Fed’s response, higher deficits in a full employment economy can also put upward pressure on interest rates through financial crowding out. At full employment, the supply of savings available to be loaned to households or businesses looking to make long-lived investments is largely fixed. Federal deficits by definition mean that the government has to go into financial markets, where supplies of savings and demands for investment meet, and increase its own demand for a share of these savings. Deficits are financed by selling government bonds to households and businesses—that is, by convincing savers to lend their money to the government for a period of time. The extra demand for borrowing meets the fixed supply of savings and pushes up the price of loans, or interest rates.

Because most capital investment by businesses (building new factories and buildings, purchasing new equipment and software, and paying salaries of workers engaged in research and development) is financed by borrowing, higher interest rates stemming from large budget deficits in economies that are already strong will slow capital investment over time. As the price of something rises—in this case, the price of borrowing to finance new investment—less of it will be demanded.

This reduction in capital investment slows long-run economic growth. A key contributor to growth in productivity—the amount of income generated in an average hour of work in the economy—is how much capital workers have available to them to do their jobs. Construction workers today are far more productive than 50 years ago because they’re more likely to use mechanized earth movers rather than shovels for excavation.

If deficits crowd out capital investment, this can slow productivity growth. Productivity growth is the ceiling on how fast average living standards can rise in an economy. So when large deficits during full employment crowd out of investment, this can damage economic growth. A key point in this analysis is that it is higher interest rates that are the transmission mechanism for this damage: If interest rates do not rise, there is no damage being done.

Deficits when private spending is weak

When private spending is too low to fully employ all available productive resources, the boost to aggregate demand from large deficits actually helps to employ these resources and move the economy closer to its productive potential.

Some increases in deficits that push the economy closer to its productive potential during downturns happen automatically. Spending rises on safety net programs like unemployment insurance, and this supports private consumption. Tax collections fall as private incomes fall, buffering disposable incomes from the full fall in pre-tax incomes.

Some increases in deficits that push the economy back to its potential come from discretionary legislation passed by Congress in direct response to the downturn—relief packages like the American Recovery and Reinvestment Act (ARRA) of 2009 and the CARES Act of 2020.

Weak private spending places sharp downward pressure on inflation and interest rates as it generates idle resources (like rising unemployment). Given this, a boost to demand from larger deficits tends to not manifest as faster inflation or higher interest rates. A boost to demand when there are idle resources mostly causes output, not prices, to rise. And the higher output and income generated by higher deficits create savings that keep interest rates from rising in response to greater demand for investment.

Because this scenario sees no rise in interest rates, and because investment responds positively to output growth, larger deficits that boost economic activity almost certainly “crowd in” private investment, leading to more investment and higher productivity than would have occurred had deficits not been allowed to rise.

Excessive structural deficits are hurting the U.S. economy today

The upshot is that deficits can hurt if they’re too large when the economy is already near full employment, and that the data signature for this damage is rising interest rates. For decades, large budget deficits have not been accompanied by higher interest rates, making it very hard to argue that the economy’s long-run growth prospects were being damaged by crowded out private investment.

Over the past year, however, interest rates have risen noticeably. In fact, as of September 2026, 10-year Treasury rates have reached their highest levels since the early 2000s (though still far below highs reached between the mid-1970s and mid-1990s when—among other things—inflation expectations were much higher). Because inflation is a bit higher now than in the early 2000s, real (inflation-adjusted) rates have not risen quite as fast, but they are always noticeably higher than the average of the past 20 years. Between this and the fact that unemployment is likely not too far above full employment at the moment and the fact that inflation remains above the Fed’s 2% target level, it seems clear that too large U.S. deficits are putting unwelcome pressure on the larger economy.

Too large U.S. deficits are not the only driver of recent interest rate increases. Another contributor is larger deficits being run by many European countries. Many of these countries have loosened fiscal rules to spend more on the military in the face of the Russian invasion of Ukraine. The Japanese economy is also stronger than it has been in decades, and interest rates there are rising for the first time in decades. Finally, there has been a huge surge in private investment demand driven by the race between AI companies to dominate the market.

On the one hand, it seems hard to worry that higher interest rates are crowding out private-sector investment if it is precisely strong private investment contributing to higher rates. But the investment in AI is clearly not interest-sensitive (at least so far). It is driven by exogenous events and factors: Now just happens to be the time that the technology has reached tipping points where scalability and profitability seem possible, hence sparking a race between private companies to be the first to capitalize on this. Additionally, investment in sectors in the U.S. not being pulled along by the AI boom is notably weak in 2026, posting negative growth. If U.S. fiscal deficits were lower and this led to lower interest rates, this would help investment in non-AI sectors.

Noting that too large structural deficits are likely slowing U.S. growth today does not map directly onto policy solutions. It’s not the case that the damage from too large deficits right now is so overwhelming that anything that reduces deficits should be done in response. In a later post, I will walk through the considerations about how policymakers should optimally respond to too high structural deficits. They definitely should do something—but it’s not the case that they should just do anything.