If you scroll back through your high school economics course, it will talk about the negative effects of a large government deficit. A major one cited is the ‘crowding out’ effect. Since everyone is lending the federal government money to finance the deficit, there is a shortage of cash for other investment purposes, pushing up real interest rates.

We haven’t seen this sort of effect yet during the credit crisis. Given the exceptionally low yields in 4th quarter 2008, one would have thought the crowding out effect doesn’t even exist. But as treasury rates continue to climb, and as our budget deficit widens, we will gradually see it come back again.

Obama’s budget, with its massive government spending on social welfare programs and random pet projects, will take our debt/GDP well over 120%. Some scenarios have it over 200%. Even Obama lovers admit that the president is wildly optimistic with his aim to reduce the deficit, as it makes insanely optimistic assumptions about economic growth (3.5% in 2010!) as well as just takes for granted that the tax hikes will produce proportionate increases in revenue, essentially banking that high income earners don’t ‘work less’ to avoid the extra tax, corporations don’t attempt to guard against their added tax liabilities, etc.

With the rising deficit, the government will have to get the money somewhere. The Chinese don’t have unlimited amounts of money, and will be more and more reluctant to keep gobbling up US treasuries. The US government will be forced to pay higher and higher interest rates on their treasuries issued. Banks, already scared to lend, will just put whatever cash they have towards the treasuries.

If it’s tough to get a loan now, try getting one when the government is gobbling up all the available credit out there.