I’ve received several emails questioning why I’d like to see the deficit settle in at 2-3% of GDP, instead of seeing it disappear altogether. It’s time I posted a more detailed explanation.
First, take a look at the latest “Deficit Watch” chart. The gap between the orange and green lines is the deficit in the General Fund. The gap between the red and blue lines is the “unified budget deficit.” The latter makes all the headlines (largely because it is the increase in publicly-held debt), but the former determines the “total debt” I use for the debt-to-GDP ratio.
I’ll explain the boring math details behind the 2-3% deficit goal, then I’ll explain why I think there’s such a big disconnect between that goal versus conventional wisdom.
The boring math:
Unified Budget Deficit = General Fund Deficit minus Trust Fund Surplus. Because the General Fund Deficit equals the growth in "total" debt, the GF debt can grow as fast as nominal GDP grows, without increasing the debt-to-GDP ratio. Assume nominal GDP grows at (only) 6%; that means the total debt can grow 6% x $8.4 trillion, or $504 billion, if interest rates remain steady. With a target GF Deficit of $504 billion and an expected Trust Fund Surplus of $180 billion, we get a target Unified Budget Deficit of $324 billion, or 2.4% of GDP.
In other words, we're already overshooting the mark; that's why the debt clock on this site is ticking backwards. But I won't complain too loudly until the ratio of debt to GDP gets down to 60% (from 65%). In any case, if people would just pay attention to that ratio, instead of debt in isolation, it would be a big win for objectivity over demagoguery. As it is, conventional wisdom is 180 degrees from what it should be.
The counterintuitive reason why a deficit is desirable
A deficit [in the Unified Budget] is an increase in the government's debt to the public; i.e., an increase in the public's supply of Treasury securities. Conversely, a surplus is a decrease in those. Now consider the hypothetical case in which the government had run nothing but surpluses for all these years. Result: Instead of the government's debt to the public in the trillions, we would now have the public's debt to the government in the trillions. [The technical reason is because the government would have had to purchase large quantities of private assets to keep the money supply growing with the real economy’s growth]. In other words, a surplus is a step towards eventual government ownership of private assets. It's another reason, in a long list of reasons, to welcome deficits and frown on surpluses (see this article, for example).
The government's deficit is the public's surplus, and vice-versa.
Why the disconnect?
I'm convinced that the difficulty in getting this counterintuitive message across lies in the natural negative emotion triggered by the word "debt." It's too easy to hear that word and falsely infer "my debt to someone else" -- instead of "my T-bonds," or "government's debt to me." The word “debt” really gets our attention—and politicians are well aware of that fact.
Do politicians understand?
Rather than generalize, let’s envision a hypothetical debt-phobic politician named John Bumpersticker (D-TN), a Blue Dogma Democrat with a track record of flashing our big, scary debt number around, and telling us how many times that many dollars of debt would stretch to the moon and back (...always conveniently omitting how many times our dollars of GDP would stretch to the moon and back).
In John's case, there are only two possibilities: Either (1) he does understand the true nature and implications of deficits, or (2) he does not understand. In either case, we have a problem. If he doesn’t understand it, there’s a knowledge gap in our leadership; if he does, there’s an integrity gap. As I said: In either case, we have a problem.
Where should we draw the line? What about 'Crowding Out'?
Although I personally draw the line at keeping the debt-to-GDP ratio "inside the guardrails" (40% to 80%), there is a school of thought out there that says, Why even limit it to that? (One proponent of that idea was a Nobel prizewinner; see this and this.) As you can imagine, that position is far enough from conventional wisdom to keep them in a minority; however, before laughing it off, try to think of reasons and examples why 80% should not be exceeded—i.e., try to explain Japan, and try to explain why the "Crowding Out" theory ("deficits cause interest rates to rise") is contradicted by a substantial body of evidence with sound theoretical support, articulated expertly in this paper by Alan Reynolds.
Trying to defend conventional wisdom is a good exercise, but a losing battle.
In summary:
At least some level of fiscal deficit is desirable, because a government deficit is a private sector surplus. If we can continue to trust the private sector to turn its surplus into extra economic growth, then we can trust that the government’s ability to service its debt will grow at least as fast as its debt.
On top of all that, an added bonus accrues when the government invests its borrowed money wisely in national security, infrastructure, or knowledge acquisition: the result is even more wealth creation—or, equally importantly, the prevention of wealth destruction.
Government deficits are private sector surpluses. When we spend our surplus wisely, and government spends its borrowed money wisely, our nation gets safer and wealthier that much faster.
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End note:
For a more-detailed, step-by-step explanation, see my six-part series on Money. It ends with the same conclusion.
Several thousand additional reactor-years of statistics since Three Mile Island testify to the safety of nuclear power itself. Its wastes do not present any serious engineering problem—uranium is such an energy-rich fuel that the actual volume of waste is comparatively tiny; it is easily converted into chemically stable forms, which are easily deposited in deep geological formation that have been stable for tens of millions of years.
No conceivable mix of solar, biomass, or wind technology could meet even half our current energy demand without (at least) doubling the human footprint on the surface of the continent.
Which will win today’s big battle: fear of the future, or faith in the future? Many politicians and their mainstream media friends seem to have all their bets down on the former; worse, some of them actually seem to be hoping they turn out to be correct. Sad, but true. 
Joseph Schumpeter insisted that innovation is the very essence of economics and most certainly of a modern economy. . . In the economy of change and innovation, a profit, in contrast to Karl Marx's theory, is not a "surplus value" stolen from the workers. On the contrary, it is the only source of jobs for workers and of labor income. The theory of economic development shows that no one except the innovator make a genuine "profit"; and the innovator's profit is always quite short-lived. 
