Personal Debt vs Aggregate (Public) Debt

......what recipe does common sense recommend for getting out of financial trouble as a person, a family, a firm? The answer surely is to lower your expenses in order to rein in the red ink on your balance sheet. And to work harder and more intelligently. However, when this recipe is taken to a higher level of aggregation, it simply does not add up. To see this, suppose that, in a bid to reduce our individual and collective debt during a crisis (what financial economists refer to as deleveraging), each one of us follows this same recipe andat the same time. The result, I submit to you, may be quite the opposite of that intended. Indeed, aggregate real debt may rise!
To see why these individual recipes do not add up to a collectively efficacious strategy, consider the great difference between your family (or firm) and the economy at large. In the case of your family, if your income has declined, and you are facing a shortfall at the end of each month, cutting down on expenses is a sensible course of action for one simple reason: Your income is independent of your expenses. For instance, if you do not eat out tonight (and, instead, cook at home), your income has not suffered and, as you have reduced your expenses, your balance is healthier.
In sharp contrast, an aggregate economy’s income is not independent of its expenditure. Indeed, the two are one and the same thing! (The nation’s aggregate income equals exactly its aggregate expenditure.) To see why this matters, suppose that the whole country is tightening its proverbial belt, with families and firms ‘deleveraging’ at once. Private expenditure will be, naturally, falling (in aggregate). Now if, on top of that, the government also reduces its expenditure (in an effort to shrink its deficits), then the sum of private and public expenditure will decline. But what is that sum equal to? The answer is: National income! As national income shrinks, the state’s tax revenue falls, families have less money to pay down debt, and the nation’s overall capacity to repay its debts diminishes. Thus, we all fall collectively into the trap of ‘common sense’; of the fallacy of aggregation; of mistakenly thinking that a recipe which is good for families and firms must be good for an indebted country in aggregate.....


Yanis Varoufakis