Kartik Athreya on making bankruptcy law tougher

Everyone’s responded to the guy’s essay on blogging, but what about his research?  I gave it a peek and found the following opinion piece on bankruptcy.

The law says that people have a right to avoid unsecured debts by seeking bankruptcy protection. Creditors know that everybody they lend to has this option. It’s expensive to borrow in this kind of world because lenders must charge extra for the very real possibility that they won’t be able to fully collect. In effect, bankruptcy law disables those who possess few assets from making commitments to fully repay debts.

Why do we foist this “protection” on all households? If we lived in a society that allowed borrowing but forbade defaulting under any circumstances (an admittedly extreme and unrealistic scenario) it would become significantly cheaper to borrow. In the models I’ve looked at, the gains accruing per U.S. household would be equivalent to as much as $280 a year.  These gains encompass everything from cheaper borrowing costs to eliminating after-the-fact punishments like stigma.

He concludes:

…I believe we should offer some form of bankruptcy, albeit with strings attached. Means-testing, while piecemeal, seems like a small step in the right direction…

His research page is here and it includes many articles on bankruptcy.  He argues here for harsh default penalties, again to lower the cost of credit.  For a contrasting perspective, defending relative leniency, here is Megan McArdle.


Aslong as you don't force people to have kids -- and force those kids to inherit debt, you're always going to have bankruptcies. If people literally -cannot- pay, then they really can't, no matter what the laws say.

Also, once the line is crossed, the slide to hopelessness is quick. The magic of compound interest, with a interest higher than inflation, means that if it's unmanageable today, it's sure as hell going to be so in a few years.

With no bankruptcies, you'd also set a unfairly high punishment for what is, in the greater scheme of things, a small crime. For rape, you're back on the streets in a few years, for the crime of borrowing from someone who willingly gave you the money (knowing full well you might not repay it, and asking a premium of his own choosing to accept that risk), you'd be living on welfare-minimum for the rest of your life.

The only downside to good bankruptcy-protection, is that it becomes harder for people with no collateral to borrow money. But is that really nessecarily such a bad thing ? Is it generally speaking all that good to be allowed to borrow large sums of money, for buying nothing of value ? (if you're buying a house or a car, you can use that for collateral, which helps a lot)

I guess the exception might be if you are buying an education. It's beneficial that people manage to finance it, yet it cannot directly be used as collateral. That problem is a lot smaller here (here=Norway), because we've got free schools at all levels, so nobody is dependant upon private investors to finance their education.

The issue is choice, isn't it? Or put another way, why should we expect a corner solution to be optimal (no bankruptcy law at all, or forced bankruptcy protection for all)?

I'm curious how optimal bankruptcy protection might become a way to signal.

On one hand, if someone in my family gets sick I will be put into wage slavery. On the other hand, Americans might get, on average, $280 a year. Well, sign me up!

I would like to see the results of his model expressed as interest rates on different types of debt. At any rate I'm skeptical that his model adequately captures the pro-growth properties of easy bankruptcy.

I suppose this is true if we take out human psychology from the mix. Is the extra $1000 the less credit-worthy person paying being paid exclusively because of risk, or because they are desperate for credit and the creditor knows they can get away with it?

In a state with no bankruptcy there's still no reason why their wouldn't be these extra charges. The banks could just say they were because of the hassle of late payments and hiring collection agencies.

Desperation makes you profitable. Bankruptcy's a red herring. Eliminate bankruptcy and banks make more money. They don't charge less.

Back in bankruptcy class, we learned that bankruptcy laws are put in place in part to aid creditors (to avoid the race to the courthouse or to seize property). Would lending really be cheaper if creditors lived in an all or nothing collection world?

I'd gladly accept a complete no discharge rule if banks couldn't ostensibly borrow money zero cost, which makes the return on my deposits a complete joke. In other words, if you are going to throw a bone to the banks, you might as well throw one to depositors as well. Likewise, doesn't the US system already favor debt financing enough in this country? What is wrong with issuing stocks?

As an earlier poster said... you have to include human psychology.

Some people can't stop themselves from taking risks. Sure, these people will chance really bad outcomes no matter what.

A lot of people weigh the potential cost of failure. If you severely penalize failure, you are definitely going to decrease innovation a lot - these people are going to drop out of the "innovation mode."

I'm willing to guess that more innovation is worth >$280 to each family in the USA.

Wait a minute. In the 90s, the push was on to make bankruptcy harder to do in order to reduce the cost of lending/borrowing and eliminating the moral hazard of bad debt.

The result was even more lending backed by no income and no assets with the costs of credit and other related financial transactions going higher to the consumer.

This by the way follows the push that was really hot in the 70s to eliminate Regulation Q in order to lower the cost of lending/borrowing.

Why should we listen to people who argued that the financial rules from the 30s through the 70s were driving up costs, so new rules are needed to lower costs, and now that we have costs so high that bankruptcy is more frequent, the problem is a failure to move even further from the rules of the 30s?

Perhaps we should just jump to debtors prison, amputating limbs, and involuntary servitude.

Better yet, solve the problem of organs for transplant by full liquidation of individuals like is done with corporations and cars: creative destruction of failed individuals.

But to bring corporate responsibility, make the CEO and other management subject to the same rules; if they lead a firm into bankruptcy, then they either make good on the debt, or they are liquidated with their prime organs sold for transplant.

mulp is a correct troll though!

Imagine what wonderful delights the 2000's binge bust cycle would have outcomed with lower borrowing costs and harsher consequences...mmmmh! PRO-CYCLICAL kool-aid, my favourite!!!

Just a couple observations on these writings:

For a guy who seems to pay lip service to the importance of credentials, does he have a law degree that would qualify him to say such things as "[t]he law says that people have a right to avoid unsecured debts by seeking bankruptcy protection"? Really, what code section is that?

Central to his thesis is that bankruptcy is like insurance. That is a dubious premise, and leads to fallacious arguments and invalid conclusions. Aren't the losses borne by the lenders (the free market at work) and in the longer run, by the borrowers (in terms of lower credit scores and higher future borrowing costs)? How does a market outcome constitute 'foisting protection' on other households? Maybe the term "protection" as in "bankruptcy protection" has led to some of the muddle.

Bankruptcy is an essential human right that makes the capitalist system survivable with human welfare intact. Without it we would could not have liberal democracy. There are plenty of places where bankruptcy doesn't exist to the extent that it does in Western countries, and in those places (rural India being one of the most publicized), it devolves into something that looks a lot like warlord-based chattel slavery. Farmers take out high-interest loans to cover bad crops, and when they can't pay the loans... interest continues to accrue. Perhaps they sell their land to their loan shark and work in his factories - but it's often not enough to make interest payments, so the debt passes to their kids when they die.

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