Bankruptcy Reform

Todd J. Zywicki, Federal Trade Commission, has recently published a paper: "Why So Many Bankruptcies and What to Do About It. An Economic Analysis of Consumer Bankruptcy Law and Bankruptcy Reform." At the outset, the author clearly states his purpose: "This article argues that there has been an unacknowledged sea change in the nature of consumer bankruptcy in America." In turn, this change requires a new model of the consumer bankruptcy process and certain amendments to the Bankruptcy Code.

The first permanent American bankruptcy law was passed in 1898. Since that time scholars and pundits have tended to believe that consumers who filed for bankruptcy were in financial distress. Thus, bankruptcy was viewed as a "safety valve" that relieved financial pressure on consumers who had succumbed to blandishments to buy more on credit than they could afford, or who simply had lost a portion of their income. This "traditional model" of bankruptcy was reflected in the current Bankruptcy Code of 1978 and strongly supported by academics, such as Harvard Law Professor Elizabeth Warren, an academic who also opposed the Uniform Consumer Credit Code.

According to the "traditional model", bankruptcies decline during periods of prosperity and rise during periods of economic stress. During the recent long period of prosperity and economic stability, business bankruptcies did decline; but consumer bankruptcies rose dramatically. This counter-intuitive behavior raises fundamental questions about the validity of the traditional model. When empirically testing it, Zywicki found that the traditional model "…was unable to account for the upward surge in bankruptcies over the past twenty-five years." Zywicki then tested a new model, drawing from the school of New Institutional Economies (NIE). Accordingly, Zywicki argues that his findings support many of the current bankruptcy reform efforts.

Zywicki argues that filing for bankruptcy has become more profitable for consumers, especially high-income consumers, and, as a result, more consumers take advantage of the process. Serious efforts towards means-testing bankruptcy relief would filter out opportunistic applicants who want to shelter high income or valuable exempt assets from creditors, and leave the bankruptcy process open for those who truly need a "fresh start." Chapter 7 shelters future income from today's creditors, a tempting perk for high-income households. Chapter 7 also offers some generous asset exemptions, such as pension accounts and expensive homes. Such exemptions benefit wealthy households, not poor households.

The author notes that the 1978 Bankruptcy Code was written with the intent to eliminate the stigma of bankruptcy and that the drafters may have "..underestimated the probability of debtor opportunism" and the overall effect on social norms. Current bankruptcy reform legislation calls for requiring debtors to have mandatory consumer credit counseling to attempt to work out a repayment plan before they can file for bankruptcy. This requirement reinforces the value of repaying one's debts. Means-testing bankruptcy relief also encourages respect for the opportunity for a fresh start and the value of repaying obligations if one is able.

Current bankruptcy reform efforts recognize that the traditional model, on which the 1978 Code was based, is no longer adequate. Generous and poorly monitored bankruptcy policies encourage opportunistic filings by consumers with substantial repayment capacity and decrease social norms that promote financial responsibility.

The 113-page document may be downloaded from the Social Science Research Network Electronic Library.