An Economic Analysis of Consumer Bankruptcy Law and Bankruptcy Reform

George Mason University SCHOOL of LAW WHY SO MANY BANKRUPTCIES AND WHAT TO DO ABOUT IT: AN ECONOMIC ANALYSIS OF CONSUMER BANKRUPTCY LAW AND BANKRUPTCY REFORM Todd Zywicki 03-46 LAW AND ECONOMICS WORKING PAPER SERIES This paper can be downloaded without charge from the Social Science Research Network Electronic Paper Collection: http://ssrn.com/abstract_id= 454121 WHY SO MANY BANKRUPTCIES AND WHAT TO DO ABOUT IT: AN ECONOMIC ANALYSIS OF CONSUMER BANKRUPTCY LAW AND BANKRUPTCY REFORM TODD J. ZYWICKI DIRECTOR, OFFICE OF POLICY PLANNING FEDERAL TRADE COMMISSION PROFESSOR OF LAW, GEORGE MASON UNIVERSITY SCHOOL OF LAW (ON LEAVE) 600 Pennsylvania Ave., NW Washington, D.C. 20580 ABSTRACT Since the inception of the first permanent American bankruptcy law in 1898, the intellectual and political understanding of the bankruptcy process has been anchored in a model of the bankruptcy process that views bankruptcies as being driven by household financial distress. For much of the Twentieth Century, this “traditional model” of bankruptcy accurately explained observed trends in bankruptcy filings. Moreover, the widespread consensus on the traditional model was reflected in the enactment of the current Bankruptcy Code in 1978, which rested on the intellectual foundations of the traditional model. To this day, the overwhelming number of leading bankruptcy scholars continues to believe in the descriptive accuracy and normative policy recommendations of the traditional model. Thus, scholars as diverse as Elizabeth Warren and Jay Westbrook, Douglas Baird, and Kenneth Klee, have all expressed strong opposition to the bankruptcy reform legislation. Regardless of whether they draw from a progressive and sociological background (Warren and Westbrook), law & economics background (Baird), or doctrinal background (Klee), scholars have continued to express consensus belief in the traditional model and the policy implications that it implies. For most of this period, the traditional model has provided both empirically descriptive findings and normatively clear implications. Over the past two decades, however, the traditional model has broken down. During a period of unprecedented prosperity and economic stability, personal bankruptcies have soared, raising fundamental questions about the validity of the traditional model. This article argues that there has been an unacknowledged sea-change in the nature of consumer bankruptcy in America and that this requires a new model of the consumer bankruptcy process and that this new model of consumer bankruptcy also implies the need for certain amendments to the Bankruptcy Code. This article first provides a scientific analysis of the traditional model to determine whether these new trends can be accommodated within the traditional model. The model is examined in the light of the available evidence and the conclusion is that the traditional model is unable to account for the upward surge in bankruptcies over the past twenty-five years. The article then offers a new model to explain the anomaly of the rising bankruptcy filings of recent years and examines the available empirical evidence on point. This model draws from the school of New Institutional Economics (NIE) and focuses on the institutions, incentives, and transaction costs associated with filing bankruptcy. Although the model will require further testing and refinement before it can be said to be definitive, available evidence tends to support the model advanced here. The article then turns to the normative conclusions that are suggested by the New Institutional Economics model. Widespread acceptance of the traditional model animated the framework of the 1978 Bankruptcy Code and continues to animate the opposition to the current bankruptcy reform movement. The replacement of the traditional model with the NIE model offered here also has certain normative and policy implications. Most fundamentally, whereas the premises of the traditional model are inconsistent with the bankruptcy reform movement, the finding of the NIE model justifies many of the key bankruptcy reform efforts of recent years. Keywords: Bankruptcy, consumer credit, New Institutional Economics JEL Classification: G33, Z13, G20, K00, K19 2 WHY SO MANY BANKRUPTCIES AND WHAT TO DO ABOUT IT: AN ECONOMIC ANALYSIS OF CONSUMER BANKRUPTCY LAW AND BANKRUPTCY REFORM * TODD J. ZYWICKI TABLE OF CONTENTS I. Introduction II. The Traditional Model Triumphant: 1898-1945 III. The Crisis of the Traditional Model A. Consumer Indebtedness 1. Equity Insolvency and Consumer Bankruptcy 2. Balance Sheet Insolvency and Bankruptcy 3. Credit Cards and Bankruptcy 4. Summary on Household Financial Condition and Bankruptcy B. Unemployment, Downsizing, and Bankruptcy 1. Unemployment and Bankruptcy 2. “Downsizing” and Bankruptcy 3. Summary on Unemployment, Downsizing, and Bankruptcy C. Divorce D. Health Problems, Medical Costs, and Insurance 1. Health Care Costs and Bankruptcy 2. Health Insurance and Bankruptcy 3. Health Problems and Income Interruptions 4. Summary on Health Care, Insurance, and Bankruptcy E. Other Evidence Questioning the Traditional Model F. Summary: The Intellectual Crisis of the Traditional Model IV. Why So Many Bankruptcies? A New Institutional Economics Model of Consumer Bankruptcy A. Changes in the Relative Costs and Benefits of Filing Bankruptcy * Director, Office of Policy Planning, Federal Trade Commission; Professor of Law, George Mason University School of Law (on leave); Research Fellow, James M. Buchanan Center for Political Economy, Program in Philosophy, Politics, and Economics. J.D. University of Virginia; M.A. Economics. Clemson University; B.A. Dartmouth College. I would like to thank the Law and Economics Center at George Mason University School of Law for financial support for this article. I would also like to thank Enrico Colombatto and the International Centre for Economic Research in Turin, Italy, where I was a Fellow during the drafting of part of this article. I would like to thank David Hyman, Richard Hynes, Edith Jones, Joe Pomykala, David Skeel, Jack Williams, and Kim Zywicki for comments on this article. Previous versions of this article were presented at the Society for the Evolutionary Analysis of Law annual conference, Canadian Law and Economics Association, and workshops at Boston College Law School, Benjamin N. Cardozo School of Law, University of Colorado School of Law, Emory University School of Law, George Mason University School of Law Levy Fellows Workshop, George Washington University School of Law, University of Georgia School of Law, Notre Dame University School of Law, and University of Virginia School of Law. The views expressed in this article are wholly the author’s and do not necessarily represent the views of the Federal Trade Commission, its staff, or Commissioners. 3 1. The Economic Benefits of Filing Bankruptcy Have Risen 2. The Economic Costs of Filing Bankruptcy Have Fallen 3. Summary on Changes in the Costs and Benefits of Bankruptcy B. Changes in the Nature of Consumer Credit 1. The Shift to Unsecured Consumer Credit 2. Greater Nationalization and Impersonalization of Consumer Credit 3. Development of Formal Institutions as “Trust Substitutes” C. Changes in Social and Personal Norms Regarding Bankruptcy 1. Consequences of Change in Social Norms Regarding Bankruptcy 2. Empirical Evidence of Effects of Changes in Norms on Filings 3. Causes of Changes in Social Norms Regarding Bankruptcy V. What to Do About Rising Bankruptcies? A. Do Nothing? Ex Ante Responses to an Ex Post Problem B. Bankruptcy Reform: Ex Post Responses to an Ex Post Problem 1. Adjust the Relative Costs and Benefits of Filing Bankruptcy 2. Reversing the Decline of Social Stigma 3. Increasing Use of Formal Institutions as Trust Substitutes VI. Conclusion I. Introduction The test of the validity of a scientific theory is its ability to explain the world.1 Consumer bankruptcy theory has been long-dominated by the “traditional model” of consumer bankruptcy, which views bankruptcy filings as a result of household financial distress. In the traditional model, bankruptcy is seen as a largely involuntary act, a “last resort” to deal with insoluble financial problems.2 The traditional model argues that bankruptcy results from factors such as heavy indebtedness or sudden and unexpected income or expense shocks, such as unemployment, medical problems, or divorce. In the traditional model, individuals use bankruptcy as a form of social insurance, allowing individuals to “smooth” unexpected income or expense shocks. To this day, most bankruptcy scholars continue to believe in the descriptive accuracy and normative policy recommendations of the traditional model. Thus scholars as diverse as Elizabeth Warren3 and Jay Westbrook,4 Douglas Baird,5 and Kenneth Klee,6 have all expressed strong opposition to the bankruptcy reform legislation. Regardless of whether they draw from a 1 See KARL POPPER, CONJECTURES AND REFUTATIONS: THE GROWTH OF SCIENTIFIC KNOWLEDGE (1962); THOMAS KUHN, THE STRUCTURE OF SCIENTIFIC REVOLUTIONS (2d ed. 1970). 2 For a recent statement of the traditional model, see TERESA A. SULLIVAN, ELIZABETH WARREN, AND JAY LAWRENCE WESTBROOK, THE FRAGILE MIDDLE CLASS: AMERICANS IN DEBT (2000). The conclusions of the Report of the National Bankruptcy Review Commission also generally reflect the traditional view as well as the policy implications associated with it. See REPORT OF THE NATIONAL BANKRUPTCY REVIEW COMMISSION (Nov. 24, 1998). 3 See Elizabeth Warren, The Bankruptcy Crisis, 73 IND.

Load more