The Bankruptcy Bill and Debt Obesity

Bankruptcy legislation in the works for eight years passed the Senate by a 74-25 vote on March 10, and is now poised to pass in the House. The President has indicated he will sign the bill into law.

And yet there are complaints that the legislation narrowly focuses on consumer debtors, when the real problem is an excess of credit and its availability. This is a curious argument. It echoes the discussions of obesity in America, where lawsuits against McDonalds are both absurdly humorous and seriously wasteful. During 2004, Illinois became the twelfth state to pass a law protecting restaurants from such suits, and the U.S. House felt compelled to pass a similar law last year by a vote of 276-139. Yet obesity that supposedly plagues young and poor Americans stands in sharp contrast to global poverty, where the problem with food is scarcity, not abundance.

A World of Credit Poverty

Some seven percent of world's population survives on less than a dollar a day. But they lack more than food. They lack access to credit that could help them work out of poverty. Economist Hernando de Soto's books "The Other Path" and "The Mystery of Capital" paint the picture of a way out: recognizing property rights and freeing up markets for credit to the poor. His work has been praised by Presidents George H.W. Bush, Bill Clinton, even Richard Nixon.

The key fact in the U.S. debate is that bankruptcy filings have been doubling every decade for nearly three decades. The abundant supply of credit is not matched by an abundance of personal responsibility in current bankruptcy law. Do the critics really believe Congress should do nothing and let the problem continue to fester?

America has a proud history of second chances, embodied in the frontier spirit that one can always pull up stakes, load the wagon, and build a new life further west. Many economists believe that one reason America enjoys such a fast GDP growth rate compared to other industrialized counties, and the reason that technology businesses gather in Silicon Valley especially, is that our culture is failure-tolerant.

Critics would have you believe that the bankruptcy legislation will curtail risk-taking, but make no mistake: runaway bankruptcies are not a sign of healthy entrepreneurship. As Richard Posner points out on the Becker-Posner blog[1], the bill's most important likely effect is "to reduce interest rates." The hurdle to obtain capital and start a business will therefore be easier, meaning more new companies, and more job creation, not less.

There were nearly 1.6 million consumer bankruptcies in the U.S. in 2004. Yet in 1980, there were only 300,000 bankruptcies. You don't have to be a bankruptcy expert to recognize that trend reveals a problem. The stunning fact is that there are more bankruptcies per capita today than there were during the Great Depression. Common sense and economic theory agree that debt failure should be more common during a recession, and less common during periods of prosperity. So how is it that the richest economy in human history has this much bankruptcy, and that the occurrence has been rising, not falling, as average incomes have risen?

The answer is that the law as revised in the late 1970s set up a flawed system. The result is more personal distress on the part of debtors, and an unfair shifting of the costs to others in the form of high credit card interest rates.

What the Bill Does

The Senate bill (S.256[2]) includes many features that the media simplistically characterize as "making it harder to declare bankruptcy." A better way to think of the bill, the economists' way, is that it reshapes the incentives for bankruptcy, which previously were an invitation for abuse without consequence. Specifically, the bill includes:

1. Introduction of a means test. High-income debtors would be barred from filing for chapter 7, which is the easier "liquidation" form of bankruptcy. Those who pass the means test, which is the median annual income for the state, could still file for Chapter 7. The rest will be forced to use assets to pay off debt with a payment plan under chapter 13, which means they would have to pay off as much debt as possible under a court-supervised plan for a number of years before getting a clean slate. Estimates of the percentage of filers likely to fail the means test range from 3 to 10 percent, or no more than 150,000 individuals, but even those individuals would have a plan to start fresh a few years later.
   
2. Requires credit counseling and a course in financial planning. This step is essential to actually help bankrupt Americans break the bad habits of over consumption, and Congress truly deserves great credit for including these provisions in the bill. The bill also increases the number of years that must pass before an individual can file for bankruptcy a second time, to eight years from the current six.
   
3. Requires documentation of income. According to the FBI, ten percent of bankruptcy filings are fraudulent. New rules require all filers to submit paperwork that documents their recent income, making it harder for people to abuse the system and feign poverty.

Although the legislation includes many other improvements, critics contend that it neglects to do anything to protect debtors. They point to abusive credit card companies, aggressive marketing schemes, and the like. This is not only factually incorrect - the bill does include some provisions along these lines - but also misses the point. Irresponsible debtors primarily need protection from themselves, and that cycle of debt is precisely what the bill aims to break.

The liberal line that some 50 percent of modern bankruptcies are driven by health care emergencies has been discredited in the blogosphere over the last month. The study with the "50 percent" claim is based on a survey of debtors that sets the bar so low that any filer with medical bills exceeding $1,000 counts as a medical bankruptcy. By this logic, anyone with a car payment over $100 a month who goes bankrupt would count as a "car bankruptcy." Todd Zywicki, a law professor at George Mason University, has been tireless in defusing the "half truths, distortions, and fundamental misunderstandings" surrounding the bill, noting that it prevents, not encourages, abuse of homestead exemptions, and that it will fight deadbeat dads who use bankruptcy to avoid supporting their children.

As for credit markets in America, it is clear that we are blessed in ways the Third World is not. We have an abundance of credit. The rise of bankruptcies is not, however, caused by excessive supply or even demand for debt finance, but by a lack of accountability in America's bankruptcy laws. We should be thankful to the 74 Senators, both Republican and Democrat, for moving to restore balance and personal responsibility to U.S. credit markets.

Tim Kane, Ph.D., is the Bradley Research Fellow in Labor Policy in the Center for Data Analysis at The Heritage Foundation.