Very good article by Megan McArdle explaining how the generous American bankruptcy laws actually facilitate risk-taking, entrepreneurship, and innovation:
Our leniency toward those with unsustainable debts helps not only profligate debtors, but the rest of us as well. Less onerous bankruptcy procedures boost rates of entrepreneurship: reduce the cost of failure, and people become more willing to take risks. America’s business environment is much more dynamic than that of Europe or Japan, for many reasons—and our generosity to capitalism’s losers is one of them.
The issue, as is often the case, is the perception of the general public versus what benefits society as a whole:
Americans’ public attitude toward the bankrupt, however, is not nearly as generous as our law. Every move to make things easier for debtors meets with fierce resistance, not merely from creditors, but from ordinary people who are making payments on time. As this article went to press, the Senate was scrambling to find a compromise on a long-stalled House proposal that would allow bankruptcy judges to reduce the principal of home loans where the value of the property has fallen below the mortgage’s outstanding balance. Known as a “cramdown,” the idea was popular with most congressional Democrats, but apparently not with the voting public, which was telling pollsters in ever higher numbers that they thought the whole housing-bailout package was unfair.
And isn’t it? Most people didn’t take out giant loans with tiny down payments or do repeated cash-out refinancings. Yet the cramdown plan would make the sober, steady majority foot the bill for other people’s mistakes. First they would pay as taxpayers by helping to subsidize troubled loans. Then, the next time they needed a mortgage, they’d be charged a higher interest rate to compensate for the risk that they might declare bankruptcy and ask a judge to cram down their loan. And maybe they’d have to pay a third time, again as taxpayers, by bailing out banks that got too many of their loans crammed down. Meanwhile, the guy down the street who took out a second mortgage he couldn’t afford, to remodel, would be sitting pretty in his $60,000 kitchen.
It isn’t fair. But by the time someone is in bankruptcy, the time for fairness is already long past. Bankruptcy is the legal recognition that someone lacks the resources to meet financial obligations. Our system works so well precisely because it mostly sets aside our instinct for just deserts, and instead focuses on minimizing the costs to everyone. It lays out clear and predictable rules for lenders and borrowers, so that they can plan for disaster, and escape as quickly as possible if it arrives. Still, it’s plain as day that, in the current crisis, a whole lot of people are getting help they haven’t earned. As a result, commentators, academics, and legislators presiding over hearings have diverted much time and energy away from hashing out the ugly details of rescue efforts and toward making the one point on which we can all agree: these relief measures don’t seem fair.
McArdle goes on to explain why being harder on both companies and individuals when they get into debt they can't afford is actually worse on society:
Let’s start with the corporate side. Receivership, even as practiced in a relatively forgiving country like Britain, often results in liquidation, not reorganization. Sudden changes of the entire management are hard enough in normal times, but when they take place in bankruptcy, the difficulties are multiplied. Very few people want to go to work for a company that may be terminal, particularly if a tightfisted receiver refuses to pay a premium for their efforts.
Liquidations are very costly. Workers get fired, of course; suppliers lose business; local governments lose tax revenue. But they’re costly even for creditors. Picture what would happen if a receiver shut down GM’s assembly lines until they could be sold. The workers would scatter, and with them, painstakingly accumulated human capital. The value of the inventory would plummet. Who wants to buy a car with no warranty and no pipeline for replacement parts? The residual value that GM has built up over decades in marques like Cadillac would vanish. Thus, creditors are often better off accepting partial debt payments from a going concern than selling off the assets piecemeal.
But if corporate liquidation, Euro-pean-style, is so punitive, why does America encourage individuals to liquidate—letting them trade the assets they have on hand for a full discharge—rather than making them work off as much of their debt as possible? In theory, making bankruptcy harder should make us all better off: by discouraging people from taking on too much debt, by paying creditors as much as possible, and by delivering a little just retribution to debtors for their profligacy.
That was the reasoning behind the 2005 bankruptcy reform. Although filings spiked before the law took effect, immediately thereafter they fell off a cliff. In 2006, just 598,000 people filed for bankruptcy, the fewest since Ronald Reagan was president. Filings have increased since but are still well below the rates that prevailed in the relatively sunny economic climate of 2004.
Harsher bankruptcy rules are seemingly doing what we wanted them to do: discouraging excessive risk taking. The question, though, is Which risks?
Look at entrepreneurs. All of the business literature indicates that starting a business is a phenomenally stupid thing to do. Most new businesses fail, and not simply because most would-be entrepreneurs are actually no-hopers. Even people who have founded successful companies in the past still have a 70 percent chance of failing. All those business failures are costly—but the successes are the difference between us and Tanzania. We want people to take these kinds of risks, even if that means we write off a lot of bad debt.
Tougher bankruptcy laws don’t necessarily curb the kind of behavior we want to discourage: borrowing money you have no way to repay, in order to buy unnecessary consumer goods. The amount that households put on their credit cards didn’t fall after the 2005 reform; over the next two years, it rose 12 percent. According to Michelle J. White, an economist at the University of California at San Diego, many bankrupts are what economists call hyperbolic discounters—people who pay a lot of attention to current pleasures, and very little to future costs. That’s why a person’s debt, not unemployment or divorce, may be the best predictor of bankruptcy.
If you’re the kind of person who buys now and worries later, the idea that government is making your inevitable bankruptcy filing slightly more annoying won’t discourage you. Actually, a higher hurdle to bankruptcy will make things worse, because banks will offer to lend you more money if getting the debt discharged is harder for you—money that you will happily, and irresponsibly, borrow and spend. The people who are most likely to be deterred from borrowing are the people who are taking the rationally contemplated risk of starting a company or buying their first home.
Great stuff - read the whole thing.
