Why be against bankruptcy reform?

One of my commenters has asked me to explain my assertion that the bankruptcy reform bill was a bad idea. I think this is an interesting question, even though it's a little bit of ancient history, so I'm going to answer it.

For readers who were not following along at home, the bankruptcy reform bill passed in 2005 made it somewhat harder to discharge one's debts.

• If your income was above the median in your area, you had to file for Chapter 13 (which requires that you cut your budget and go on a payment plan, rather than simply discharging your debts.)
• Everyone was required to provide more documentation of their income and assets in order to file, particularly tax returns.
• It altered the procedure for writing down loans somewhat, which some advocates argued would have the effect of making car loans senior to child support payments.
• Bankruptcy lawyers were required to certify their filings, which forced them to charge higher fees--both to cover insurance, and to do more due diligence.
• It outlawed specific abuses that virtually no one is willing to defend--serial filings of Chapter 13 in order to stave off foreclosure or eviction; the practice of buying large houses in states with unlimited homestead exemptions in order to shelter assets from pending civil judgements. (This latter was made famous by OJ Simpson, who bought a mansion in Florida to shelter his money from the Goldmans.)

I covered this for the Economist, which consisted of being ranted at by two groups:

• Credit card issuers, who claimed that the steady march upwards in the bankruptcy rate was due to consumers having, suddenly and for no apparent reasons, deciding en masse to become deadbeats. Backed up by amusing but entirely anecdotal "research", they argued that the real problem was fraud, or strategic behavior by consumers who ran up debts knowing full well that they were never going to pay them back.
• Consumer advocates, who claimed that the steady march upwards in the bankruptcy rate was due to the predatory behavior of lenders, and the cruel, cruel realities of America's heartless economy. Backed up by less amusing, but not much more rigorous, "research", they argued that the real problem was skyrocketing medical bills, or strategic behavior by banks who lent money knowing full well that consumer would never be able to repay it.

Neither of these explanations were particularly plausible. Research into the causes of bankruptcy, and the amount of fraud therein, is all pretty much . . . what's the word I'm looking for? Well, I can't use that word, because this is a family blog, but the research is pretty much all garbage. Bankruptcy is one of the most shameful things that can happen to you in American society, and the first rule of survey research is that people lie about the things they are ashamed of. They certainly don't confess that they used their credit cards to have a nice shopping spree before the bank came and took it all away. Moreover, untangling the cause of a bankruptcy is often like trying to untangle the reason for a marital fight--the proximate cause is usually only the straw that broke the camel's back. For example, most Americans don't save that much. Most Americans get away with not saving that much. But those who don't are vulnerable to a sudden event--a job loss, a divorce, an illness¹--that brings their income below their house/car/student loan payments. Was the cause of the bankruptcy the divorce, or the fact that they were living up to the edge of their income before the divorce?

To be sure, there was evidence of strategic behavior on the part of the consumers--but a lot of that seems to have consisted of people running up credit card bills so that they could keep paying the mortgage, not a massive conspiracy to defraud lenders. And there was evidence of strategic behavior by some borrowers--but only a lunatic would lend money that they were sure wouldn't be repaid. Both sides were advancing justice claims, when there was no real justice claim to be made. Lenders lent the money voluntarily; borrowers borrowed it voluntarily. Both of them knew the rules when they entered into the transaction--or should have. Most of the consumer advocates seemed to regard easy bankruptcy as a way to advance social justice--but credit card companies are not in the business of social justice, nor should they be. If we want poor people to have free money, we should dig down into our own pockets and give it to them, not demand that MBNA do it for us.

Ultimately, the best explanation of the rise in bankruptcies was not some sea change in either banker greed or consumer culture. Though I find it plausible that there was some easing on the stigma of bankruptcy, making it less psychologically costly to borrow, the best fit with the data is simply the fact that starting in the 1970s, it became easier to borrow. The invention of credit cards gave consumers access to something that had previously only been the province of the wealthy: substantial revolving credit. And the improvements in credit information, and the subsequent advances in credit scoring, made lenders much more willing to lend. And that, in turn, meant that consumers for the first time had substantial unsecured debts that could be discharged in bankruptcy. It's hardly shocking that we got a lot more bankruptcies.

This is not a bad thing. Contra Elizabeth Warren et. al., there's no evidence that this was, on net, bad for the poor, who used to have to get their revolving credit at loan sharks, or take out a secure loan from a pawnbroker. It certainly wasn't bad for the banks, who made a whole lot of money on the transactions. And it was good for us. I'll take on the critics of fractional reserve banking some other day--but suffice it to say that one of the many reasons that the American economy grows faster than most of the rest of the developed world is that we have better and deeper credit markets. Yes, even now--check out the Northern Rock nationalization if you think we've got problems.

There is also substantial evidence--good, solid research, not awful surveys--that easy bankruptcy is one of the hidden strengths of the American economy. American bankruptcy law offers an interesting natural experiment; the code, meaning the rules under which debts are discharged, is national, but the details of what is exempt from bankruptcy are done at the state level. Researchers consistently find that the more generous the exemptions are, the higher a state's rate of entrepreneurship. When failing is less risky, people are more willing to try.

Given that, my question for the bankruptcy reformers was: what problem does this change solve? It solves a problem for the credit card issuers, to be sure--but it does so by essentially allowing them to rewrite the terms under which they lent money, which was at least as unjust as any unjustice we might have been trying to rectify. The economic benefit of tighter bankruptcy restrictions is that they make banks more willing to lend, but this was hardly a problem for the economy in 2005. And the economic cost is that people are more afraid to take risks with their income.

Bankruptcies are down substantially since 2005, even despite the subprime crisis and the economic slowdown--giving lie to the consumer advocates who claimed that everyone declaring bankruptcy had no other choice. But I suspect that the change has cost the rest of us a lot more than it saved the banks.

¹ Contrary to popular belief, illness often brings on bankruptcy not through high medical bills, but loss of income to pay other bills.

Update Typo regarding Chapter 13 fixed.