Bankruptcy is a good thing

by Philip Brewer on 14 February 2008 3 comments

I don't mean that declaring bankruptcy is a good thing--obviously that sucks for everyone involved. But a system of bankruptcy is a good thing. It's good for creditors and debtors, and it's good for the economy.

There are actually three situations that need to be dealt with:

  • Some debts were not incurred in good faith--the borrower never intended to pay the money back. Debts of that sort should be dealt with as the cases of fraud that they actually are, and not as a bankruptcy at all.
  • Some debts could be repaid, but the debtors would rather not. Ordinary legal processes for collecting unpaid debts generally suffice in these cases, without a need to resort to bankruptcy.
  • Some debts, though, simply cannot be paid back. Bankruptcy is a legal framework for recognizing that fact.

Many debts--most debts--are incurred in good faith. The people who borrow the money have every intention of paying it back, and have good reason to expect that they'll have the means to do so. Sometimes, though, those expectations are not fulfilled. Death, illness, family crisis, legal trouble, business reversal, economic downturn, natural disaster, war--these are just some of the kinds of situations that can lead to a borrower simply lacking the means to repay a debt.

We know what happens when there's no functioning bankruptcy system. The details may vary--debtors prisons are optional--but what happens is that everything gets stuck. Borrowers fight tooth-and-nail to hold on to any collateral, as it's often the only leverage they have. At the same time, they attempt to hide any income they might have, spending it on the necessities of life before the lenders grab it. Lenders stop spending their time and energy finding new customers to lend to, devoting it instead on trying to track down any collateral or cash that their deadbeat customers might have--a never-ending quest, because there is never going to be enough money to pay all the interest and fees owed.

This is bad for the whole economy.

Productive assets sit idle, because the borrower doesn't have enough money to put them to use, but nobody else can use them either, until the legal processes grind on to a conclusion.

At the same time, the borrowers aren't working at whatever would make them the most productive, because whatever they earned would be taken from them. Instead, they chose to work at whatever will get them food and shelter, often in the underground economy, taking cash under the table or payment in kind.

Bankruptcy is the way to clean up when a debt isn't going to be repaid. In theory, the borrower gives up the collateral and any wealth beyond a necessary minimum to start over again. (Bankruptcy laws have always, for example, permitted the bankrupt to retain the tools of his or her trade.) In exchange for that, the lender gives up on getting anything more. The productive assets and the productive people are then free to go back to being productive (rather than wasting their time in a pointless game of hide-and-seek).

People generally accept this structure for businesses, but individuals don't always get the same indulgence.

There's a certain amount of bitterness when a company goes belly-up with invoices unpaid, pensions unfunded, and workers let go, but people generally don't think of it as a moral failure. It's quite common for managers of a bankrupt business to pay themselves large bonuses (to make up for the fact that their stock options have become worthless), and that does arouse some ire. But it's nothing compared to the reaction that some people have to individuals who go bankrupt.

Part of this, I think, is a result of getting hung up on those first two categories of debtors--people who never intended to pay their debts (or who incurred them with reckless disregard for whether they could ever be paid back) and people who could pay the money back, but just don't want to. Any bankruptcy system includes provisions to deal with these situations. The bankrupt is required, for example, to disclose any assets, and a failure to do so is cause to undo any discharge of debts. Still, the notion that there must be some money there somewhere, leads to a desire for punitive measures to extract money. That's what the last major revisions to the US bankruptcy code was all about--a determination to get as much money out of borrowers as possible. (It's the logic of loansharks as well.)

To the extent that moral opprobrium encourages people to incur debt cautiously and to apply themselves diligently to paying what they owe, it's probably a good thing. But some debts are never going to be repaid. In those cases, having a system of bankruptcy to get things sorted out and let everybody get on with their lives is a good thing.

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Guest's picture

When you remove the moral opprobrium, it becomes a question of what works and what doesn't. We as a society are fixated on punishment and seem somehow afraid that "letting people off the hook" will cause values to slide off the side of the moral mountain like an avalanche. Staying angry when forgiving someone would put your own heart at ease, jailing minor offenders to teach a "lesson," driving people into a lifetime of marginal earnings to avoid erasing impossible debts--when will we realize that these actions impoverish us as much as the person we want to punish?
You cut right to the heart of it when you talk about things getting "stuck." Sometimes we have to clear the books and start from the reality that actually exists rather than the one that was promised to us. Thanks for this!

Guest's picture

Well credit card companies need to CHILLAX over interest rates, otherwise people could actually pay them back.

Raising interests rates because someone was late on a completely different account, card, or line of credit is assinine. It just creates a hole you can never dig yourself out from.

Guest's picture

Yes, thanks for this.

Good points about the "hide and seek". The quicker insolvency is recognized and dealt with the less onerous it becomes. In my case, problems festered for years and became progressively worse because of the difficulty of admitting the failings.