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March 15, 2005

Bankruptcy and Paternalism; The Zywicki Article

I've just come across by far the best description I've yet seen of the proposed bankruptcy bill. It's by Todd Zywicki, and I've quoted the most important part below (his description is also useful in that it starts by listing many other important but uncontroversial parts of the bill). Personal bankruptcy law is part of the social regulation I am forever hoping to write a book about, so I'll take the time here to think about it.

The real question is this: Should foolish people be allowed to have credit cards? We all know people who are forever in debt, having run up their credit card balances and never managing to reduce their spending enough to get the balance down to zero despite the burden of high interest rates. Should these people have been allowed to get credit cards?

The bankruptcy bill is not about this directly, of course. Here is the connection. Currently, some people with high incomes and low wealth would like to get credit cards, but they can't, because lenders are afraid they will declare bankruptcy and not pay back their debts. (This includes, for example, people who have already declared bankruptcy once or twice.) The new bill says that if your income is high enough to pay back a lot of your debt within five years, then you can't declare simple bankruptcy and liquidate your debts. Rather, you declare a different kind of bankruptcy, similar to business's Chapter 11, under which a judge decides how much of your debt you repay over a five-year period, during which your creditors cannot seize your assets. Thus, under the new law, some of those people who couldn't get credit cards will be able to.

The bill actually won't have this effect on the foolish people we know who now are in the thrall of credit card debt. Those people were already able to get credit cards.

The bill also isn't really about the profits of the companies issuing credit cards. They'll make more money in the short run, but the bump up in profits won't last. This is a fiercely competitive industry, with easy entry, and the companies compete strongly to lend to the spendthrifts. The spendthrifts pay high interest-- but they also default a lot. The debt slaves are, in effect, subsidizing the deadbeats, but as a group, debtors come out even.

I think I've heard it said that the credit card industry has high profits. That may be true, but I'm a little skeptical because of the competition and easy entry, and because proper accounting is tricky in that industry. A new company will look very profitable at first, because it will be earning high interest and not have any defaults yet. Overall, though, expected profits must even out to not be higher than if the entrepreneur had invested in some other industry-- say, the pickle industry. Thus, if we know profits will be abnormally high in the first five years of the company, we must expect them to be abnormally low in the rest of the company's lifetime. After the first five years, the company will be stuck with a lot of debtors who have a high rate of default. By then, some will be in such poor shape that the company will regret having lent to them-- but it will be too late. I wonder, in particular, what will happen when the debt slaves reach retirement age and their income drops. We may see mass bankruptcy thirty years from now-- and mass losses for the credit card companies.

Also, proper accounting, whenever a new debtor is added, the company should list as a cost some fraction of the expected loss from default. Estimating that expected loss is hard. Thus, even aside from the real path of profits and losses, the accounting path may be distorted-- and usually the company has an incentive to distort it towards having more apparent profits now (and therefore less later).

So the issue should not be credit card company profitability. Let's get back to the question of whether foolish people should be allowed to have credit cards. If bankruptcy is made more difficult in the law, more foolish people will end up with credit cards and debt. If we said that nobody had to pay back credit card debt at all, on the other hand, we'd reduce credit card debt markedly because most people wouldn't be able to find someone to issue them a card. So what should we do?

The libertarian position is that freedom is what matters, so people should be allowed to make any kind of deal they want. In fact, they should be allowed to sign away their right to bankruptcy at all, which would make it much easier for people with little wealth and income to get a credit card.

A liberal position might be that people cannot be allowed to put themselves into debt that is hard for them to repay, even if they want to, because it is degrading to human dignity, and what is good is not what they want but something else. They must be forbidden to borrow for the same reason that they must be forbidden to sell themselves into slavery.

The conventional economic position is similar to the libertarian one, but with a different objective, value maximization. Putting constraints on contracts is almost always bad for value creation, if people are rational decisionmakers. After all, even if

If we depart from the standard economic convention, however, and assume that some people are poor decisionmakers or poorly informed, then credit card debt might be a bad thing. Some people don't realize how unhappy they will be once they are in debt, and we would like to stop those people from making bad decisions. The question then becomes how many people are foolish, and whether we can restrain them without stopping smarter people from taking on debt. Can we keep someone from borrowing to buy clothes while not stopping someone from borrowing to start a home business whose quality can't be understood by a commercial lender? Usually we can't, and so a tradeoff must be made.

This is why some conservatives oppose the new bill, I think. A conservative, as opposed to a libertarian, is willing to be paternalistic on occasion.

A different argument is the moral one-- that consumer debt is bad because it encourages materialistic current consumption and a disregard for the future. This gets as complicated as the poor-information economic argument, though, so I won't pursue it here.

After thinking about it, I'm inclined to think the bill is a good thing. (Actually, of course, Tom Veal is correct when he says that this is complicated enough that we should really trust elected representatives whose opinions we value, rather than wanting to make the decisions ourselves.) The key is that this bill is not exactly about making bankruptcy more difficult. Rather, it is about shifting people from Chapter 7 to Chapter 13 bankruptcy-- from liquidation to court-ordered repayment. Consider a high-income low-assets foolish person who was intending to liquidate, but must now repay over a 5-year period. That person would have erased his old debt, and immediately set about getting in debt again. Now, the person will not be able to acquire new debts and overconsume for five years during which his expenditure will be controlled by the court. To the extent that we want to be paternalistic, this seems like a good change. We want to keep money from coming under the control of the foolish person. To the extent we do not want to be paternalistic, it is not a bad thing. The borrower and lender can contract around it, and still allow liquidation to be an option in the borrowing agreement, even though it would not be an automatic option if they did not write it in.

Here's the important passage from the Zywicki NR article:

The most important and controversial provision of the legislation is the "means-testing" of chapter-7 bankruptcy relief. Under current law, a person filing bankruptcy has two options. The debtor can file in chapter 7, the "liquidation" provision, which permits debtors to simply surrender all their assets and get a full discharge of unsecured debts a few months later. Or the debtor can file in chapter 13, under which he enters into a court-supervised repayment plan for a period of 3 to 5 years, during which he pays all of his "disposable income" to pay off what he can of his unsecured debt. To calculate the debtor’s available "disposable income," a judge uses his own subjective preferences to determine the debtor’s allowed living expenses.

The means-testing provisions of the bill will bring some rationality to this system. Those who make above the state median income (adjusted for family size), and can repay a substantial portion of their debts without significant hardship, would be required to file in chapter 13. At the end of the chapter-13 plan, this high-income filer would still get a discharge, just as other bankruptcy filers do. There is no "endless treadmill of payments," just a requirement that high-income debtors repay what they can.

In determining whether the debtor can repay a substantial portion of his debts, the legislation makes allowances for a whole range of expenses right off the top. First, it creates a standardized slate of expenses based on the relevant family size and regional cost of living, for such things as clothing, food, transportation, etc., eliminating the subjective judicial navel-gazing of the current system. It then subtracts from your income all of the debtor’s actual payments on secured debts, such as a home mortgage, car loan, or the like. The debtor can subtract any actual expenses for health care for himself or a dependent, as well as payments for health insurance premiums. Finally, there is an allowance for children’s educational expenses. If after subtracting out all of these expenses, the debtor still can repay $10,000 or 25 percent of his debts over a 5-year period, then he would be presumed to have to file in chapter 13.

The debtor could rebut this presumption by showing "special circumstances" that make it too much of a hardship to file in chapter 13, in which case the debtor would still be permitted to liquidate his debts in chapter 7.

So how many people would be affected by means-testing? The estimates are that some 7-11 percent of current bankruptcy filers would be affected by the means-testing provisions of the bill. Roughly 80 percent of bankruptcy filers earn below their state median income, and so will get tossed out of the means-test immediately. For that 80 percent -- roughly 1.2 million of the 1.5 million bankruptcy filers last year -- the means-test will be completely irrelevant. They will be permitted to file chapter-7 bankruptcy just as under the current system. Roughly half of the remaining 20 percent of filers won’t be able to repay enough of their debt to meet the repayment criteria, so they will be dropped out as well and be permitted to file just as today. So in the end, only the highest-income filers with the largest repayment capacity will be affected.

Posted by erasmuse at March 15, 2005 09:43 AM

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