What’s so Bad About Bankruptcy?

Objections to the availability of bankruptcy are bountiful, with a majority relying on implicit “moral” arguments that too often miss the point. In the commercial realm, anti-bankruptcy arguments tend to be a bit more sophisticated. For example, in an era of global trade in goods and services where state-backed subsidies are typically frowned upon, Chapter 11 bankruptcy protection in the United States is perceived as “cheating.” For instance, in the realm of air services trade where European states have long publicly subsidized their respective air carriers, the U.S. has cried foul since its airlines are ostensibly exposed to the forces of raw competition without recourse to the public piggyback when times get tough. While the creation of a common aviation market within the European Union has reduced the availability of subsides for Union member state carriers, these airlines argue—with some plausibility—that Chapter 11 operates in much the same way as a subsidy, shielding U.S. airlines from the natural effects of competition, namely exiting the market altogether.

With respect to personal bankruptcy, those unable to pay their debts are sometimes castigated as “lazy” or “deadbeats.” Some even go so far as to blame larger economic problems on the fact that people refuse to pay their bills. This type of rhetoric can be leveraged to curtailing debtors’ rights. Rarely, if ever, are practical matters taken into account.

Setting aside the empirical question over whether or not debtors unable to pay their bills act as a drag on the economy writ large, imagine a world without bankruptcy protection (Chapter 7 (discharge) or Chapter 13 (structured repayment plan)) where debtors would risk losing all of their worldly possessions to satisfy as much of their debt as possible while risking future earnings being diverted to pay off the leftover balance. Under that scenario, borrowing is likely to decrease substantially, leading to a downturn in major and minor spending that will reverberate throughout the economy.

From the lender’s perspective, bankruptcy protection may not be such a bad thing after all. Instead of lending recklessly on the belief that payment will be forthcoming no matter what, the possibility of debtors filing for bankruptcy may discipline lenders into being more scrupulous. At the same time, lending institutions are expected to stay within the parameters of the law when collecting on debts. Unlike, say, the mafia, banks wield baseball bats or employ thumb breakers to get their money bank. (Of course, there’s a fair argument to be made that these institutions wield other noxious instruments to collect, but we’ll reserve that matter for another post.)

Beyond these practical considerations lies moral considerations that are not easy to ignore. Does a country as wealthy as the U.S. really want to contemplate the return of debtor’s prisons or forced servitude as an “answer” to unpaid bills? Moreover, let’s face it: life is uncertain and everyone makes mistakes, including calculations that appear rational at the time and yet prove to be flawed in hindsight due to a lack of information. Bankruptcy serves as a “do ever” for individuals and businesses who may have a great deal to contribute economically and socially and yet have run into some financial bumps throughout the stages on life’s way.