Against Bankruptcy Laws

by Gil Guillory

I don’t intend to lose your interest by discussing at length the history of the dubious institution of bankruptcy. But a few points must precede my remarks.

History 

For a rather good history, see http://www.nolo.com/encyclopedia/articles/dc/history.html from which much of this is drawn. 

Bankruptcy started out in England in 1542 as a quasi-libertarian answer to debtor’s prison. Debtors who could not pay their bills had their assets forcibly seized and sold, and the proceeds were distributed pro-rata among the creditors. Since you can’t squeeze blood from a turnip, this was a practical solution. It applied only to debtor merchants (common folks still landed in the pokey), and only the creditors could initiate a proceeding. Further, this procedure did not nullify the debtor’s outstanding debt. The creditors could still pursue the debtor on the remaining balances.

This tradition continued largely unchanged in the English colonies. Fast forward to 1792. The Constitution of the US specifically empowers congress to enact bankruptcy laws. Early on, this power was used only a few times, with short-lived bankruptcy laws being passed in 1800, 1841, and 1867.

The Bankruptcy Act of 1898 marked a new era in US law, with bankruptcy law on the books ever since, and its libertarian character vitiated. This law allowed for both voluntary (debtor-initiated) and involuntary (creditor-initiated) cases, permitted debtors to claim exemptions, and removed most barriers for discharging virtually all debts. I have not researched the matter, but it is clear that this era witnessed the rise of Fabian socialism and other initiatives now known collectively as “the welfare state”. It is likely that self-described proletarians pushed for such legislation that systematically favors debtors over creditors.

The law has been tinkered with since then, but Congress has not changed the essential nature of bankruptcy in America for 100 years.

The Social Problem

Most of us have the power to run up more debt than we have the ability to pay back. And, a segment of the population exercises this power. In doing so, this creates problems for both debtor and creditor.

The creditor, of course, is owed money that is not repaid. The debtor is in the unenviable position of being constantly hounded by creditors seeking payment, which grates on his morale, and saps his sense of life. These social problems, caused primarily by the debtor, have solutions which fall into two categories: voluntary action and state action.

Voluntary Action

For the most part, the interests of the creditors and the debtor are aligned. They are both interested in maximizing the income of the debtor over the long term. The one, so that what is owed can be paid back. The other, so that he can both get out of debt and prosper and flourish in future endeavors, seeking to fulfill his manifold wants and desires.

There is some conflict between the two, since the debtor would prefer to not pay on his debts at all, and the creditor would prefer that the debtor devote none of his pay to luxuries, maximizing the payback. However, both parties realize that there is a happy medium between these extremes. There is an appropriate debt load that will take into account the ability of the debtor to repay while also not treating the debt frivolously.

Creditors, with their financial houses in order (by definition), have realized that a third-party mediator/arbitrator institution is needed to adjudicate on the matter of appropriate debt load. Through donations, they maintain the NFCC and its affiliated institutions.

Known as Consumer Credit Counseling Services in many cities, the staff of counselors and financial advisors work as an intermediary between debtors and creditors. The usual arrangement is for the CCC to collect a single, negotiated, monthly payment from debtors and distribute the proceeds to the creditors.

The CCC does this even for creditors that do not financially support the NFCC, and without any fee whatsoever to the debtor. The creditors sometimes partially forgive debt, by waiving late fees, deferring interest, and even sometimes reducing the principal amount owed.

Tracking Reality

Advocates of bankruptcy laws have claimed that creditors cannot squeeze blood from a turnip, and that bankruptcy proceedings are a way to impose this reality upon creditors. However, this line of argument does not agree with theory or practice.

Being on the supervisory board of a credit union, I have witnessed how delinquent accounts are handled. Since it is important for the credit union to know the likely future income to be gained from its delinquent accounts, subjective determinations are made, putting each delinquent account into a category. To the total of delinquent accounts in each category, a factor is applied. By way of example:

T = Total expected income from all loan accounts

OK = total of accounts that are not delinquent

SS = total of delinquent accounts where the debtor is slow to pay, but we expect our money eventually

U = total of delinquent accounts where the debtor is unlikely to pay without vigorous collection efforts

L = total of delinquent accounts which are considered wholly losses

T = OK + 75% (SS) + 50% (U) + 0% (L)

This is only an example to demonstrate the concept. This is not the actual formula employed at our credit union.

In short, creditors are very interested in, and continually track, how much blood is in any particular turnip. There is no “reality check” that creditors undergo as a result of bankruptcy proceedings.

State Action

Bankruptcy law, as currently instituted, is an example of state action. In the words of Stephen J. Ware (Professor of Law who teaches on bankruptcy law):

Bankruptcy filings by individual debtors have two main effects. One is to confine creditors’ collection efforts to the bankruptcy forum; this often has the effect of treating vigorous creditors no better than apathetic creditors. The second main effect is to discharge the debtor's liability on, i.e., to nullify, a substantial portion (often 100%) of the debt.

Both of these effects are undesirable from the standpoint of justice. Firstly, it is not legitimate for the debtor to claim that since he cannot pay, that he does not owe, a particular sum. I will not here launch a defense of this position. This position is a minority, but mainstream, view (see Rasmussen Poll 1523, of 17 November 2000: “Should individuals be allowed to declare bankruptcy?” Only 63% said “yes”, with 38% saying “no” or “not sure”).

Secondly, by treating all creditors equally, they punish the creditors who were vigorously pursuing collection.

It is for these reasons that I have heard an NCUA representative, sympathetic to the plight of creditors, refer to bankruptcy as “just legalized theft, really.” Sound familiar?

A Case Study

What is objectionable about bankruptcy laws can be summarized by the following fictional case, based upon a real case.

Jim joins a credit union with his career and life in ascendancy. His periodic raises, his wife’s new job, and the booming stock market create an aura of imperviousness, and he borrows against his very good credit. Three years later, he finds that his now stay-at-home wife is divorcing him, taking the kid, and moving in with her mother. Of course, she is demanding alimony and child support. His stock portfolio is in the dumps. A general downturn in his field puts him out of work. He has credit card debt, signature loans, two car loans, student loans, a house note, and even a loan on his boat.

Despite his best efforts, he cannot find a job, can’t get a good offer on his second car or boat, and doesn’t really even have the time to put his house up for sale. He answers every phone call, just in case it is a job offer or at least an interview, but most of them are creditors. One of his creditors suggests CCC, but since they just shuffle the same debt around, he doesn’t really see how that’s a solution to his problems and as a technical professional, he hardly thinks that some counselor could help him.

In despair, he contacts a lawyer and files for bankruptcy. His creditors stop calling, his secured debt (mortgage, auto, boat) is reduced from $145,000 to $116,000 and his unsecured debt of $20,000 is completely nullified (credit card, signature loans).

Fast forward 7 years, and Jim is back in clover. His bankruptcy well behind him, he is back at work, he has accumulated a good deal in his 401-K, he has some CD’s set aside, and he is nearly debt-free. His spending on luxury items, like going out to eat and to the movies, is back up. He has even bought a new boat.

Meanwhile, the creditors that lost a total of $49,000 cannot pursue Jim to pay even part of that amount back. They can ask Jim to pay them back, but he is not legally obliged to, and the creditors cannot get judgements against him.

The problem in a nutshell: by nullifying debt, bankruptcy laws prevent the possibility of repayment of debts by debtors that become able to discharge them.

Socioeconomic Effects

To finish off the case against bankruptcy laws, I will show how they result in social bads. Bankruptcy proceedings are chosen over voluntary mediation and arbitration because they result in nullification of loans. It is clear that bankruptcy laws result in a greater amount of unpaid loans than would otherwise occur.

The greater amount of unpaid loans results in two effects: higher interest rates on loans and/or lower returns on investments.

The lower returns on investments means that potential investors will spend more of their wealth on consumption goods rather than capital goods, meaning that the amount of capital investment is lower than it would otherwise be.

One might initially think that the higher-interest-rate loans, excluding the marginal borrowers, will somehow balance with this phenomenon. But such is not the case. There are fewer borrowers, and the borrowers are necessarily investing the money in projects that are, on average, of higher profitability. However, there is no reason to think that the rate of default on loans is lower with those investing in potentially higher profitability ventures. Bankruptcy laws do not affect the percentage of defaults.

With bankruptcy laws, then, less capital is invested in ventures, but the same percentage of that total is malinvested, meaning that the total capital invested in fruitful (capital forming) ventures is lower.

Lower capital formation means that the economy expands at a lower rate. That sounds dry and uninteresting. Let me put a face on it. Acquaint yourself with Julian Simon’s excellent empirical work on how capitalism delivers the goods. Try http://www.cato.org/pubs/pas/pa364.pdf to start. There, you will find truly inspiring graphs of how, over the past century, life expectancy, home ownership, car ownership, GDP per capita, and many other goods have risen dramatically. You will also find graphs of poverty, infant mortality, length of workweek, price of wheat, air pollution, and many other bads declining over the course of the twentieth century.

The thing that alleviates poverty is capital. The thing that cures illness is capital. The thing that allows one to have leisure time is capital. All of these metrics are tied to capital. Intellectual capital. Physical capital. Artistic capital. It is capital formation that drives all of the advancement of social goods.

Anything that improves the rate at which capital is formed in the economy saves lives, alleviates poverty, and makes our lives richer.

A special point must be made concerning moral capital. By legitimating the nullification of loans, the state, through its bankruptcy laws, undermines the moral foundation of property rights. Like other “welfare” laws, bankruptcy laws subsidize behavior that should, if anything, be punished. To systematically encourage such behavior is to de-civilize our country, leading the way for an even more degenerate culture.

In short, bankruptcy laws tend to bankrupt our society.

March 27, 2002  

discuss this article in the forum!