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Americans Go Broke Faster
I don’t really know what to make of this. Daniel Gros, Director of the Brussels-based Center for European Policy Studies, suggests that one reason the American economy is healthier than Europe’s is because we go broke fast, get to declare bankruptcy more quickly, and are able to wipe our debts away with less fuss. From Project Syndicate:
Millions of American homes that were purchased with subprime mortgages have been foreclosed in recent years, forcing their owners, unable to service their debt, to leave. But, as a result of no-recourse mortgages in many US states, the entire mortgage debt was then extinguished, even if the value of the home was too low to cover the balance still due.
Moreover, even in those states where there is full recourse, so that the homeowner remains liable for the full amount of the mortgage loan (that is, the difference between the balance due and the value recovered by selling the home), America’s procedures for personal bankruptcy offer a relatively quick solution. Millions of Americans have filed for personal bankruptcy since 2008 , thereby extinguishing their personal debt. The same applies to hundreds of thousands of small businesses.
Of course, there has also been a surge of bankruptcies in the eurozone’s periphery. But in countries like Italy, Spain, and Greece, the length of a bankruptcy proceeding is measured in years, not months or weeks, as in the US. Moreover, in most of continental Europe a person can be discharged of his or her debt only after a lengthy period, often 5-7 years, during which almost all income must be devoted to debt service.
Is this really a positive feature of the American economy? The ability to get heavily into debt and then wipe it all away in a month or so?
The bedrock American idea that you can reinvent yourself and make a comeback — a popular theme in self-help books, sports, the stories of the early pioneers, and immigrant tales — supports this idea, I guess. America is a place of second — and third, and fourth — chances. We believe in the comeback and the underdog.
But it makes me uneasy to think that there’s something useful and even virtuous about the ease with which we allow ourselves to accrue debt and then efficiently make it disappear.
Or am I being silly?
Published in General
Perhaps you should read “The Upside of Down” whose author explores the very idea that the ability to fail without being devastated is the prerequisite for all great success. I have not read the book yet (it is on my list) but I have heard her give interviews on it and it really gave me something to think about. One of the things she talks about is actually the benefits of the easy bankruptcy policies of the US, and how they foster small business creation and keep businesses alive through rough patches that in Europe would just sink them.
A pressure relief valve is a great safety device that should not be used to regulate a system under normal conditions. I think our bankruptcy laws act as such. However, when people start relying on the safety mechanisms for day-to-day operations and one fails then you end up with Chernobyl. We’re getting closer to that mindset, but we’re not wholly there yet. I hope. The same logic applies to our safety net programs that are quickly turning into a hammock.
We conservatives routinely talk about the difference between government and the culture. But the Culture is more than just how we think about sex … it’s also about how we approach living, and that includes our economic life. It’s also about how we approach money. And right now, we have developed a culture that discourages risks.
That’s not American. It’s American to take risks. But the Puritan DNA of Americans means that risk-taking also brings the responsibility to be prudent. That’s the part that’s missing.
The American economic psychology is out of whack. The psychology is extremist. All or nothing. Right now, the economy is stagnant because we’re in a period of Nothing, a hesitation brought on because we had too many imprudent risks before. And when that’s compounded with regulations that penalize risk-taking, along with taxes that reduce the payoff, you’re not going to have a lot of small, prudent risks. Instead, the incentives are geared to sure-fire big risks, which you can only take if you already have the resources.
Making bankruptcy easy is the economic version of making sex easy. You lose the discipline of prudence.
I disagree. Just because there’s a whore house down the road doesn’t mean you or I will visit it. Similarly, just because we refrain doesn’t mean others will follow suit. There must be a threshold for bankruptcy, of course, but finding the sweet spot between mercy and justice is always tricky.
Even if relatively easy bankruptcy proceedings are ultimately good for the economy, shouldn’t it be the free choice of individual investors and banks whether or not to forgive a debt? I can see the usefulness of bankruptcy. But doesn’t forcing it as an option just shift the risk burden from borrowers to lenders? Shouldn’t it be a lender’s choice whether or not to accept that burden?
Are bankruptcy laws a form of wealth redistribution? Do they constitute a welfare program for entrepreneurs?
It will certainly raise the bar to borrow this way, provided government doesn’t artificially lower it the way it did with the CRA. Again, it’s a balancing problem probably much more suited to a Hayakian approach than to what we’ve seen the last 50+ years.
Bankruptcy has negative consequences, too: It makes people less willing to lend you money in the future. I don’t have a problem with easy bankruptcy, as long as the information is freely available to potential lenders.
However, I recall something about recent legal or regulatory changes that shorten the period of time someone has to report bankruptcy. (I think from 7 years to 3?) If so, withholding that information from potential lenders can create real information asymmetry. Does anyone know if this is accurate?
We should differentiate between bankruptcies caused by the real estate bubble versus other bankruptcies. The real estate bubble tricked a lot of ordinary people with previously great credit to take good-faith mortgages without realizing the market was rigged to nearly twice its actual value (by mandated sub-prime lending IMO).
That said, the pendulum in our culture has swung far towards financial irresponsibility, or maxing out one’s credit during the good times under the assumption that the good times will never end. But look at the example our government gives us.
Easy bankruptcy is a good thing from the perspective that it allows for small business owners to take risk and thus allows for innovation. Much has been said, negatively, about families having to file for bankruptcy due to medical bills. It is true that medical bills are the number one cause of bankruptcy in the US, but medical bills are also considered a low priority debt. They are kind of like common shares when a company files for bankruptcy. They are last in line and among the easiest settled. This is good as it allows people to get great medical care based on need. It can be discharged in a Chapter 7 if your income is low enough.
This is good. It means that lower income people will not be unduly burdened by unforeseen medical expenses. There are even those considering making the discharge of medical bills through bankruptcy fade from credit faster due to the nature of the acquisition of the debt as a risk to lenders, though lenders already tend to treat bankruptcy due to medical debt differently than credit card debt when making decisions.
Transparency to lenders and to borrowers is key.
Yes, the idea that bankruptcy is an easy way out is wrong. Beyond the obvious long-term credit damage, it’s often a problem when looking for many jobs or security clearances. Moreover, bankruptcy is an important incentive for lenders to avoid expanding credit too much. The inability to bankrupt student debt in nearly all cases is one of the reasons that student loan debt has exploded. The loans are positioned as “financial aid”, yet the student doesn’t appreciate she could be yoked to that loan forever.
BTW, bankruptcy stays on your credit report for 10 years.
Bankruptcy may be easier, but it is reflected in the cost of the loan, which is a fine way to do it.
We must draw many lines between the rights of one and the rights of another. It sounds plausible that the US happened to draw the line between debt and forgiveness close to the optimal place.
Hmmm. This has given me a lot to think about. But I think I tend to agree with most of you that simplified, efficient bankruptcy is basically a good thing. Encourages risk-taking and innovation etc. And that a transparent and multi-year way of reporting an instance of debt-forgiveness is crucial.
How did we manage to evolve our way into this kind of sensible set of regulations? Does anyone know the history of bankruptcy laws?
You’re not being silly. The relative ease with which a person can get out from under his debts should-should-result in more cautious behavior by lenders. In practice, though, lenders have become conditioned to expect that if they are “systemically important” enough-in other words, politically connected- they will be bailed out by taxpayers. This results in reckless behavior, leading to bubbles which will collapse as happened in 2008.
The problem is the faction of society that lives off of exploiting leniency. Every time this faction sees leniency towards a deserving person, they exploit that leniency toward undeserving ends. “Equality” demands that you encourage both the risk-takers and the free-lunch-takers. What happens when the latter start outnumbering the former?
A loose acquaintance used to make his money by helping people declare bankruptcy. Then, in 2005, the laws were changed, tightening filing requirements and making it much more difficult to escape creditors that way. So, in an ironic twist, his business collapsed and he had to… declare bankruptcy.
Was hoping someone would bring up student debt.
The government interfered in the lending market via guarantees at first and now via direct lending.
This discouraged the private lending market from due diligence since their loans are guaranteed.
Rather than doing their own due diligence in lending only to qualified applicants via actuarial calculations, the government used its unique position to disallow student debt to be handled via bankruptcy.
The exclusion of student loan debt happened before the government took over the subsidized student loan market. It was part of the 2005 bankruptcy “reform” law and was one of the many concessions to the banking industry tucked away in the law.
I stand corrected on the timeline. Thanks also for the info on the applicable law.
Here are some links.
“It was passed by the 109th United States Congress on April 14, 2005 and signed into law by President George W. Bush on April 20, 2005.” http://en.wikipedia.org/wiki/Bankruptcy_Abuse_Prevention_and_Consumer_Protection_Act
I’m having trouble finding commentary about it from any of my trusted sources.
Here’s the closest I could find, which is barely a mention.
http://www.volokh.com/archives/archive_2005_11_20-2005_11_26.shtml#1132664176
I agree. And variations on this theme add up to lenders behaving more like silent partners than Shylocks. They’re less likely to win if the borrower loses. Can bankruptcy be made too easy? Absolutely, but the downside for the filer is currently such that few people take the decision to file lightly.
Besides, what’s the alternative? Having debt obligations for life is meaningless if you’re under no real obligation to pay. As a practical matter, I’m not sure what lies between bankruptcy and debtor’s prison. I haven’t heard anybody advocate resuscitating that venerable institution since 1992, when an inebriated, iconoclastic college roommate of mine proposed it, literally, for the sake of the argument. (I miss that guy.) Anybody prepared to carry that banner?
I think far too much is made of this effect. I don’t see the evidence that these firms take enormous risks in lending. The math is easy and there’s no incentive to take risks. An individual mortgage makes very little money, however if I hold 4 million of them they can provide the steady cash flow I need for other investments. If you look to the recent housing crisis for an example, it was the way the loan risk was collateralized that encouraged the risk-taking.
But even if you’re correct, you’re not necessarily making an argument against bankruptcy. I suspect the argument you really want to make is against government bailouts.
“I don’t see the evidence that these firms take enormous risks in lending”- I guess that depends on how you define enormous. But enormous or not, the real estate default/foreclosure fest that began in 2008 seems like evidence of excessive risk-taking to me. But yes, this is more an argument against bailouts than against bankruptcies. That was my point.
In a true free market it shouldn’t be a problem because lenders would be free to charge interest rates based on actual risk.
Are European lenders free to set their rates without government interference?
When the loans are underwritten by the federal government, it ain’t the lenders taking the risk.
Jimmy Gault-“I don’t see the evidence that these firms take enormous risks in lending”. I see the massive default and foreclosure fest that started in 2008 as evidence of excessive risk-taking. I guess you might not consider that to be enormous, though, so I guess we’ve got no argument there. The argument I really did make was against government bailouts. But the combination of EZ bankruptcy, no-money down mortgages, and government bailouts makes a situation in which nobody but the taxpayer has anything to lose on a risky loan.
You can count on the Ricochetti for a different take on things. This is the first time I heard that the bailout caused the crisis.
I should have made my point more clearly, but I’m sticking to it. Yes, these banks were taking enormous risks, however, it had nothing to do with the prospects for a bailout. In hindsight it seems obvious that there would be a bailout under these conditions, but in 2007 would you have bet your firm on it? If so, maybe there’s an executive position for you at Bear Stearns.
The market as a whole miscalculated the risk associated with investment vehicles like CDOs and rated them higher than justified. Buyers often acquired these failed mortgages in the form of AAA bonds. You can’t argue that the safety net of a government bailout encouraged them to take excessive risks without evidence that they knowingly or negligently took those risks.
This was a market failure. Did the government help make it? Absolutely, but it was by extorting banks to issue large numbers of sub-prime mortgages. Absent that, the price bubble is much smaller and there are no CDOs or CDSs to turn sour.
The bonds were rated AAA because they were underwritten by the US government.
Then how did Lehman Bros. end up bankrupt?