Bankruptcy Functions as a Safety Valve for the Economy

I recently read an academic working paper from three professors that provided quite a bit of support for things I (and my bankruptcy-practicing colleagues) have long suspected. It’s one of those papers that are probably initially of interest only to bankruptcy law practitioners and economists, which is a shame, since it contains some very intriguing research on aspects of bankruptcy that lots of folks would find interesting. The title of the paper is daunting: “Liquidity Constraints and Consumer Bankruptcy: Evidence from Tax Rebates.” It was authored by Tal Gross (Columbia University), Matthew Notowidigdo (University of Chicago Booth School of Business), and Jialan Wang (Washington University Olin School of Business). Bankruptcy Filings and Tax Refunds The premise, despite the daunting title, is relatively simple: bankruptcy filings increase after consumers receive tax refunds, thus supporting the premise that it’s the legal fees associated with bankruptcy that keep many consumers from filing for much-needed protection. Once the money from the tax refunds comes in and is available for use, then, cash-strapped families feel more comfortable in retaining counsel and filing for Chapter 7 or 13 protection. Why Bankruptcy Is a Good Thing I wrote in an earlier post about the false perception among many, spread mostly by creditors who most definitely have their own agenda, that filing for bankruptcy is a bad, immoral thing. Contained in this paper is support for the opposing viewpoint, however: that bankruptcy, in the right circumstances, is actually a positive thing. Bankruptcy can be thought of as a necessary release valve for our economy. Just as with a pressure cooker, if enough “steam” (i.e., economic pressure) builds up, the system can actually “explode.” A release valve such as bankruptcy works by siphoning off some of that pressure so that the system functions optimally. And that’s true in consumer bankruptcy, not only for the individuals who file and their families (i.e., the “micro level”) but also for the economy as a whole on a national scale (i.e., the “macro level”). Yes, bankruptcy filings did increase over the years prior to the passage of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, the legislation that radically changed many aspects of bankruptcy law and was designed ostensibly to slow that increasing rate of consumers filing for bankruptcy protections. Whether there really was any “abuse” that needed to be “prevented” is a subject of continuing debate and controversy; I certainly have my opinion (there really wasn’t). But there’s a tendency to take a somewhat shortsighted view of bankruptcy. Acknowledging the “release valve” function of bankruptcy in a healthy capitalist economy is the first step to a more balanced viewpoint. Then, too, we need to also recognize the immediate, practical impact of bankruptcy filing and the all-important discharge which successful filers receive upon the closure of their cases. Put simply, relieving the consumer from the crush of excess debt frees up cash. That stimulates spending, which in turn stimulates economic growth. Thus, besides the emotional and financial benefits that bankruptcy provides to individuals, there is a strong argument that bankruptcy as a safety valve produces an overall net positive benefit to our economy.