Bankruptcy: A Hidden Bubble-Enabler

Economic bubbles are an accepted fact both popularly and academically, but their causes are subject to debate. Monetarists posit that reactionary, Keynesian monetary policy causes the normal ebbs and flows of the economy to fluctuate more drastically, since central bank’s “stabilizing” actions take time to work their way through the economy. Austrians argue that contemporary banking systems allow lending institutions to push the savings rate of an economy above its true level, resulting in overstocked inventory and production capacity that the consumers cannot afford. Those with a financial bent see investors who focus on capital gains in the stock market, bidding up the price above and beyond its fundamentals simply because other people will probably bid the price up more until the bubble finally bursts. Still others focus on psychological factors that cause common investors to overvalue categorically the future prospects for the economy as a whole. Depending on one’s assumptions and background, any of these explanations may be appealing. They largely possess internally correct logic and are not necessarily mutually exclusive.

While these models require certain assumptions regarding the intrinsic framework of the economy, these explanations do not need to be the whole story. Stepping on a gas pedal causes a car to move faster, but its rate of acceleration also depends on the texture of the road, the power of the engine, and the weight of the car, among myriad others. One, two, or three of the above positions may be the analog of stepping on the gas pedal and the power of the engine, but there is no reason to believe that there does not exist an equivalent to the less important texture of the road.

I conjecture that one of these factors is the very existence of bankruptcy law in the United States. This is a very strong statement; I’m firmly aware of this. At the same time, if you dissect what bankruptcy law really is and really does, its existence and nature is peculiar and bizarre.

Declaring bankruptcy is a painful, terrible thing. No one wishes it for herself. Due to factors entirely outside of his control, bills may add up and the bank may even seize an individual’s house. Bankruptcy, while very damaging to one’s reputation and prospects, allows a way out and a fresh start. Creditors couldn’t have ever really expected to get paid, but bankruptcy allows swift resolution and the opportunity for them to get something, anything. On a case-by-case basis, the process allows a resolution and the likely best outcome for all parties.

When lawmakers write public policy, however, their job is not one specific case study or example. It is (or should be) what is best for the economy looking forward. The existence of bankruptcy as an alternative to forever digging out of a hole of bills eliminates a cost associated with taking on financial risks. No one wants bankruptcy, but its difficulties set a mathematical lower bound for the downside risk of a particular venture. For instance, say, opening a pizza parlor has a 3/5 chance of succeeding, 1/5 chance of failure, and 1/5 of utter failure, with the latter two options both resulting in bankruptcy. However, if “failure” means “$500,000 in debt” and “utter failure” means “$10,000,000 in debt”, the entrepreneur does not see the full cost to opening the pizza parlor. Presumably, since he declared bankruptcy at $500,000 in debt, being bankrupt was better (and hence less costly) than a $500,000 debt and much less costly than a $10,000,000 debt. This asymmetry encourages citizens to put themselves in situations that result in massive failure by only making them pay for a fraction of the cost of that failure.

Call bankruptcy what it really is, a statute automatically written into any contract that allows an individual or corporation out it if she really, really has problems paying it.

While eliminating bankruptcy as an option may decrease demand for credit since the borrower now faces the true cost of borrowing, it also, arguably more importantly, eliminates many of the moral hazard issues that banks have to put up with right now. The lender must ask for collateral and do all sorts of background checks because it really can’t trust the borrower to present himself honestly. However, with the elimination of bankruptcy, this cost would be reduced since the borrower can be trusted much more fully to police himself. While certain moral hazard issues still exist (if the borrower is successful, the bank is only going to get paid back what it lent while the borrower can possibly receive an unlimited high return), this fixes one side of the equation. Thus, while two effects are at play, there combined effect of these is an empirical question that requires study before asserting that it would either increase or decrease the quantity of investment across the economy.

However, I’m not too concern with the small-time entrepreneur, but the stockholders of financial firms.

Incorporation laws, virtually worldwide, allow the owners of a business to hide their personal assets from bankruptcy courts when profiting from a business. Therefore, the lower bound effect of bankruptcy alluded to earlier is pushed higher. The only thing the owner has to lose is the equity in the firm. In contrast to real bankruptcy, she gets to keep her house.

The same thing holds true with shareholders of public company. If the firm they collectively own makes a risky investment, and the most they could lose is the value of their stock, they will not value the investment efficiently. The shareholders must feel the effects of the choices of the board of directors if the market is to hold them accountable for choosing managers who are too risk averse. If this philosophy were to be adopted, suddenly, stocks stop becoming an interesting hobby, one where there are real repercussions for risk. Stocks become far less fun to speculate upon when the stockholder could lose his house by holding them.

The direct economic effect bankruptcy laws have on society is a misallocation of resources in favor of stocks over investment vehicles. This is primarily of academic concern, although it ultimately has negative consequences down the line. The real problem for the economy is its upwards bias for prices across all stocks. Any such bias facilitates the complete collapse of the market, setting the stage for the already mentioned orthodox causes of bubbles to consummate. While practically and morally, giving an individual or corporation a second chance through bankruptcy may seem ostensibly to be a bad outcome to worse alternatives, policy makers must weigh the negative effects of misallocation of resources and bubble-enabling against such benefits. If bankruptcy laws should ultimately remain in place despite their costs, so be it, but the costs must enter the discussion.

I have not found any literature in libertarian (Monetarist or Austrian) economics that may provide another solution for this problem, and whether there are arguments for bankruptcy as being an innate aspect of private property. If this question has been discussed elsewhere, please direct me to it.