The Benefit of Bankruptcy to Society

Bankruptcy is a legal procedure by which an individual or a business can discharge its debts when the petitioner, the individual or business debtor filing for bankruptcy, does not have the means to pay it off within a reasonable time, thus, giving the debtor a fresh start, 1 of the 2 major objectives of bankruptcy policy. For individuals, in particular, in today's environment of easy credit, it is very easy to fall deeply into debt will little hope of paying it off. This is not a good thing for either the individual or for society.

The purpose of earnings is to motivate people to work; if they have to pay most of their money to creditors, there would be little incentive to work any more than would be necessary to simply survive. Without bankruptcy, many people would become veritable slaves to credit card companies and other credit issuers, creating a massive amount of misery. Many of these people would turn to crime or find ways to earn money without reporting it.

Bankruptcy helps to prevent this scenario by giving debtors a fresh start, alleviating what could be a tremendous burden.

Bankruptcy Helps the Economy

Another major benefit of bankruptcy is that it can help to moderate the economy, restraining it from overheating during booms, but stimulating the economy when it is in a recession. Booms occur when people spend too much money within a short time; recessions occur when people do not spend enough. People tend to spend extra money when they have easy credit, then they spend less money paying back the debt: a direct cause of the boom and crash cycles.

When bankruptcy is readily available, creditors will be more prudent in lending money. When creditors readily extend credit, especially to subprime borrowers, then these poor people tend to spend the money quickly, causing the economy to heat up more. However, the stimulation must come to an end, because people can only borrow so much, then they have to pay back the debt. When paying back the debt, they have less to spend, so the economy starts spiraling downwards. Businesses cut back by laying off people, causing people to cut back on their expenses, causing the economy to fall further, and so on. Additionally, because of the ready availability of credit, much of the population is mired in debt, so they have to cut back on expenses even more to pay the debt, thus deepening the recession. Didn't this happened recently, when, in 2006 and 2007, lenders were competing to lend money for real estate, even when the people were unable to pay it back. Home prices increased dramatically in 2006 and 2007, so most people projected that it would continue, making the debt burden more affordable. Alas, it did not continue, and the economy spiraled downward into a deep recession for several years.

The central banks tried to stimulate the economy by lowering interest rates, but what good was low interest rates when people had no jobs and no credit? Banks would not grant them credit regardless of the low interest rates because they had no income and they already had a great deal of debt.

Creditors are generally richer than borrowers, but it is the borrowers who stimulate the economy by spending money. When richer people receive money, they tend to save or invest it, while poor people quickly spend it, since they need all their money simply to live. Lenders and other rich people often cause the economic problems that occur with economic excesses, so it is only natural that they should pay when people suffer. During the 2007 - 2009 credit crisis, many people in the middle class and the poor suffered, while richer people benefited from the lower prices and other opportunities presented by the recession. The rich got richer, while the poor — and the middle class — got poorer.

By making bankruptcy easier, creditors will restrain themselves from lending out too much money. After all, Congress passed a law making it much more difficult to get debts discharged just a few years before the credit crisis of 2007 to 2009. Had the new bankruptcy law not taken effect in October 2005, then lenders would have been more cautious in lending out money. Furthermore, the economy would have recovered faster, because more people would be able to eliminate their debts through bankruptcy, thus enabling them to spend more money, which would stimulate the economy faster.

Some people consider this unfair! Doesn't this cheat creditors?

The Business of Credit: Making Money by Charging Interest

The business of credit is much like investing—the greater the risk, the greater the potential profits. Any creditor, if it wishes, can simply extend credit to only the most creditworthy individuals or businesses, especially those with significant assets, thereby greatly reducing losses. However, this market is much smaller. The competition for the most creditworthy individuals is keen. To get significant market share, a creditor would have to offer low interest rates, cash-back or other incentives, and other benefits that would cost the creditor, resulting in lower profits.

Money can and is made by extending credit to less creditworthy individuals—the so-called subprime market. All creditors know about bankruptcy. They know that some portion of their customers will file for bankruptcy, yet they continue to extend credit to the same market. Why? Because it pays! They can charge higher interest rates and other fees, and they can tap a market where competition is lower. Like some investors, some creditors may take on too much risk, and go out of business, such as some of the mortgage companies that catered to the subprime market during the recent real estate boom. But this is the nature of business. You go into business hoping to make a profit, but you might lose instead. You take the risks because of the potential profits. These creditors entered the market willingly. No one forced them to extend credit to the subprime market. And it has been evident for years that large banks continue to cater to less creditworthy individuals, because, as Willie Sutton explained why he robbed banks, that's where the money is. If the big banks weren't making money in the subprime market, they wouldn't be there—but they are making money! Record profits, in fact!

Some people argue that bankruptcy raises prices for everyone. This simply isn't true—it only raises prices for the subprime market for the same reason that an investment must have a greater payoff if it has a greater risk. If the subprime market was not profitable by itself, no one would extend credit to this market. Thus, the subprime market is not being subsidized by any other sector. The prime market, for instance, is not paying higher interest rates because of the subprime market—otherwise some lenders would just cater to the prime market and outcompete those lenders serving both markets.

Some will argue that it raises prices for others in the subprime market. Well, it does, but only because it is a riskier market. If someone were not in the subprime market, then they would be in the prime market. There is no way to tell who will file for bankruptcy and who will not; if it were possible, then losses for creditors could be eliminated, but this isn't possible, because anyone can file for bankruptcy. Instead, statistical methods are used to gauge the probability that one will default on a loan, or fail to pay on time.

Over the years, creditors and others have used statistical techniques to measure risk—indeed, this is the primary purpose of credit scores, which is a statistical analysis of the data in one's credit reports that is condensed to a single number for easier comparison and processing, which measures the probability that the debtor will make timely payments on his loans, or will default. If someone in the subprime market wants better interest rates, he could simply do the things necessary to raise his credit score enough so that he will be in the prime market, but not everyone can do this. For whatever reason, some people are going to present a greater risk, and so, if they want credit, they will have to pay a higher price. If they didn't pay a higher price, no business would extend them credit.

Some argue that an easier bankruptcy would limit credit to the poor. But the poor cannot afford credit. Even if they receive credit, most of them would probably fall behind in their payments, becoming a greater credit risk than before. Afterwards, they would not be able to receive credit anyway. People who cannot get credit will learn to live without the credit, which is necessary when they are only making enough to live.

Thus, bankruptcy is beneficial for both individuals and society by giving people a fresh start, which is why it has been part of American law for over 100 years. (Actually, bankruptcy has been part of the federal law since the United States Constitution gave the federal government jurisdiction over bankruptcy. However, up until 1898, bankruptcy was mostly a creditors' remedy. The Bankruptcy Act of 1898 was the first law to provide some relief to the debtor, making the fresh start a policy objective of bankruptcy. Since then, the law has tried to strike a balance between the rights of creditors and debtors, with more protections being accorded to debtors in recent times. See Bankruptcy Law Public Policies and Bankruptcy Law Sources for more information.) When a creditor extends credit, there is always a risk it will not be paid back, even without bankruptcy, but this is the nature of the lending business. If a business doesn't want to take this risk, then it can take some other risk by doing something else.

External Links

Bankruptcy as a Step to Solvency