Summary
The consensus belief in the Traditional model animated the drafting of the 1978 Bankruptcy Code, the basic architecture of which remains in place today.4 In the spring of 2005, however, Congress enacted comprehensive bankruptcy reform legislation by an overwhelming bipartisan majority.5 These political efforts came in response to a surge in consumer bankruptcy filings over the past twenty-five years, and the perception of excessive fraud and abuse in the consumer bankruptcy system. Scholars have attempted to reconcile this anomaly by incorporating the available evidence within the Traditional model.15 If the underlying model is sound, the process of ordinary science will generate increasingly accurate and instructive refinements to the model.16 If the model is flawed, however, it will become increasingly difficult to account for anomalies, as efforts to account for some anomalies will create incoherence in the model and new anomalies.17 At some point, the model itself will reach an intellectual "crisis" and collapse, creating an opportunity for a new model to arise and replace it.ls This Article reviews the efforts of the Traditional model to explain the world of consumer bankruptcy in the United States over the past century, and especially the rapid escalation in bankruptcy filings during the past quarter-century.
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Extract
An Economic Analysis of the Consumer Bankruptcy Crisis
I. INTRODUCTION: THE CONSUMER BANKRUPTCY CRISIS
The test of the validity of a scientific theory is its ability to explain the world.' The Traditional model of consumer bankruptcy theory views bankruptcy filings as a result of household financial distress. In the Traditional model, bankruptcy is seen as a largely involuntary act, a "last resort" to deal with insoluble financial problems brought on by exogenous factors such as heavy indebtedness or sudden and unexpected income or expense shocks, such as unemployment, medical problems, or divorce.2 In the Traditional model, bankruptcy is a form of social insurance, allowing individuals to "smooth" unexpected income or expense shocks. To this day, most bankruptcy scholars continue to believe in the descriptive accuracy of the Traditional model and advocate normative policy recommendations based on it.3 Moreover, the success of the Traditional model has not been purely academic. The consensus belief in the Traditional model animated the drafting of the 1978 Bankruptcy Code, the basic architecture of which remains in place today.4In the spring of 2005, however, Congress enacted comprehensive bankruptcy reform legislation by an overwhelming bipartisan majority.5 These political efforts came in response to a surge in consumer bankruptcy filings over the past twenty-five years, and the perception of excessive fraud and abuse in the consumer bankruptcy system. During that period, annual filings rose from 250,000 in 1979 to over 1.5 million last year. But these bankruptcy records come on the back of an era of unprecedented economic prosperity-low unemployment, low interest rates, and a roaring stock market. This anomaly of record-high bankruptcy filings during an era of unprecedented prosperity spurred efforts to amend the bankruptcy code and place greater restrictions and conditions on access to bankruptcy, which culminated in the enactment of the recent bankruptcy reform legislation.6Throughout the legislative process, many leading bankruptcy commentators criticized these reform efforts as purely politically motivated and lacking intellectual justification.7 Adherents to the Traditional model argue that the surface appearance of prosperity disguises deeper economic problems that remain consistent with the Traditional model. If this is true, then bankruptcy reform designed to place greater conditions on access to bankruptcy appears to be cruel and short-sighted.8 Instead, critics argue, policy should focus on alleviating the underlying economic distress, of which increased bankruptcy filings is merely the symptom.9On the other hand, if the upward trend in bankruptcy filings is not the result of increased financial distress, then it is appropriate to consider whether an alternative intellectual model better explains the available evidence. The Traditional model generates a clear, testable hypothesis about trends in consumer bankruptcy filings-consumer bankruptcies should rise as household financial condition deteriorates and should fall during times of prosperity. Household financial condition can change for many reasons, but whatever the causes, the forces must be sufficiently widespread and adverse to account for major changes in bankruptcy filings. With respect to an observable trend, such as the upward consumer bankruptcy trend of the past twenty-five years, the Traditional model predicts that there must be some important, systematic, and chronic negative effect on household financial condition that has continued to worsen over time.An accurate understanding of the causes of the consumer bankruptcy crisis has important policy implications for American families. The economic and noneconomic costs and benefits of the American consumer bankruptcy system are evident. Consumer bankruptcy provides a fresh start to those who need it, relieves them of the financial and psychological burdens of insolvency, and provides incentives for work and entrepreneurship. In addition, the availability of bankruptcy reflects society's noneconomic values of compassion, charity, and forgiveness. On the other hand, the option of bankruptcy creates a moral hazard problem and increases the risk associated with consumer lending, leading creditors to charge higher interest rates, demand collateral or a larger down payment, increase monitoring to prevent default, or increase penalties for risky behavior such as late payments.10 At least some of the costs of the consumer bankruptcy system thus are borne by all borrowers as a group; other costs are borne by lenders, and still other costs are social deadweight loss." The noneconomic costs can include the weakening of social and individual virtues of personal responsibility, trust, and reciprocity.12 The public policy challenge, therefore, is to identify the set of bankruptcy rules that strikes the optimal balance between the benefits and costs of consumer bankruptcy, and where appropriate, to identify reforms that minimize those costs whil...See the full content of this document
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