"Bankruptcy is perhaps the greatest and most humiliating calamity which can befall an innocent man"
From an evolutionary perspective, bankruptcies may be seen as an important selection mechanism. Bankruptcy, however, has not received much attention in the economics literature. As the quotation from Smith, above, intimates, bankruptcy is an unpleasant process for individuals, their families and for wider society. Bankruptcy laws differ widely across countries and even within a federalized country such as the United States. Filing practices within a country also differ substantially across regions as well as among social groups (Fay, Hurst, and White 2002). Thus, bankruptcy is not the uncomplicated selection mechanism in the economic realm it sometimes is believed to be.
This paper discusses how one may evaluate bankruptcy regimes from an economic perspective. It contrasts the instrumental rationality approach of the Chicago (law and economics) school with the instrumental valuation principle (IVP) from original Institutional Economics (OIE) in the context of personal bankruptcy.
Recently most developed countries have experienced some increase in the number of personal bankruptcies. Conventionally, personal bankruptcies tend to be framed as failures of self-control (cf. Starr, forthcoming), although there is clear evidence that malevolence is only involved in a minority of cases (Congressional Budget Office (CBO), 2000). (1) Some mainstream economists also frame personal bankruptcies as personal failures (cf. Fay, Hurst, and White 2002). (2) This highlights the enduring vilification of the individual as bankrupt and the pejorative nature of the term.
Uniquely, and until recently, U.S. citizens had the potential to select from two alternative methods of declaring bankruptcy (Efrat 2001): Chapters 7 and 13. Under Chapter 7, debtors surrender all their un-exempted assets to a trustee; the trustee liquidates and repays creditors. Unsecured debts such as credit card debts, installment loans, medical bills and damage claims are discharged. Government-backed student loans, child support and alimony, and recent income taxes are not eligible for discharge. Homesteads tend to be exempted. Chapter 7 is an attractive avenue for filing for bankruptcy; constituting 70% of U.S. bankruptcy filings (CBO 2000). Chapter 13 is intended for fliers who earn a regular income. Filers do not surrender assets; instead, a re-payment schedule, usually over a 3-5 year period, is arranged through due legal process.
As may be expected, there is a wide variety of institutional arrangements associated with bankruptcy. Some arrangements reflect the historical antipathy toward those unfortunate enough to experience bankruptcy (Kilpi 1998). (3) U.S. type Chapter 13 arrangements tend to be the norm in most developed economies. In the Netherlands and UK, for example, bankrupts must accept a repayment plan in effect drawn up by the creditors or their trustees: the converse of the latitude within the U.S. system. (4) While a judge can compel creditors to cooperate, creditors usually possess sundry instruments to pursue their interests. (5) Potentially, many creditors are not only motivated by the prospect of asset recovery, but also by a sense of grievance (Jungmann, Niemijer, and ter Voert 2001; Kilpi 1998) or even a Puritan ethos (Galbraith,1976). In general, few assets are exempted. Any income above a legally defined minimum usually has to be surrendered entailing erosion in the material incentives for insolvents to earn additional income. Moreover, this may be conceived as attenuation in individual autonomy. In more liberal judicial systems, this attenuation is limited as debts tend to be discharged after three years. In less liberal systems, bankruptcy can amount to debt-bondage (peonage) when insolvents are denied their autonomy for more protracted periods, and in the extreme, indefinitely.
A Chicago Interpretation of Personal Bankruptcy
The dominating Chicago approach to law and economics usurped Ely-Commons inspired institutional law and economics some time ago (Mercuro and Medema 2006). The Chicago approach, typified especially by Gary Becker, Richard Posner, and Ronald Coase, reduces Commons' rich delineation of transactions into one essentially of commodity exchange in an overarching ubiquitous market. The defining feature of Becker and Posner's approach is a price-theoretic analysis of law (Engelmann 2005; Mercuro and Medema 2006). Posner in particular has justified this in terms of explaining legal and business practices within the parameters of "basic economic theory" (Posner 1978, 931). He avows the efficiency of common law on the basis that judges select legal rules that generate efficient outcomes within the cost constraints of administering the legal system. (6) He declares: "It is as if the judges wanted to adopt the rules, procedures, and case outcomes that would maximize society's wealth" (Posner 1990, 356 original emphasis). Legal rules are analogous to prices that influence rational individuals' incentive structures. Contracts, supported by common law...