How the new Bankruptcy Bill will only hurt the American economy

Tele-evangelists wax philosophical about our nation’s moral bankruptcy on a regular basis. The average American is often derided as a materialistic, effete consumer whose sense of “moral values” has depreciated. Yet while the jury is out on the ubiquity of moral bankrupts, the number of fiscal ones is indeed rising. Over 1.6 million Americans filed for bankruptcy last year, a figure which is alarming compared to other developed nations even after adjusting for population – our per capita bankruptcy rate is 9 times higher than that of Britain. Debt relief commercials abound in print, on television, and on the Internet; everyone seems to have an answer for the debt-laden American consumer. Now it seems the government has jumped into the fray with its own solution.

The Bankruptcy Bill signed by President Bush on April 20th has been in the works for 8 years. Credit card companies and financial institutions have been lobbying for it since the Clinton administration, when it was successively defeated due to a clause that provided bankruptcy protection for abortion-clinic bombers. The new bill institutes a means test to determine which individuals can file under Chapter 7 and Chapter 13. Those with few assets and little income can still file for Chapter 7 bankruptcy, which allows all debts to be cancelled except for student loans, overdue tax payments, child support, and alimony. Those individuals with an income higher than the state’s median who can afford to pay $100 per month for the next 5 years – $6,000 in all – will be forced into Chapter 13 bankruptcy, regardless of their actual expenses, in which case a judge will order a repayment plan.

The American Bankruptcy Institute (ABI), a non-partisan think-tank, estimates that 3 to 20 percent of those who file for bankruptcy every year will be prevented from doing so due to the new law. Supporters of the bill claim that its passage will encourage American consumers to become more responsible with their spending, and those individuals who can clearly pay their bills will no longer be able to unnecessarily rely on the state.

Phrases like “consumer responsibility” and “fiscal restraint” always make for good PR, so it’s no surprise that the credit card companies have championed their cause with such claims. The media has unquestioningly latched on. The theory being forwarded goes something like this: bankruptcy reform is needed to reign in the profligate spending habits of Americans who have become used to living beyond their means, by rejecting irresponsible defaulters and lowering lending risk so that credit is more cheaply available to legitimate borrowers. To call this a distortion of facts would be an understatement.

Proponents of the bill seem to singularly operate on the premise that widespread abuse is occurring, a claim that is not borne out by available research. The image of bankruptcy being forwarded by credit card companies, and duly championed by a lazy media, is not representative of the majority of individuals who choose to go that route. Contrary to popular opinion, the “stigma” associated with bankruptcy has not been reduced – it is not thought of by entrepreneurs as a “battle-scar” on the road to riches. Personal bankruptcy is the same as ever: a difficult, last-resort step often taken by those who’ve suffered misfortune. The American Bankruptcy Institute reported in 1998 that instances of abuse were present in less than 3% of personal bankruptcy cases it reviewed. The fact is 90% of personal bankruptcies are filed following divorce, job loss, death in the family, and illness. A Harvard study published in Health Affairs, a policy journal, cited job loss as a major factor for bankruptcy filings, superseded only by medical causes which are a factor in more than half of all bankruptcy filings. This isn’t entirely surprising, the United States may have the best healthcare system in the world, but it also has the highest healthcare costs per capita. Each patient in the United States is treated at a 70% premium to a similar treatment north of the border in Canada; one would be hard-pressed to argue that our marginal quality advantage deserves such a premium.

Furthermore, the bill has some severe shortcomings on the administrative side, notably in the undeservedly tougher terms it sets for poorer households, for whom it raises the price of filing. Even the lowest income earners, if they qualify for Chapter 7 bankruptcy, must still jump through hoops to file a claim, producing all kinds of documentation and seeking credit counseling from a financial advisor. Levying additional administrative costs on households struggling to make ends meet is a poor decision. On the other hand, mandatory credit counseling is a step in the right direction. Massive consumer debt cannot be attributed entirely to risk-takers; there are those entirely ignorant of the intricacies of debt management and the benefits of a high credit rating. Educating households on money-management matters would promote responsible consumerism and possibly help narrow our current account deficit.

Tougher bankruptcy laws can also have adverse effects on entrepreneurship, long considered a unique part of the American economy. Traditional economic theory dictates that only the best start-up ideas succeed. If there are no penalties for failure, the costs for any entrepreneurial venture will become too great. If every entrepreneur reasons that he can depend on the government to bail him out in case he fails miserably, the number of individuals attempting risky endeavors will only increase. Creditors, taking into account the increased possibility of default, will raise interest rates on loans, making it more expensive for the truly needy to obtain credit.

But the traditional view is being challenged. Michelle White of the University of California at San Diego has conducted research on the relationship between entrepreneurial activity and bankruptcy laws, an undertaking made possible due to America’s unique bankruptcy procedures. When filing for bankruptcy, the owner forfeits assets above a fixed exemption level. While the Federal government sets policy on bankruptcy, each state can determine what kinds of assets owned by the debtor can be protected in case of a default. These exemption levels vary widely. White’s research shows that states with higher exemption levels – those that offer greater security for aspiring entrepreneurs – have a greater percentage of individuals that own businesses – by as much as 35% – and a greater probability an individual will start a business. Congress may be seeking accountability at the cost of greater economic growth, an uneven bargain at best.

While this particular bankruptcy law is inadequate, there is some misplaced resentment towards the credit card companies, many of which are characterized as “hawks preying on unsuspecting consumers.” This is a rather ridiculous notion; the label of “predatory lending,” often thrown around in discussions involving this aspect of the industry, rings hollow. If the companies refused to extend credit to lower-income Americans, many of whom depend on their credit cards to pay the bills when they hit a rough patch, the same group of people decrying credit card company-lending practices would be charging these companies with discriminatory business practices. The credit card companies are businesses, they are hawking a product and the onus is on the consumer to make a wise decision when he/she signs up for a credit card. There is no forced subjugation: contracts are provided, papers are signed, and both parties mutually agree to the terms that have been set out. A consumer who refuses to scope the provided literature cannot later plead ignorance of the matter. Laziness is not a proper excuse for indebtedness.

For big business, the passage of this bill marks another long sought-after victory on the heels of the Tort Reform bill passed earlier this year. The bipartisan support in Congress for such inadequate legislation is a troubling reminder of the power of K Street. Had the Democrats been united in opposition to this bill, as they have been against Social Security reform, they would have done a great service to the country by exposing the shortcomings of an initiative that is sure to adversely affect many Americans in the coming years.