Response on Bankruptcy Reform_BECKER

Only a few comments, so I can respond briefly. I do not see how equity loans can discourage entreprenuership or investments in human capital. Does allowing companies to issue equities discourage borrowing by companies? No, for instead it gives companies greater options, and so too would such human capital equity loans. Companies that do not want to share their profits can only take on debt; similarly, individuals that do not want to share their earnings can only take on fixed interest debt. I find it strange that some of you are perfectly willing to have governments make special rules for their insured lending so that student loans are not dischargeable by bankruptcy. Yet you are nervous about allowing this privilege to private lenders making other human capital loans. The purpose of my suggestion about bankruptcy is to encourage greater amounts of human capital loans-at present there are practically no fully commercial human capital loans. This situation does not hurt rich persons much, but does badly limit the opportunities of young persons from poor families. They might gravitate to the equity side of my proposed human capital loans, but why is that bad if this gives them more opportunity for investments in themselves, and in other ways? A good comment about selectivity among which persons take out equity loans and which take fixed interest loans that is highly relevant. Yale's system of equity human capital loans for their students of a couple of decades ago failed partly for this reason. But this is also a problem with equities for private companies, and that works reasonably well. To the extent that information about talents and occupations, etc is generally available, then the lending market on human capital loans should adjust its conditions to the abilities and occupations of indviduals.

Comments

[db]

Human capital loans, now that is smart. That would do an incredible amount for able people of modest means and for the country as a whole by unlocking potential.

[logicnazi]

So most people (and I take it you included) do not support debtors prison and most people think that some form of bancruptcy protection should be availible. Why is this? After all if consumers were perfectly rational the unpleasent consequences of debtors prison (or more accurately the unpleasent settlement with creditors made to avoid debtors prison) or a debt ridden life would cause them to be appropriately careful about taking out debt or making obligations.

I think the only plausible response is that we recognize that people are often irrational and can't be trusted to accurately compensate for certain types of future risks. In fact some compelling studies (Kahnerman, Tversky 1982 forgot book title) have shown that nearly everyone is absolutely horrible at evaluating probabilities and hence likely has similar problems with risk. This is not to mention the effects of youth, improper discounting of the future and other causes of unconsidered borrowing.

So once we recognize that bancruptcy laws are designed to protect people from their irrational actions, i.e., they are really a type of required insurance people pay through their interest premiums, the reason why we might allow human capital education loans but not other type of loans is quite obvious. We think that educational loans are not liable to the same forms of irrationality, waste and discounting of the future that other forms of credit allow.

If we understand bancruptcy laws as protecting people from themselves (just as SSI and similar programs can be said to do) then making exceptions for loans which *must* be invested in the individuals economic future makes perfect sense. Of course other types of specific exceptions might make sense as well but credit in general is much more likely to be lost on a gambling habit, blown on an ill considered buisness proposition or otherwise inappropriately wasted without economic gain which would allow payback than an educational loan.

Most likely you don't agree with this attitude of protecting people from themselves. However, given this understanding you should admit that it does make sense to pick educational loans out as a special low likelihood of abuse category.

[Dr. Donald Cole]

Professor Becker - When are you and other "Chicago School" economists ever going to see that your analysis rests entirely on perfectly competitive assumptions? To confuse ideal competition and actual competition does a great disservice to your argument and misleads your readers. To suppose that the new bankruptcy bill won't inflict pain on a large percentage of the population is only true if one accepts your highly unrealistic and outdated assumptions. Please, get real. Respectfully, Donald P. Cole (Ph.D., Drew University, Madison, NJ 07940)

[RWS]

I don't think it is accurate to analyze Becker's analysis as resting entirely on the assumptions of perfect competition. I think they rest on assumptions of a robust amount of competition, assumptions which are born out by the evidence in the CC industry, which is generally considered to be highly competitive.

In response to logicnazi(!), I think the answer is that while analyzing bankruptcy as a form of insurance is valuable, the problem with it is that it is a government monopoly insurance program that one cannot bargain around to get a lower rate. There are less anticompetitive ways for a consumer to achieve security in the event of a financial shock.

[Marc Johnson]

Prof. Elizabeth Warren, who knows a lot more about bankruptcy law than either Becker or Posner, takes the learned bloggers out to the woodshed here:

http://www.talkingpointsmemo.com/bankruptcy/archives/2005/04/index.php#005317

[logicnazi]

Ohh I disagree that bancruptcy laws are an anticompetitive way to require debt insurance. In fact it seems like the perfect paradigm of the government legislating the result and letting the market sort the rest out.

In bancruptcy the government merely legislates that individuals who get into too much debt recieve relief. The credit card companies are then free to compete to provide this insurance at the lowest price and paid for in whatever manner the market finds most attractive (up front, in higher interest payments etc..)

Finally on the question of the assumption of competitiveness. I do think that the credit card markets have enough competition for this part of the analysis to hold up. The part of the analysis which doesn't go through is the assumption of rationality on the part of the consumer. Not only does common sense tell us that most consumers aren't rational about future risk and cannot reason correctly about risks (most people have never taken a probability course how the hell do we expect them to calculate expected harm) but plenty of rigorous studies have demonstrated people's very imperfect rationality. I think it is just somewhat silly to ignore these results in consumer products (assumptions of rationality are probably reasonable in the stock market when many players are sophisticated companies employing mathematicians and the like).

[Robert Schwartz]

"I do not see how equity loans can discourage entreprenuership or investments in human capital. Does allowing companies to issue equities discourage borrowing by companies?"

The difference is that if a company defaults its assetts are liquidated, or if they are capable of producing a positive operating cash flow, taken over by the creditors.

That is well and good for a company which is a pile of papers. But for an individual human being neither option is available. The only things left are peonage, debt slavery, or debtor's prison. I really don't think I have to argue the inadvisability of reviving those instituions or their unconstitutionality.

The larger question about the role of bankruptcy raised above is best answered by recursion to Schumpeter (Not a Chicagoan, but we read him in Soc 121 back in my day), who taught us that capitalism produces economic growth by means of creative destruction. This means that at any moment even the most rational business plan may be disrupted by unexpected innovation. When that happens asset values and the ability to produce positive cash flow will suddenly disappear.

The best thing to do when that happens is to liquidate or redeploy the assets as soon as possible. The danger in not doing so is shown by the course of the Japanese economy during the last 15 years.

In both the US and Japan there was a credit fueled, real-estate lead boom in the late 80s. In the US, the overvalued assets were liquidated and the financial institutions that loaned to them were liquidated by the FDIC. By the mid-90s the US was back on a vigorous growth track. OTOH, Japan liquidated very little and did not begin to restructure its now de-capitalized financial institutions for a decade. The result has been chronic economic difficulty and long bouts of recession.

The debtors discharge in this analysis serves the purpose of giving the debtor a strong incentive to speed up the process. Otherwise the debtor will hold on to his assets and hope, usually in vain, that they will recover their value. Everyone is better off if the debtor turns over the keys quickly, even the lender who has to take the write-off.

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