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 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.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. 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.6 Throughout 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.9 On 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. …