Working Paper No. 04-35:
An Economic Analysis of the Consumer Bankruptcy Crisis

Author(s):

Todd Zywicki

Date Posted: 2004

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Abstract:

Since the inception of the first permanent American bankruptcy law in 1898, the intellectual and political understanding of consumer bankruptcy has been anchored in a model that views bankruptcies as resulting from household financial distress. For much of the Twentieth Century, this "traditional model" provided a plausible explanation of bankruptcy filing patterns and clear normative policy implications. Moreover, the widespread intellectual and social consensus on the traditional model was reflected in the enactment of the current Bankruptcy Code in 1978, which rests on the intellectual foundation of the traditional model. To this day, leading bankruptcy scholars adhere to the traditional model and its implications. Over the past twenty-fiver years, however, the traditional model has broken down. During a period of unprecedented prosperity and economic stability, personal bankruptcies have soared, raising fundamental questions about the validity of the traditional model.

This article argues that there has been an unacknowledged sea-change in the economics of consumer bankruptcy in America. This article first provides a scientific analysis of the traditional model to determine whether these new trends can be accommodated within the traditional model. It focuses on the key variables offered by the traditional model as components of household financial distress: first, high levels of household indebtedness, including the influences of credit cards and home mortgages; second, unemployment and downsizing; third, divorce; and fourth, health problems, health care costs, and lack of health insurance. A scientific analysis of the evidence demonstrates that although these factors can explain part of the background exogenous level of bankruptcies, as well as some regional variation in bankruptcy filing rates, they cannot explain the upward trend in bankruptcy filing rates over the past twenty-five years. The article then briefly discusses an alternative model of consumer bankruptcy that can explain the increased propensity for consumers to file bankruptcy through an examination of the legal, social, and economic institutions of the consumer bankruptcy system.