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The Path to Economic Growth: Bankruptcy

posted by Elizabeth Warren

For years, lenders and the IMF have told developing countries that if they really want economic growth they need to adopt strong creditor-protection laws.  Without that, no one will lend--or so they said.  A new empirical paper takes another cut at that advice.  According to a country-by-country analysis of merger and acquisition behavior, Creditors' Rights and Corporate Risk-Taking, strong bankruptcy laws may do more to promote beneficial risk-taking and economic growth. 

The insight of the paper is interesting:  strong creditor rights make corporations risk averse. As a result, these laws "induce costly risk avoidance," causing the companies to engage in practices that fail to maximize the value of the firm and it's potential.  The study finds the effects are particularly strong in countries where management is ousted whenever the business fails. 

The paper doesn't track failing companies.  Instead, it focuses on corporate M&A decisions at the national level.  It documents notes how asset-wasting, risk-averse decisions correlate with the strength of creditors' rights on a country-by-county basis. In other words, the failure to have strong bankruptcy laws to balance against the rights of individual creditors echoes through the whole economy, not just the behavior of distressed businesses. 

The paper reminded me of a conversation that I used to have with my bankruptcy classes about why American bankruptcy law was so generous. In part, bankruptcy fit the the risk-taking attitudes of a young and growing nation populated by people who wanted to take a risk--and wanted to know that there would be a chance to take a second risk if the first one failed.  As the US Congress limits the usefulness of bankruptcy as a reorganization tool--both in business cases and consumer cases--that conversation has become more historical.

Efforts by Congress, by the IMF, and by big secured creditors who press for laws to give a handful of creditors the whip hand seem short-sighted to me. Whether a policymaker is sympathetic to debtors or creditors, a bankruptcy system that encourages beneficial risk-taking, that keeps corporations searching out new business opportunities, that encourages entrepreneurs to form small businesses, and that gives consumers a reason to go to work every morning is better for everyone--debtors, creditors and all the rest of us.


I never looked at bankruptcy from that perspective before. I have been dealing with bankrupt debtors for the past 14 years. I guess I am too close to the subject.

At first I thought maybe it applied only to our “Business Debtors” but it is not that much of a stretch to correlate that theory to our “regular” consumer debtors. ie. Buying a home always has some risk to it and it does provide that motivation to go out and work everyday to keep it. To a very small degree even credit card debt may even apply. I think most of the time credit card debt is an “unrealized” risk in that the debtors rarely know the full implications of paying that “Red Lobster” bill with a credit card. The “act” though does stimulate the economy to some degree maybe even to a greater degree. Waiters get tipped; “Red Lobster” sells food and beverages. Waiter goes out and parties after work spending the tips he or she earned that night (I know from experience), so on and so fourth. The Credit Card companies get a ton from interest payments and more likely than not double even triple their investment, thus ensuring that they issue more credit to more people. The local comptroller gets the sales tax, city and state benefit; the state and city make improvements and people want to live and work there… It’s like some morbid evolutionary “credit cycle of life”. Without the hope of starting over, consumers may shy away from using credit like that, and may live within their means (God forbid) Most of the time though, by the time a consumer files for bankruptcy, they have more than paid what they had borrowed and are only working on interest and penalties.

Thanks for that post, it broadened my view of bankruptcy and its place in society.


Is the "costly risk avoidance" in countries with stronger creditor protections offset by increased cost of credit in countries with weaker ones? I'm sure the article addresses this but as I said I can't seem to download it without a subscription, is there anywhere it can be read for free?

Andy- at the top, use the "download" location tab, then from there I used the SSRN (New York) tab. PDF comes up right away. Have at it dude!

Patches - the line between "business debtors" and "regular consumer debtors" can get quite blurry. Case in point: an associate at a firm I worked at was very active in the Japanese-American business group in our community. One of his contacts in that group asked him to help out with her parents, a resident-alien couple that had moved here after her father retired from his job in Japan. They had opened a suburban strip-mall film-developing and photography store. After speaking with them, the associate asked me to consult in connection with opening negotiations with their landlord about reducing their rent.

I was introduced by the associate to this couple in a conference room at our firm, and found out that the husband was 67 and the wife 65, and that the advent of digital photography had just killed their business. After the associate went over with them their business's income and expenses, for some reason I asked them whether they had any credit card debts. The wife mumbled something that sounded like "fifteen thousand," but I didn't understand clearly, and asked her to repeat it. When she said "a hundred and sixty five thousand," I knew right then that given their ages and situation that a discussion of a reduction of their business rent was as useless as a discussion of the seating chart for high tea on the Titanic.

Turned out they had been using credit cards to keep their business afloat, including lease payments on some incredibly expensive photo developing machines (I later contacted some equipment vendors and found that these hundred-thousand-dollar machines would have more value if used as boat anchors). All personally guaranteed, of course, as was the lease.

I asked them if they understood the concept of bankruptcy, and the husband got that blank, stone-faced expression that the Japanese do so well when they don't like what you're saying. My bankruptcy professor, like Professor Warren, had lectured us on the policy reasons for bankruptcy, allowing people to take entreprenurial risks and not be penalized for them. I must have spent two hours recalling my professor's policy lectures, and adding anecdotal stories about how Thomas Paine got on the ship to America one step ahead of the sheriff and Jefferson's problems with his creditors.

I made most of these arguments towards the wife, but I was really addressing the silent, glowering man in the corner (all the while, the associate was translating). I explained that there was no way that they could pay off their debts in their lifetimes; that they would have no time with their grandchildren and family, and would have to work until they died. The husband made a long speech about the dishonor of bankruptcy and how they could never stand it, and I tried to explain that it wasn't a dishonor to strive honestly and fail.

Anyway, a couple of days later, the wife called and said that they had decided to file, which we did (pre-BAPCPA). It was an uneventful no-asset chapter 7. However, a year later, I got a card from the daughter who had first put them in touch with our associate. She told me how grateful her parents were that they weren't under this crushing burden (they hadn't told her how deep they were); how her father was enjoying the grandkids and had become a different person, and how her mother was so much more at peace.

While I mostly do creditor work, that case has stuck with me, as an important illustration of the policy behind bankruptcy, which is to let people try, and allows for failure without life-destroying consequences.

I'm also reminded of something in my family history: In my office, in a frame, I have a little promotional calendar, the type of thing businesses used to hand out as freebies. It's about 5x7 inches, made of brushed metal (aluminum or zinc), with the tear-off paper calendar at the bottom, and a single-color ink reproduction of a photograph embossed on the upper part. The photo is of some distant relative, standing proudly in front of his store in rural Iowa, arms folded, smugly satisfied.

The sign over the door has the initials A.H. followed by our family name, and "Harness Maker." On the metal, below the photo, is the legend, "Manufacturer of buggy whips, tack, harness, dusters, fly whips and saddle blankets."

The year on the calendar? 1907. Students of automotive history will recall that Henry Ford introduced the Model T in 1908. I've never found out what happened to old A.H., but I've got a pretty good idea . . .

Thanks Patches!

Wow there was a lot of math in that. I am a lawyer, not an economist. However it seems to me (based solely on reading the intro and conclusion, all I could really get) that the article is not as normative as professor Warren suggests. Doesn't it just say that there is a correlation between increasing creditor's rights and decreasing risky behavior by firms? There is an optimal balance between encouraging risk and discouraging it, and as far as I can tell the article doesn't attempt to draw a line of where that is. In the end it just says that increasing creditor's rights "MAY" not be be optimal, assuming we could ever figure out where to draw the line. And it doesn't seem to address cost of credit which I would assume (tho I don't actually know) is much higher in countries with weak credit protections, thus as I suggested before potentially offsetting any gains through increased risky behavior (and don't forget the potentially destabilizing effect of risky behavior, isn't there a point at which 'growth' becomes bubble -- a result we are seeing right now from too much easy credit at the corporate level).

No probs. Andy.

Mark- great story. Pride, I see a lot of it down here. It is the reason why people wait so long. Little story of my own.

A farmer here in STX came to us around 1999 for a 13 not a 12. Creditors hounded him constantly and his ailing wife took the brunt of most of the calls as he worked in the fields. She passed away 2 months before he sought help from us. The case was the "peak and valley" type of 13 you get from time to time. Well in 2004 he came in to have a notice explained to him the "discharge order" after explaining "discharge" to him he broke down in tears and told me in Spanish that had he only know what bankruptcy could do he would have done it sooner. Lamenting over his deceased wife. It was too much for me to handle at the time, (machoness out the door on that one) but alas he and his sons have a successful business now and brings us some squash and even a live goat from time to time.

perhaps the over generous laws were a reflection of the perceived endless resources that America had;

in today's world, as resources aer becoming more scarce, stiffer laws are drafted since resources, which ultimately back money, are seen as scarce.

besides changing our views from "endless resources" to "finite resources" I also think that technology has enabled us to be tougher on those who misuse capital including individuals.

more specifically-- after the IOUSA movie, warren buffet said: "every project that needs capital in this country has gotten it."

hence, the blessing of "cracking down on credit" is that the real problems, like inefficient health care delivery, can be addressed.

so I think that people are becoming enlighted and, in the case of medical bankruptcy, the nation needs to learn about delivering health care well enough to avoid bankruptcies and I think banks are now smart enough to realize that the right people have to be blamed and that they need to stop convering up the problems of other industries.

Andy: "as far as I can tell the article doesn't attempt to draw a line of where that is"

what about japan? their economy crashed because of credit policies; the depression, I think, was partly caused by margin calls.

here's some info on Japan's Credit Crash:


personally, sending a family to the metaphorical casino of debt seems wrong to me.

As interesting as Elizabeth's argument is, the comments posted are even more interesting. The current problems with "easy credit" are not quite relevant, because the credit extenders are not the ones who took on the credit risk. When you disconnect the extension of credit from the risk of loss associated with a bad credit decision, bad stuff is going to happen, almost inevitably. That is what we have been watching coming unwound over the last year.

The "disconnect" of credit extension and credit risk has not been adequately factored into the mathematical models that drove the credit ratings on securitized debt. That is probably due to the inappropriate reliance on historical behavior by borrowers to whom credit was extended by entities that held the risk. As time goes on, I suspect those models will get updated, and will ultimately result in more refined predictions of performance of the portfolios created.

That said, the most unfortunate thing to see is the "rent seeking" activity of the credit industry, lobbying Congress for changes in the law designed to skew economic behavior AWAY from responsible or sensible credit extensions. All of which is to say that the point of the article, valid though it might be, might be lost in the current U.S. marketplace.

The notion of encouraging entrepreneurial activity, by providing a (qualified) fresh start via bankruptcy is one leg of the economic rationale for bankruptcy. Another function bankruptcy performs is that it takes over-valued capital goods back "to the market" so that they can be acquired at a reality-adjusted price by those who wish to put their capital to work via those goods in a new venture. Bankruptcy still can serve that function, via both business reorganization and asset sales. (So can foreclosures and secured creditor sales.) To the extent credit laws discourage risk-taking, the market for those goods will be depressed and they will command an even lower price - which might also encourage risk-taking. How that all sorts out, I've no idea, but the concepts (re-setting the price of capital goods and encouraging/discouraging risk-taking) do relate.

lmclark: ========================
"The current problems with "easy credit" are not quite relevant, because the credit extenders are not the ones who took on the credit risk."

In the Washington Post, Sptizer editorialized:

"Even though predatory lending was becoming a national problem, the Bush administration looked the other way and did nothing to protect American homeowners. In fact, the government chose instead to align itself with the banks that were victimizing consumers." [SOURCE:http://www.washingtonpost.com/wp-dyn/content/article/2008/02/13/AR2008021302783.html]


and then Spitizer got pushed out of his job as governor!

Of course, Chris Dodd (democrat banking committee chair) was getting kickbacks via "friendly loan terms" from CountryWide (and who knows what else) so the fox was guarding the chickens.

Why all of this happened is unknown: was it "helicopter ben" throwing dollars around? was it Bush trying to enslave the middle class some more? or perhaps current home prices-- which are still historically high, indirectly jacked up property taxes and average selling price so inflation was allowed to take hold.

so today's endebted wasn't your mother's idea of endebtedness.

I don't know if anyone has coined the phrase yet but here it is "Taxwards". The home is tax appraised for more then you can sell it for. You know, I am seeing this more and more these days. The Tax Assessors seems to work on volume. Not everyone disputes their tax appraisal. Even if they do, the everyday "Joe" will not know how to do it and be at a disadvantage. “zillow.com” is great for helping you dispute tax appraisals BTW. (surf the website and you will see why) When you are talking ARMs and increased expenses for insurance, the taxing authority is a "punch in the gut" when you are already squirming. You really start to hate all of that easy credit on home loans because the "comps" (comparable home sales) are there and they are high. Does it matter that the debtor should not have received that loan and paid an obnoxious amount for that house in your neighborhood? No! Not to the appraisal district.

lmclark's comments are on target and while he and I may not agree with each other at times, it is interesting that the majority of added commentaries keep circling back to Bush bashing. Lest none would have no arguments or advocacy if everything was right or the opportunity to put blame on everything on someone. There is one comment that after 40 plus years in the credit and collection business that is relative: No model can predict human behavior and today, tomorrow, and future consumer problems return to one source-income.

Is lmclark a he or she? Maybe Liticia M. Clark? Anyway where does the buck stop? Any good leader takes responsability for their position right? Our elect are not like a bunch of building contractors, trying to pass the buck and the blame to other contractors for them not meeting their own constructing madates and goals. If we can't bash Bush who can we bash? He is such an easy target.

"the majority of added commentaries keep circling back to Bush bashing"

suggesting that bush encouraged bad loans isn't bashing, it's a fact; as you remember, he was the one pushing the ownership society and it backfired on a lot of families.

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