Richard Posner, University of Chicago Law School:

"Congress is on the verge of passing and the President of signing a major overhaul of the Bankruptcy Code. (See Summary and Changes). The new bankruptcy law, popularly termed the "Bankruptcy Reform Act," has engendered passionate debate inside and outside Congress. The criticisms of the Act bespeak a failure to analyze it in economic terms.

The Act is complex, but the thrust is to make it more difficult for individuals to declare bankruptcy under Chapter 7 of the Bankruptcy Code. Under Chapter 7, the bankrupt's assets, minus exempt assets such as a home and work tools, are sold to repay creditors. When the bankrupt is an individual rather than a corporation, his assets often are too limited to enable the creditors to be paid in full what they are owed; often the creditors receive just a few cents on the dollar. However much or little they recover, at the conclusion of the bankruptcy proceeding the bankrupt (save in exceptional cases, as where the debt consists of a fine, or of damages owed because of a fraud committed by the debtor) receives a "discharge," meaning that the creditors cannot go against him for the unpaid balance of his debts. His debts are wiped out even if he has a high enough income to be able to repay them in full over a period of years.

An alternative procedure that individuals (and their creditors) can avail themselves of is Chapter 13 bankruptcy: instead of surrendering his nonexempt assets, the debtor agrees to make periodic payments to his creditors for as long as five years after the bankruptcy. Although Chapter 13 is attractive to some individuals, especially those who have substantial assets, Chapter 7 is more attractive to individuals who have few nonexempt assets but some income, and there are many such individuals. These individuals can run up huge credit card debts for purchases that do not create durable assets (such as food, travel, and entertainment), declare bankruptcy, wipe out their debts, and then start over. The Bankruptcy Reform Act will force many debtors who have annual incomes in excess of the median income in their state of residence to go the Chapter 13 route and thus make periodic payments out of their income for a period of years. The Act also increases the length of time that a bankrupt must wait, after receiving his discharge from his existing debts, before he can declare bankruptcy again and wipe out a new round of debts. The Act contains still other provisions also intended to make it more difficult for individuals to wipe out their debts by declaring bankruptcy under Chapter 7.

Critics have derided the Act as mean-spirited and hard on the poor, but they overlook the most important effect that the bill is likely to have, and that is to reduce interest rates. One component of an interest rate is compensation for the risk of default. The higher that risk, the higher the interest rate. This assumes of course that a creditor cannot, in the event of default, collect the debt owed him quickly, fully, and with little expense. If bankruptcy were very cheap and the typical individual bankrupt had assets sufficient to cover his debts, or had no right to discharge his debts and could repay them, with interest, out of future income, default would not impose a substantial cost on creditors and so the risk of default would not have a substantial effect on interest rates. But bankruptcy is costly and most individual bankrupts do not have assets sufficient to cover their debts, yet under existing law they have a right to a discharge of their debts no matter how far short of repaying their creditors their assets fall. So default is costly and this is bound to be reflected in interest rates.

Note the irony of the critics' complaint that credit-card interest rates are "exorbitant"; the so-called exorbitance is, to an extent anyway, an artifact of a bankruptcy law that by making bankruptcy inviting to credit-card debtors increases the risk of default and therefore the interest rate. Notice moreover the vicious cycle created by the present system. The greater the risk of default, the higher interest rates are; but the higher interest rates are, the greater is the risk of default, since interest rates represent a fixed cost to the debtor: if he loses his job and his income plummets, he still owes whatever he borrowed when he was flush. Of course, an alternative possibility is that the high rates will discourage borrowing; this is a paternalistic goal of some opponents of the Act. But the high rate of personal bankruptcies that the critics stress is evidence that the vicious cycle dominates the effect of high interest rates in discouraging borrowing.

I conclude that the new Act, by increasing the rights of creditors in bankruptcy (for remember that Chapter 13 enables a creditor to obtain repayment out of the debtor's post-bankruptcy income, not just out of what may be his very limited nonexempt assets at the time of bankruptcy, as under Chapter 7), should reduce interest rates and thus make borrowers better off. The most reckless borrowers—those most prone to file repeated Chapter 7 bankruptcies—will be made worse off. But there will be fewer of these, precisely because they will be worse off than under the existing system. If bankruptcy is more costly, there will be less of it.

Critics say that more than half of all individual bankrupts are not reckless borrowers but rather are unfortunate people who have been hit by unexpected medical expenses. But this ignores the fact that whether one is forced into bankruptcy by a medical expense (or by an interruption of employment as a result of a medical problem) depends on one's other borrowing. If one is already borrowed to the hilt, an unexpected medical expense may indeed force one over the edge. But knowing that medical expenses are a risk in our society, prudent people avoid loading themselves to the hilt with nonmedical debt.

At a more fundamental level, one might ask why voluntary bankruptcy is ever permitted. It is easy to understand involuntary bankruptcy—that is, bankruptcy forced upon a debtor by his creditors. Such bankruptcy overcomes the free-rider problem that would exist if multiple creditors were allowed to race each other to be first to seize the assets of a defaulting debtor, when the creditors as a whole might be better off with a more orderly liquidation. But why should a debtor ever be permitted to write off his debts? One answer is that, assuming people are risk averse, voluntary bankruptcy operates as a kind of social insurance. One cannot buy private insurance against going broke (for then people would indeed borrow recklessly), but even a prudent borrower could find himself broke as a result of an unforeseeable streak of bad luck. However, the Bankruptcy Reform Act does not eliminate voluntary bankruptcy. The social-insurance role is fulfilled by Chapter 13 as well as by Chapter 7, since after five years of partial payments the Chapter 13 bankrupt is entitled to a full discharge of the unpaid balance of his debts.

Behind the Bankruptcy Reform Act, as behind the President's proposal for social security reform, is an ideology of giving nonwealthy people greater responsibility for their own economic welfare, which entails subjecting them to additional financial risk. Under the present system, the prudent and the imprudent consumer pay the same high interest rates, assuming creditors can't readily determine which consumers are prudent and which are imprudent. By lowering interest rates on credit-card and other consumer debt while at the same time discouraging default, the Bankruptcy Reform Act will encourage consumers to exercise greater care in borrowing—yet at the same time, because interest rates will be lower, the Act will enable prudent consumers (who do not face a high risk of bankruptcy) to borrow more and by doing so will increase their consumption options. The Act will not redistribute wealth from the poor to the rich, but from the imprudent borrower to the prudent borrower." [March 27, 2005; The Becker-Posner Blog has the post]