Why So Many Bankruptcies and What to Do About It: An Economic Analysis of Consumer Bankruptcy Law and Bankruptcy Reform

Since the inception of the first permanent American bankruptcy law in 1898, the intellectual and political understanding of the bankruptcy process has been anchored in a model of the bankruptcy process that views bankruptcies as being driven by household financial distress. For much of the Twentieth Century, this "traditional model" of bankruptcy accurately explained observed trends in bankruptcy filings. Moreover, the widespread consensus on the traditional model was reflected in the enactment of the current Bankruptcy Code in 1978, which rested on the intellectual foundations of the traditional model. To this day, the overwhelming number of leading bankruptcy scholars continues to believe in the descriptive accuracy and normative policy recommendations of the traditional model. Thus, scholars as diverse as Elizabeth Warren and Jay Westbrook, Douglas Baird, and Kenneth Klee, have all expressed strong opposition to the bankruptcy reform legislation. Regardless of whether they draw from a progressive and sociological background (Warren and Westbrook), law & economics background (Baird), or doctrinal background (Klee), scholars have continued to express consensus belief in the traditional model and the policy implications that it implies. For most of this period, the traditional model has provided both empirically descriptive findings and normatively clear implications. Over the past two decades, 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 nature of consumer bankruptcy in America and that this requires a new model of the consumer bankruptcy process and that this new model of consumer bankruptcy also implies the need for certain amendments to the Bankruptcy Code. This article first provides a scientific analysis of the traditional model to determine whether these new trends can be accommodated within the traditional model. The model is examined in the light of the available evidence and the conclusion is that the traditional model is unable to account for the upward surge in bankruptcies over the past twenty-five years. The article then offers a new model to explain the anomaly of the rising bankruptcy filings of recent years and examines the available empirical evidence on point. This model draws from the school of New Institutional Economics (NIE) and focuses on the institutions, incentives, and transaction costs associated with filing bankruptcy. Although the model will require further testing and refinement before it can be said to be definitive, available evidence tends to support the model advanced here. The article then turns to the normative conclusions that are suggested by the New Institutional Economics model. Widespread acceptance of the traditional model animated the framework of the 1978 Bankruptcy Code and continues to animate the opposition to the current bankruptcy reform movement. The replacement of the traditional model with the NIE model offered here also has certain normative and policy implications. Most fundamentally, whereas the premises of the traditional model are inconsistent with the bankruptcy reform movement, the finding of the NIE model justifies many of the key bankruptcy reform efforts of recent years.