It's always unsettling to read an author you think is really really smart and then observe him writing about something you actually know something about and find him falling flat on his face. I felt that way a few weeks ago when I read Niall Ferguson (in The Ascent of Money) on bankruptcy (link; and note the comment). Today I'm reading Raghuram Rajan and Luis Zingales, Saving Capitalism from Capitalists: Unleashing the Power of Financial Markets to Create Wealth and Spread Opportunity (2008). It's an admirable book, really—accessible and well argued, strong testimony in favor of the power of financial markets for the betterment of humankind.
But then they come to bankruptcy and fall right off the cliff. Well—their general point is correct, but when it comes to the details they make hash.
The general subject is lending, and impediments to borrowing. RZ make the point that you are likely to be able to borrow only if the lender is confident he will be repaid. They identify three common impediments to lending: one the inability to give good collateral (inadequate land titling systems, for example); two, slow or expensive or impossible collection mechanisms; and three, “exemptions.” It's the third point that causes the trouble.
RZ start by discussing the Bankruptcy Commission of 1973 which, as they say, “advocated that a substantial portion of household assets be exempted from seizure by creditors,” adding “these assets are called “bankruptcy exemptions.” They go on to say that “following these recommendations, a number of states adopted exemptions” (my emphasis). They say that “high state bankruptcy exemptions led to a significantly higher probability that households would be turned down for credit or discouraged from borrowing.” And that, for poor people, “since their house is often their only form of collateral, the exemption laws effectively deprived them of their only means of obtaining finance.”
There are so many things bollixed up in this paragraph that it is scarcely possible to know where to begin. But try this: exemptions do not begin with the Bankruptcy Commission. So far as I know, every jurisdiction in any commercial economy exempts some assets from execution, and has for centuries. The Bankruptcy Commission did think that these “state” (sic—i.e., “non-bankruptcy”) exemptions were mostly too cheesy, and advocated a system of more generous exemptions for use in (and only in) bankruptcy cases—to be called “bankruptcy” (sic, and note the difference) exemptions.
The commission did not get its way. Instead, Congress hashed together a not-very-intelligible compromise, whereby debtors in bankruptcy might claim "Federal" exemptions, or they might claim their “home-state” exemptions. Congress also provided that individual states might opt out and leave their debtors only with “state exemptions.” As it happens, most states have opted out. I suspect (although I admit I don't have chapter and verse) that the opt-outs are the ones with the most cheesy exemptions. If that is true, it would leave the “bankruptcy option,” if not exactly a dead letter, still perhaps a slender reed.
Note also that while most old exemption laws may have been cheesy, some were famously generous. RZ give the example of the unlimited Texas homestead. Texas does have an unlimited homestead; so does Florida and so do a couple of farm states in the Great Plains. But these unlimited homesteads—like most state exemptions—have been part of the law all along. Bankruptcy law had nothing to do with them. Well, with one exception: some of the more recent amendments to the bankruptcy law make it harder for debtors to use these old exemption laws, not easier.
But the biggest blooper is still to come. Read the last quoted sentence carefully: “since their house is often their only form of collateral, the exemption laws effectively deprive them of their only means of obtaining finance” (emphasis added).
Take a deep breath—here's something every student learns in the bankruptcy law class: you can't use the exemption against the secured creditor. That's a black-letter rule. Giving security effectively surrenders the exemption, as far as the secured creditor is concerned. It is the unsecured creditors—the ones without collateral—who take it in the shorts. Indeed, when your client is in trouble, what you tell him is: if you want to keep the collateral, keep paying the secured creditor, and forget about everybody else. So ironically, the effect of the exemption law is to increase, rather than decrease, the likelihood that the secured creditor will be paid.
RZ go on to say that “high state (sic) bankruptcy (sic) exemptions led to a significantly higher probability that households would be turned down for credit or discouraged from borrowing.” They cite one study.* The statement is intuitively plausible, but it's remarkable how hard it is to find general support—indeed, one of the remarkable facts of American economic life is how little evidence we find that debtor protections have done anything to dampen credit markets.
And RZ go on to make a further point which, though interesting, is in a sense the opposite they just stated above. They argue that “the passage of exemptions” (?) made it harder for poor people to borrow—but easier for the rich,”because more of their assets could be protected from seizure” (they seem to be drawing their point from the study cited earlier, although they don't cite it here). Of course this might be true; but if so it badly undercuts the plausibility of the more general statement above.
As a final irony, I want to stress that I agree with the general point here: financial markets are (well: “can be”) a great thing, not least for the liberation of the poor. I agree that we need well-defined property rights and decent collection procedures. I suspect that liberal exemption laws must under some circumstances limit the power to incur debt, though I think it is far easier to say than to prove. But if this is the kind of argument that they are going to make, they'd better restrict their audience to people who really don't know anything about the topic. The phrase “D* S*” comes to mind, but I've used that one too often already.
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*The citation is incomplete, but they seem to be citing this paper: Gropp, Reint; Scholtz, John Karl and White, Michelle. "Personal Bankruptcy and Credit Supply and Demand." Quarterly Journal of Economics, 1997, 217-252.
Update: My friend Barry points out that Bankruptcy Code does allow the avoidance of certain personal property security inerests that impair exemptions. He is right, but this is pretty clearly not what RZ were talking about.
But then they come to bankruptcy and fall right off the cliff. Well—their general point is correct, but when it comes to the details they make hash.
The general subject is lending, and impediments to borrowing. RZ make the point that you are likely to be able to borrow only if the lender is confident he will be repaid. They identify three common impediments to lending: one the inability to give good collateral (inadequate land titling systems, for example); two, slow or expensive or impossible collection mechanisms; and three, “exemptions.” It's the third point that causes the trouble.
RZ start by discussing the Bankruptcy Commission of 1973 which, as they say, “advocated that a substantial portion of household assets be exempted from seizure by creditors,” adding “these assets are called “bankruptcy exemptions.” They go on to say that “following these recommendations, a number of states adopted exemptions” (my emphasis). They say that “high state bankruptcy exemptions led to a significantly higher probability that households would be turned down for credit or discouraged from borrowing.” And that, for poor people, “since their house is often their only form of collateral, the exemption laws effectively deprived them of their only means of obtaining finance.”
There are so many things bollixed up in this paragraph that it is scarcely possible to know where to begin. But try this: exemptions do not begin with the Bankruptcy Commission. So far as I know, every jurisdiction in any commercial economy exempts some assets from execution, and has for centuries. The Bankruptcy Commission did think that these “state” (sic—i.e., “non-bankruptcy”) exemptions were mostly too cheesy, and advocated a system of more generous exemptions for use in (and only in) bankruptcy cases—to be called “bankruptcy” (sic, and note the difference) exemptions.
The commission did not get its way. Instead, Congress hashed together a not-very-intelligible compromise, whereby debtors in bankruptcy might claim "Federal" exemptions, or they might claim their “home-state” exemptions. Congress also provided that individual states might opt out and leave their debtors only with “state exemptions.” As it happens, most states have opted out. I suspect (although I admit I don't have chapter and verse) that the opt-outs are the ones with the most cheesy exemptions. If that is true, it would leave the “bankruptcy option,” if not exactly a dead letter, still perhaps a slender reed.
Note also that while most old exemption laws may have been cheesy, some were famously generous. RZ give the example of the unlimited Texas homestead. Texas does have an unlimited homestead; so does Florida and so do a couple of farm states in the Great Plains. But these unlimited homesteads—like most state exemptions—have been part of the law all along. Bankruptcy law had nothing to do with them. Well, with one exception: some of the more recent amendments to the bankruptcy law make it harder for debtors to use these old exemption laws, not easier.
But the biggest blooper is still to come. Read the last quoted sentence carefully: “since their house is often their only form of collateral, the exemption laws effectively deprive them of their only means of obtaining finance” (emphasis added).
Take a deep breath—here's something every student learns in the bankruptcy law class: you can't use the exemption against the secured creditor. That's a black-letter rule. Giving security effectively surrenders the exemption, as far as the secured creditor is concerned. It is the unsecured creditors—the ones without collateral—who take it in the shorts. Indeed, when your client is in trouble, what you tell him is: if you want to keep the collateral, keep paying the secured creditor, and forget about everybody else. So ironically, the effect of the exemption law is to increase, rather than decrease, the likelihood that the secured creditor will be paid.
RZ go on to say that “high state (sic) bankruptcy (sic) exemptions led to a significantly higher probability that households would be turned down for credit or discouraged from borrowing.” They cite one study.* The statement is intuitively plausible, but it's remarkable how hard it is to find general support—indeed, one of the remarkable facts of American economic life is how little evidence we find that debtor protections have done anything to dampen credit markets.
And RZ go on to make a further point which, though interesting, is in a sense the opposite they just stated above. They argue that “the passage of exemptions” (?) made it harder for poor people to borrow—but easier for the rich,”because more of their assets could be protected from seizure” (they seem to be drawing their point from the study cited earlier, although they don't cite it here). Of course this might be true; but if so it badly undercuts the plausibility of the more general statement above.
As a final irony, I want to stress that I agree with the general point here: financial markets are (well: “can be”) a great thing, not least for the liberation of the poor. I agree that we need well-defined property rights and decent collection procedures. I suspect that liberal exemption laws must under some circumstances limit the power to incur debt, though I think it is far easier to say than to prove. But if this is the kind of argument that they are going to make, they'd better restrict their audience to people who really don't know anything about the topic. The phrase “D* S*” comes to mind, but I've used that one too often already.
==
*The citation is incomplete, but they seem to be citing this paper: Gropp, Reint; Scholtz, John Karl and White, Michelle. "Personal Bankruptcy and Credit Supply and Demand." Quarterly Journal of Economics, 1997, 217-252.
Update: My friend Barry points out that Bankruptcy Code does allow the avoidance of certain personal property security inerests that impair exemptions. He is right, but this is pretty clearly not what RZ were talking about.
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