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Bankruptcy

July 24th, 2006

My article in Thursday’s Fin (copy over the fold) was about the role of credit and bankruptcy in adaption to growing inequality and variability in income.

Add to CV: Bankruptcy

Although the consequences of the recent IR reforms and broader changes in the labour market remain to be worked out, international experience suggests that an inevitable consequence of such changes is an increase in wage variability and inequality. Both the United Kingdom and New Zealand experienced large increases in wage inequality as they moved from regulated and unionised wage-setting systems. to largely deregulated systems based on individual contracts, and the same will no doubt happen here. A more surprising, but very likely consequence is the emergence of bankruptcy as a normal life experience for Australians.

The experience of the United States illustrates this. Although there was never much formal regulation of US labour markets, an implicit social contract emerged after World War II in which companies shared much of the surplus arising from US economic dominance with their workers. The result was that even unskilled workers (particularly those employed by large manufacturing companies) enjoyed high wages and relatively secure employment.

The US social contract unravelled during the economic crises of the 1970s. Wage and income inequality rose dramatically in the 1980s and, after a brief pause, is now rising again.

In view of how unequally the benefits of economic growth have been distributed, one might expect that political parties would be advocating radical policies of redistribution towards the poor. This is evidently not the case. The current dividing line in US politics is between the Bush Administration, which wants radical redistribution towards the wealthy and the Democrats, who largely support the status quo.

Explanations of this apparent paradox often focus on ideological factors such as the prevalence of the idea (not supported by empirical data) that social mobility is higher in the US than elsewhere and therefore that the poor can hope to become rich themselves. A more plausible analysis is one that switches attention from income to consumption.

It turns out that inequality in consumption has not grown nearly as much as inequality in income. Since living standards depend, at least in the short run, on consumption rather than income, this may help to explain the limited political impact of rising income inequality.

A recent paper presented to a meeting in Alice Springs of the Econometric Society of Australia by the Society’s President, Professor Richard Blundell of University College London showed that a disconnect between income and consumption inequality has been common in countries where wage inequality has grown rapidly in recent decades. Blundell explored a range of potential explanations for this disconnect, of which improved access to credit was one. Credit markets can be seen as a social device for managing risk.

One of the important, but relatively poorly understood, institutions associated with credit markets is that of bankruptcy. Although we take bankruptcy for granted nowadays, it was a radical government intervention in the developing credit markets of the 19th Century, marking the first time that the state stepped in to manage economic risk and implicitly rewrite credit contracts. It was bankruptcy that put an end to the Dickensian institution of debtor’s prison. The idea that easy credit and access to bankruptcy offset the political impact of growing inequality is supported by political science studies which find that US states with generous bankruptcy laws have less redistributive taxation systems.

If bankruptcy is seen as a social institution for managing income risk we would expect to see it used more as risk and variability increase and this is precisely what has happened. The number of bankruptcies in the US has risen from around 300 000 per year in the early 1980s to more than 1.5 million per year in 2004.

Since most bankruptcies are joint filings by couples, the number of people affected each year is over 2 million. Strikingly, Americans are now more likely to go bankrupt in any given year than to get divorced.

Since the bankruptcy boom is comparatively recent, the number of people who have ever been divorced is much larger than the number who have gone bankrupt. But if the rising bankruptcy trend stabilises at its current level, around half of all Americans will experience bankruptcy at some point in their lives, and many will go bankrupt more than once.

Other countries, notably the UK and New Zealand, are following a similar path, with a lag of a decade or so, and it seems inevitable that the same will happen in Australia. While the prospect of bankruptcy as a normal life experience seems alarming, society has adjusted to widespread divorce and will no doubt do the same for bankruptcy.

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  1. July 24th, 2006 at 17:42 | #1

    I read this article and enjoyed it. I think many of the US bankruptcies are concentrated among divorced women – even if the male partner supports the previous partner the total costs of operating two households rise. Women are often left with just one income but a two-income mortgage and go into bankruptcy when any sory of disturbance (such as bad health) strikes.

    Women joining the workforce has driven up prices of fixed assets such as housing and made it almost essential for both partners in a union to work. Then if one party leaves the union, incomes are insufficient.

    In a ‘perfect foresight’ model when men and women anticipate all this. they don’t breed.

    The fall in fertility is strikingly linked to increases in the divorce rate as theory would suggest it should be.

  2. July 24th, 2006 at 17:50 | #2

    From Illness And Injury As Contributors To Bankruptcy:

    “Bankruptcy is common in the United States, involving nearly four million debtors and dependents in 2001; medical problems contribute to about half of all bankruptcies. Medical debtors, like other bankruptcy filers, were primarily middle class (by education and occupation). The chronically poor are less likely to build up debt, have fewer assets (such as a home) to protect, and have less access to the legal resources needed to navigate a complex financial rehabilitation. The medical debtors we surveyed were demographically typical Americans who got sick. They differed from others filing for bankruptcy in one important respect: They were more likely to have experienced a lapse in health coverage. Many had coverage at the onset of their illness but lost it. In other cases, even continuous coverage left families with ruinous medical bills.

    Medical Bills Main Culprit In Bankruptcies Americans are ‘one illness away’ from financial collapse. National Post (Canada)

    A Cautionary Note on the Number of Health-Related Bankruptcies (.pdf 2 pages) By Jeff Lemieux

  3. Mike Hart
    July 24th, 2006 at 18:09 | #3

    I don’t agree with the gender skew assignment as supported by Harry. Income is only a measure of cash flow, the real wealth, i.e. ownership of assets and capital. In the US and here in Australia, Repbulican and Conservative policies have been cleverly redistributing both social and private resources to the rich and the wealthy while socialising costs and depreciation of those resources and capitals operating costs. Thus the distribution is no longer pyramidical but almost linear, that is it has reached up even more densely to a decreasing few. That is the distribution has been via assets and capital not income (excepting of course managerial level incomes which have a marked tendency to include both assets and some capital in addition to income. The free market income policies of the past two decades have not included this part of the wealth basket for wage and most salary earners. Benefits generally have been sacrificed for income. You can price down wages but it is a lot harder to price down assets, services or shares much easier to restrict them. Remove central or legal wage management via collective bargaining and you can restrict income much easier. Perversely you can also increase it more easily as well.

    I take the measure of the bankruptcy rate as signifying an aggregation of people who have simply fallen into the Micawberian realm of outgoings versus ingoings. Credit creation to my view merely does two things, delays the onset of bankruptcy and provides a means by which any borrower can live beyond their means at a particular point in time. over the long run excessive credit hits a critical mass where servicing costs versus life maintenance costs reach a tipping point, bankruptcy is inevitable if the income stream breaks down. The unrecognised variable is time. The really interesting indicator it gives is the level of financial stress and over consumption, the trend is indisuputable, a continuing increase.

    Bankruptcy is no free meal. The legal obligations from which most bankruptcy laws are cast severely inhibit wealth creation and debtor relief is illusory, income lost is income lost. Your bankrupt when your trading while insolvent. There appears to be quite a lot of that on the statistics quoted.

  4. conrad
    July 25th, 2006 at 09:52 | #4

    I believe the rate of bankruptcy in Hong Kong is very low (or at least the rate of default on home loans is), despite no minimum wage, higher income inequality and almost everything done on individual contracts. This is therefore a counter example to the ones you gave. I think it suggests that if there was a bit of a cultural change and Australians (and others) actually tried to save some money from time to time then I don’t see why the bankruptcy rates neccesarily should rise a lot in the long term.

  5. Terje
    July 25th, 2006 at 10:06 | #5

    On radio national the other day there was a dicussion of welfare and ir reforms. One US guest commented that in the USA an employee who works more than 20 hours per week must be given health insurance by the employer (ie it is the law). The net effect is that lots of jobs on offer are for less than 20 hours per week, and people have the burden of job juggling.

  6. StephenL
    July 25th, 2006 at 10:44 | #6

    Some people will be much more worried by bankrupcy than others – some will see it as a sign of moral failure, and be careful to avoid getting themselves into positions where it is likely (leaving aside the hard to avoid cases relating to medical bankrupcy, which will presumably remain rarer in Australia than the US).

    Will this not mean that such people will end up subsidising those who take the risk of bankrupcy lightly? That is presumably banks will raise interst rates to cover the danger of bankrupcy, and those who are cautious in their borrowing will end up subsidising those willing to take the risk. Unless that is, banks can get better at identifying who is likely to live beyond their means and who is not.

  7. Terje (say TAY-A)
    July 25th, 2006 at 10:57 | #7

    Will this not mean that such people will end up subsidising those who take the risk of bankrupcy lightly?

    Within any class of borrower that the banks can readily identify then I would say yes.

  8. Terje (say TAY-A)
    July 25th, 2006 at 10:59 | #8

    One US guest commented that in the USA an employee who works more than 20 hours per week must be given health insurance by the employer (ie it is the law).

    On reflection it would seem more sane to have a law that says that any worker who works more than 20 hours per week must (by law) buy personal health insurance. In other words shift the compulsion from the employer to the employee.

  9. derrida derider
    July 25th, 2006 at 11:11 | #9

    Yeah, I think it’s their health system (or rather, lack of such a system) that makes for a lot of individual bankruptcy in the US. Assuming we are not silly enough to go down the route of full user pays for health, I don’t think we’ll ever see bankruptcy rates in Oz like those in the US, even if we end up with a US-style labour market. Plus both law and social attitudes are harder on bankrupts here than in the US, so people at the margin will try and avoid it.

    But the point about deregulated credit muting the impact of income variability is right – and has been pointed out in the past by proponents of such deregulation.

  10. Terje (say TAY-A)
    July 25th, 2006 at 14:08 | #10

    One US guest commented that in the USA an employee who works more than 20 hours per week must be given health insurance by the employer (ie it is the law).

    On talking to people in the USA I get the impression that the rule only applies to large businesses (ie more than 250 employees). So maybe the effect on jobs is not so pronounced. Although I understand that there are less small businesses in the USA (proportionally speaking).

  11. July 25th, 2006 at 14:43 | #11

    dd – I dunno – anecdotally I’d reckon the societal attitude is changing here to bankruptcy. I now know a few people who have been through it – a one been through it twice. Two I know a bit about didn’t change their lifestyle and spending habits one bit leading up to it – small busineses who must have known things were going bad for about 18 months. I don’t have much to do with these people any more, I can’t reconcile them still living the relatively high lifestyle whilst going down the gurgler and not paying debt.

    I think I’m a bit old fashioned.

  12. July 25th, 2006 at 16:39 | #12

    Yeah, me too. The solicitor, David Robinson, who was in the news lately because he was killed by a lunatic, was mentioned as being bankrupt. But his kids, unlike mine, went to private schools and they appeared to be living quite a comfortable lifestyle. Looking further up the scale, “disgraced businessmen” who have purportedly lost everything still often appear in posh suburbs, driving nice cars et cetera. I know this is all politics of envy-ish, but really, it makes me feel like a mug for trying my best to live within my means and living a lifestyle so much less opulent than theirs.

  13. Terje
    July 25th, 2006 at 17:39 | #13

    Bankruptcy seems reasonable when it avoids a debtors prison but suspect when it is just a way to avoid paying bills (that you do have the ability to pay, if not the desire).

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