Expenses > income = bankruptcy
Andrew Leigh points me to a recent study of US bankruptcy (paywalled, but the abstract is over the page). which concludes that the increased variability of income, and exposure to expense shocks such as medical expenses are not important factors in explaining the dramatic increase in bankruptcy rates since 1970. (I’ve seen a blog link to this also, but can’t find it now).
Count me as unconvinced. The main reason for rejecting income shocks is an explanation of bankruptcy is that, in the model of the paper, households should respond to increasing variance of permanent shocks by increasing precautionary savings. This appears to impute to households a much higher level of ex ante information about future income shocks than they actually possess, and also to rely critically on strong assumptions about rational planning. The whole credit card business is centred on the fact that lots of people (about half the population) don’t pay their monthly balances down to zero and therefore carry semi-permanent debt at very high interest rates. It seems pretty clear that it is people in this group who are most exposed to bankruptcy, and it’s hard to imagine that they are the type to hold precautionary savings.
That’s not to discount the importance of the ‘supply side’, in terms of easier access to credit, which has assisted people in managing increasingly risk in income and expenses, at the cost of steadily increasing debt-income ratios. But you have to look at both sides of the story, and this paper rules out one side by assumption.
Accounting for the Rise in Consumer Bankruptcies by Igor Livshits, James
MacGee, Michele Tertilt – #13363 (EFG)
Personal bankruptcies in the United States have increased dramatically,
rising from 1.4 per thousand working age population in 1970 to 8.5 in 2002.
We use a heterogeneous agent life-cycle model with competitive financial
intermediaries who can observe households’
earnings, age and current asset holdings to evaluate several commonly
offered explanations. We find that increased uncertainty (income shocks,
expense uncertainty) cannot quantitatively account for the rise in
bankruptcies. Instead, the rise in filings appears to mainly reflect
changes in the credit market environment. We find that credit market
innovations which cause a decrease in the transactions cost of lending and a
decline in the cost of bankruptcy can largely accounting for the rise in
consumer bankruptcy. We also argue that the abolition of usury laws and
other legal changes are unimportant.