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.

6 thoughts on “Expenses > income = bankruptcy

  1. I recall it being said that 60 percent of Americans are one payday away from bankruptcy. Assuming that this has any truth to it then I would think that American incomes are more highly tuned to income and expence shocks. Australians are more protected from that criticality by our stronger social welfare and by the heritage of the strong union era.

    I recently bought a very nice vehicle from a comapany representative who calls on my factory. This guy, although on a 70 thousand dollar salary, had allowed himself to become overloaded with debt by accepting a flurry of credit cards and increased limits that were pushed on him by lenders. He had a very nice time for a while. He also bought into the mortgage relocation farce. So when the interest rate increases caused property values to drop he discovered that he no longer had sufficient equity to cover his debt and therefore the debt consolidation option was closed to him. As his outgoings had exceeded his income he opted for bankruptcy.

    In his case the bankruptcy was not such a hard option. He had a company car so selling the expensive family car cleared that debt, he was somehow able to keep the house but the credit cards were zeroed and cancelled (they were the big losers), he was able to buy a very cheap car for the family, and so things did not change much for him. That would be one of the best bankruptcy outcome that you might find.

  2. I think the standard figure is 2 paydays away. You also have to remember than Americans are standardly paid by the month, so that means 1/6th of annual income, not 1/26th.

    Bankruptcy used to be very much easier in the US to abuse as well, which would have led many to tread the precipice, knowing that the safety net would catch them. When that went away, but the risk didn’t, many would have been in real trouble.

    Barristers in OZ certainly had a reputation for being sreial bankrupts, especially as regards tax bills. And for some reason, breaking the tax laws by not paying tax for years did not seem to disqualify you as a ‘fit and proper person’ to practice law. That appears to be changing, but slowly.

  3. I too am unconvinced that people behave in ways that are economically rational. If they did then the advertising and sales industries would wither.

    Four Corners showed that undereducated people could be enticed through aggressive marketing to take out mortgages which they had little chance of paying in the long term or where the true terms were unclear at the beginning. Meantime the need to house a family acted as a rational reason to take irrational action based on income and where something unexpected could lead to disaster. Meantime those in the financial loop could convert others lack of sophistication and misfortune into a fortune for themselves as regulations did not prevent predatory behaviour. This negates the statement that the abolition of usury laws will have no impact.

  4. Elizabeth Warren at Harvard has different data, http://www.msnbc.msn.com/id/14604090/site/newsweek/page/0/:

    Q:Some in the credit industry have blamed bankruptcies on overconsumption.

    I wish they were right. If that were the problem, then the solution would be obvious: don’t buy so many Game Boys and $200 sneakers. The problem is that’s not what’s wrong with families. Ninety percent of the families who file for bankruptcy do so following a job loss, a medical problem or a family torn apart by death or divorce.

    Q:So is the stereotype of debtors with too many big-screen TVs false?

    It’s right up there with the welfare mom who drives a Cadillac. A great story but not true.

    Q:It’s commonly thought that people simply don’t pay most medical debt, that they default and the hospital covers it.

    The data show that more than half of the families who file for bankruptcy do so in the aftermath of a serious medical problem. And three quarters of those people have health insurance at the onset of the illness or accident that ultimately landed them in bankruptcy. Sometimes it’s hospital bills, but more often, it’s about co-pay, deductibles, uncovered treatments, drugs, rehab, supplies, all the things that aren’t covered by insurance. So part of the answer is that the financial impact of a serious medical problem goes beyond hospital bills. Lost jobs, drugs, physicians, rehab, health supplies. It’s expensive to get sick in America today—too expensive for the average family.

    Q: Health insurance companies say your figure—that medical bankruptcies contribute to more than half of all bankruptcies—is too high.

    The insurance companies want us to believe that the private health insurance industry works and that everyone who is paying huge premiums monthly is safe. Our data shows that it’s simply not true.

    Q: According to your research, three quarters of the people whose medical debt contributed to their bankruptcies had health insurance. What are the implications of that finding?

    If our finding had been that every person in bankruptcy following a medical problem had no health insurance, then the industry would have had a very different response—we need to help more people get health insurance. Let’s get the state to subsidize health insurance. Let’s use this study to frighten families into paying even more for insurance. When the study showed that even those with health insurance were at terrible risk for financial collapse, the health insurance industry went crazy.

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