The Seduction of Bankruptcy

Abstract

Consumer bankruptcy has been rising for three decades until 2005, when the Bankruptcy Abuse Prevention and Consumer Protection Act was enacted. According to the standard theory of bankruptcy, bankruptcy filing is caused by financial distress of consumers. The prediction of this theory is that bankruptcy filings will be cyclical: rising in recession and falling in prosperity. The prediction is consistent with observations until 1979. However, during the 1979-2005 periods, bankruptcy filings have been rising rapidly in spite of strong economic growth. Between 1979 and early 2000s, personal bankruptcy filings increased by more than 400 percent. An alternative explanation considers the fact that the Bankruptcy Reform Act of 1978 has been more forgiving to debtors than earlier laws. This theory considers incentives in rational choice model in explaining the rapid rise in bankruptcy filings. The rational choice theory is not sufficient to explain the fact that the rise took several decades. Considering the stigma people have about filing bankruptcy and the opportunistic behavior, I propose a behavioral theory in which individual behavior results in horizontal evolution. An empirical work has been proposed and performed to compare my proposed theory with the traditional theory. The GINI index is used as a proxy for financial distress. The tentative result based on the data for the 1969 through 2002 indicates that behavioral theory better explains the observed behavior.