Consumer Bankruptcy: A Fresh Start

TLDR

Consumer bankruptcy provides partial insurance against bad luck, but by driving up interest rates it makes life‑cycle smoothing more difficult. The study aims to evaluate the trade‑off between bankruptcy protection and its cost by developing a quantitative model of consumer bankruptcy. The authors build a quantitative model incorporating a life‑cycle component, idiosyncratic earnings uncertainty, and exogenous expense shocks. The model shows that persistent earnings shocks increase the desirability of bankruptcy, whereas larger transitory shocks reduce it, implying that the current US bankruptcy system may be appropriate for realistic parameter values. JEL codes: D14, D91, K35.

Abstract

Consumer bankruptcy provides partial insurance against bad luck, but, by driving up interest rates, makes life-cycle smoothing more difficult. We argue that to assess this trade-off one needs a quantitative model of consumer bankruptcy with three key features: life-cycle component, idiosyncratic earnings uncertainty, and expense uncertainty (exogenous negative shocks to household balance sheets). We find that transitory and persistent earnings shocks have very different implications for evaluating bankruptcy rules. More persistent shocks make the bankruptcy option more desirable. Larger transitory shocks have the opposite effect. Our findings suggest the current US bankruptcy system may be desirable for reasonable parameter values. (JEL D14, D91, K35)