On Moral Hazard

By Rohan Pavuluri

July 25, 2016

Those who oppose bankruptcy often argue that it creates moral hazard. If people or companies can just fill out some paperwork to get out of debt, the logic goes, they’ll make irresponsible financial decisions.

We don’t believe this for two reasons. 

First, Congress has created several checks to prevent abuse of the bankruptcy system. A DOJ-appointed trustee reviews each case to root out fraud. Anybody who earns over half his state’s median income, purchases a single item for more than $500 within 90 days of filing, or transfers property out of his name within the last year of filing is presumed to be abusing the system. Several more checks also exist, resulting from a 2005 Congressional Act signed into law by President Bush.

Second, we know the most common cause of bankruptcy is unexpected medical debt. Divorce, job loss, and small business failure are other leading causes. In cases where credit card debt is the main driver of bankruptcy, predatory lending has often been part of the equation. The data shows that the majority of people who file for bankruptcy are not trying to game the system. 

Jonathan and I agree that bankruptcy should never provide an excuse for people to live beyond their means. That’s why we focus not just on helping people file for Chapter 7, but also on helping them rebuild their finances after they receive their discharge. Today, Congress requires Americans to take a two-hour budgeting course after their bankruptcy case. That’s helpful, but it’s not nearly enough. Through sustained financial education, we aim to make sure that our debtors never end up in their position again.

As Bruce Mann outlines in Republic of Debtors, bankruptcy played a large part in defining the American experiment. One only needs to consider the alternatives—prison, servitude, and death—to understand why.

In our view, Chapter 7, like Chapter 11, is one of the best parts of American capitalism. It allows honest but unfortunate debtors—like Abraham Lincoln—to get back on their feet and reenter productive economic life. It’s about second chances. And that’s something we can all appreciate.