How Does Bankruptcy Affect the Economy?

by Joseph Nicholson - Updated September 26, 2017

Bankruptcy and the Economy

Ideally, the bankruptcy process should benefit the economy. Giving debtors a way to have their debts discharged theoretically encourages borrowing and spending. For consumers, this means using credit cards or mortgages to buy goods and make large purchases like homes or cars. For businesses, this means taking on more risk by investing in research and development and expanding. If debts could not be forgiven, there would be little incentive to take on debt or engage in relatively risky activity. Conversely, the bankruptcy process gives creditors an equitable means for collecting to the fullest extent possible on debts and repossessing collateral property.

Corporate and Consumer Bankruptcy

Consumer bankruptcy only has negative effects on an economy when it occurs en masse. This is usually a symptom of a larger economic downturn and serves as part of a negative feedback loop that can reinforce a recession or depression. For example, significant increase in the rate of consumer bankruptcy will lower consumer confidence and spending. It will increase the savings rate, which can have short term negative impacts on a consumer-driven economy. This, in turn, will have implications for corporate profits, usually resulting in, if not bankruptcy, then reduced corporate investment, hiring and wage freezes and job cuts. These reactions, especially higher unemployment rates, then further impact consumer attitudes and behavior and reinforce an economic downturn. But because corporations can take these actions, widespread corporate bankruptcy is very rare. Whereas consumer bankruptcy has negative effects when it is widespread and the bankruptcy of one wealthy individual will have negligible effects on its own, corporate bankruptcy tends to only be a problem when large individual companies go under. General Motors, for example, faced bankruptcy as a result of the recession that began in 2008. It not only employed large numbers of workers and represented a significant part of the economy in certain regions, but had corporate debt that was widely held in mutual funds, pension funds and other institutions. The default on this debt would have had far reaching implications beyond the layoffs and lowered industrial output if the company simply ceased to be. Ironically, whereas individuals benefit more from liquidation than reorganization, the features of Chapter 11 bankruptcy that allow for restructuring of a company rather than its outright liquidation, were widely believed to be the ideal remedy for an interconnected corporation such as GM.

Bankruptcy Reform

The bankruptcy process was significantly reformed by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. The major thrust of the reform was to make it more difficult for individuals to qualify for Chapter 7 bankruptcy, under which debts can be forgiven. Instead, most cases were forced through Chapter 13, where debts are renegotiated and reorganized, but not discharged. Naturally, creditors heralded this as a victory and assumed it would lead to less “abuse” of the bankruptcy system and higher rates of collection. By 2009, however, researchers at the Federal Reserve were already conceding that the reform legislation probably had the effect of making the economic downturn even worse than it might have been. Simply put, the fact that debtors cannot have their debts forgiven, does not make them any more able to pay the debts. Instead of being liberated from their burdens and allowed to return to a more normal state of earning and spending, consumers were largely saddled with monthly debt payments to insolvent lenders that prevented what income they could make in a slowing economy with rising unemployment from entering general circulation, as it would if they were able to spend on goods and services.

About the Author

Joseph Nicholson is an independent analyst whose publishing achievements include a cover feature for "Futures Magazine" and a recurring column in the monthly newsletter of a private mint. He received a Bachelor of Arts in English from the University of Florida and is currently attending law school in San Francisco.

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