Monday, September 23, 2013

How Bankruptcy Fits Into the Larger Economy

In this video, a successful hedge fund manager named Ray Dalio does a great job of explaining how the economy works. This is primarily a macroeconomics presentation, which is a discipline that is highly criticized.

In this article, I’m going to focus in on a small part of Dalio’s presentation—the part about default as a response to overleveraging. As a bankruptcy attorney, I help people default properly and responsibly. It is important that the nation have an organized and responsible system for defaulting? In fact, the foundation for bankruptcy (which is by definition, an managed default) is in the U.S. Constitution, which give Congress the authority to regulate bankruptcies.

When I was in college, focusing on political economy and minoring in economics, I never saw a presentation that laid out the operations of the economy so clearly. I had learned the basics from people like Milton Friedman and others. I had—over the years—read countless books that concentrate on several aspects that are presented in this video. Each time, I have found that different people tend to agree on certain ideas and disagree on others.

Why Bankruptcies Happen
At one point in this video, you will see that one of the four methods of dealing with over-leveraging is default. “Default” on a debt means not being able to pay the bill. This can happen for a multitude of reasons. The video discusses defaults as a reaction to overleveraging. This is true, in the context of the entire economy.

However, from the perspective of the individual person, most bankruptcies in America are due to changed circumstances, such as medical bills or divorce. This can include factors which are resulting from widespread economic collapse, such as losing a job or seeing asset values tank. However, many bankruptcies are in fact due to overleveraging, i.e., the person simply took out too much debt relative to their income.

What is rare is the person who goes out and accumulates a ton of debt with no plan to pay it back later. During good times in the economy, people often take risks that they would not otherwise have taken. In fact, this is a point that I think the video underemphasizes: the importance of risk. The video does talk about confidence, which is essentially the same thing as risk.

In either case, there is no reason to be ashamed of filing bankruptcy. It is part of the natural cycle that goes on in the economy. It is true that no nation could tolerate too many bankruptcies all at once. However, it is also true that society does not benefit from having its members bogged down in bad debt, working to pay off creditors. We want people working to make money for themselves.

Why We Need Good Bankruptcy Laws
We’re all better off if the overleveraged person can get a fresh start for several reasons. First, that person actually goes back into production.  Nobody likes to work merely to pay off a bank or a creditor—so when people are overleveraged they tend not to work as much or as productively.

Filing bankruptcy allows a person the opportunity to work for his/herself again. This makes the person more productive. Ultimately, that person will be ready for credit again, and will presumably prefer not to go through bankruptcy again—in fact, the person actually cannot go through it again for some time. The creditors will ultimately make more money as the person borrows again. There is no question that creditors lose in the short term in a bankruptcy. However, ultimately they benefit in the long term in the same way every other person is who will transact with the person filing in the future.

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