Optimal Bankruptcy Code: A Fresh Start for Some

38 Pages Posted: 12 Sep 2014

See all articles by Grey Gordon

Grey Gordon

Federal Reserve Banks - Federal Reserve Bank of Richmond

Date Written: September 8, 2014

Abstract

What is the optimal consumer bankruptcy law? I examine this question in the context of an incomplete markets lifecycle model with a planner who can choose state-contingent bankruptcy costs. I develop two key theoretical characterizations. First, the optimal policy has a bang-bang property: The planner either gives a household a "fresh start" or forbids it from filing. Second, it is optimal for the planner to always allow bankruptcy if the household cannot repay or would prefer an outside option. Consequently, a natural borrowing limit economy - an economy where bankruptcy is never allowed - is suboptimal. Quantitatively, the optimal policy results in large amounts of debt and default with ex-ante welfare gains, relative to a no-borrowing economy, as large as 12.8% of lifetime consumption. While the optimal policy is complicated, a simple cutoff rule allowing bankruptcy when a household's debt is 2.6 times its endowment results in a welfare gain of 12.2%.

Suggested Citation

Gordon, Grey, Optimal Bankruptcy Code: A Fresh Start for Some (September 8, 2014). Available at SSRN: https://ssrn.com/abstract=2494888 or http://dx.doi.org/10.2139/ssrn.2494888

Grey Gordon (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of Richmond ( email )

P.O. Box 27622
Richmond, VA 23261
United States

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