This article is part of Sweet Forgiveness, a forum on debt relief.
G. Marcus Cole
While Mike Konczal believes that “this time is different,” that the financial crisis and its aftermath reflect a fundamental shift in American law and policy, his argument is as old as western civilization itself. Versions of it persist no matter how effectively they are rebutted. But their persistence demands that they be taken seriously.
In The Merchant of Venice, Portia weaves a clever legal argument to save her husband’s benefactor from the importunate creditor, Shylock. The audience finds itself torn between a desire to uphold the letter of the law and the sense that a law favoring the cruel Shylock would be unjust. Portia resolves the conflict on the side of the higher, aspirational law upholding the “moral” order, and the audience cheers.
Konczal’s argument is essentially the same: if the consequences of default can fall so harshly upon so many innocent people, then the law must be wrong. For him, that wrong is a product of legal changes promoted by the Shylocks of the world. Amid the downturn, creditors are using their unjust laws to extract pounds upon pounds of flesh.
Perhaps. But the simplest explanation is more likely. Cheap money, gifted us by central bank monetary policy as well as the “ownership society” advanced by fiscal policy, made consumption irresistible. That consumption manifested itself in increased levels of home ownership and spending on luxury goods. People treated their rising home values (rising primarily because money was being made ever cheaper by the Federal Reserve) as personal ATMs. When the market was saturated, the housing bubble burst.
But for the sake of argument, let’s accept Konczal’s premise. Suppose creditor-friendly legal changes as well as balance-sheet indebtedness created a perfect storm. Should we eliminate debt obligations? Or change the law to frustrate creditor recoveries?
Those questions translate into another: Do we need a credit economy? Many societies get along without credit, debt, and bankruptcy. But we often refer to such societies as “developing” or impoverished. The fact is that developed economies require capital, and the cheaper the capital, the more development a society can afford.
The purpose of bankruptcy law is, and must be, to lower the cost of capital ex ante. All other laudable purposes are only affordable if bankruptcy is capable of achieving this purpose, and the prosperity that results from it.
Other economies have chosen different aspirations for bankruptcy law. In Spain officers of any business closing under the local bankruptcy regime face criminal sanctions—including prison—if remaining assets don’t guarantee each employee a year of wages. Banks are repaid only after other requirements are met. Spain now wrestles with 25 percent unemployment, and its banks are in desperate need of a bailout. Italy too has sought to punish banks for providing capital, by placing them at the end of the recovery line.
Investors are not all Shylocks. Many are blue-collar workers.
The fundamental problem with Konczal’s argument is that, like Shakespeare’s audience, he doesn’t see creditors as investors who can choose where to put their money. Banks and other creditors get their money from these investors; if their returns to debt investments don’t satisfy, they will invest elsewhere.
These investors are not all Shylocks. Many are blue-collar workers whose pensions or retirement plans depend in part upon debt investment. More than half of all Americans own stock, and that doesn’t include investments owned indirectly through pension and mutual funds. So it is likely that the very people losing homes to foreclosure have some financial stake in the lender who is foreclosing.
Is there something wrong with the current state of debtor-creditor law? Not really. In fact, many provisions of the bankruptcy code that Konczal laments are founded upon important principles. For example, Konczal asks why we would allow lien stripping on a wealthy homeowner’s second mortgage, but refuse it on a primary residence. The reason is that a lender will price a mortgage loan to a potential homebuyer to account for the risk of default. This price, over a portfolio of loans, must compensate the lender upon any one borrower’s default. Denying lien stripping ensures the risk of loss is lower, and, in turn, mortgage rates are more affordable for all homebuyers. Take away the prohibition of lien stripping on primary residences, and we will witness an increase in mortgage rates and a decrease in home ownership.
It also makes sense that student loans cannot be discharged. Students seeking to invest in their “human capital” often have no current income or assets. This makes them different from other consumers seeking credit. Students must say “please give us money now, and we promise to give it back when we get out of school and get jobs.” If these students were able to file for bankruptcy and discharge their loans upon graduation, what rational lender would make the loans?
Konczal may be right, however, about private student loans. Private, for-profit schools and lenders—often the schools themselves—have no “skin in the game.” They make loans to students whom they admit, but those students have little chance of graduating or, if they do, increasing their income. No other market would lend against such a risky investment. But a student lender lends because it has an assurance that the borrower can never discharge the loan in bankruptcy.
One solution would be to permit discharge of any student loan amount that exceeds a particular percentage of the average income of a given school’s graduates. This change would still encourage student loans, but only where the lender is assured that the marketplace values the education provided.
This is a tweak to a system that has served the American economy well and should be protected from the popular urge to “occupy” creditors. It is tempting, in difficult times, to condemn those who make our very choices possible. But would we prefer a world without such choices, even if they occasionally turn out to be the wrong ones?
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