Bankruptcy Law and Policy: Good for the Few, Good for the Many

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John Perrott hanged at Smithfield

England passed the first modern bankruptcy law during the reign of that lovable old curmudgeon, Henry VIII.  The law’s purpose?  Make sure no one could ever fail to pay back a loan without severe consequences.  In other words, only one social purpose was served:  repayment of creditors — or else.

Although several American colonies and later states experimented with a more rational and humane approach (at a time when bankruptcy was still punishable by death in Merry Olde England), not until 1841 did the USA (or any nation) pass a bankruptcy law whose intent included an equitable system for discharge of debt.  Although England in 1705 began to allow discharge, the central purpose was still relief for creditors; in no way did the law reflect any humanitarian concern (or even sound social policy) regarding debtors.

The 1841 law was short-lived, but both the federal government and individual states kept experimenting, now and then, with variations.  Finally, following the catastrophic Depression of the mid-1890s, in 1898 a modern federal bankruptcy law was passed, and there’s been one (but not the same one) ever since.

In a way, that’s surprising.  One hundred and fourteen years is a long time for laws with the same basic premise to survive without serious opposition.  Obviously, it is the “common sense” of our nation that society as a whole benefits from allowing individuals to get a fresh start, rather than spend the rest of their lives paying off creditors.

But it’s even more surprising, in retrospect, that it took an entrepreneurial nation like ours more than a century before finally putting the law in place.  After all, the United States is built on the idea of encouraging individual risk, i.e., experimentation in launching businesses with the sober knowledge that a majority of new small businesses fail.  Without bankruptcy laws, far fewer Americans would be willing to take the risks and invest the personal savings that, combined, have given us the most dynamic and innovative business environment in history.

And even with respect to those (like me) who have no entrepreneurial talent, the existence of the bankruptcy code benefits society as a whole.  Think about it:  how motivated would individual workers be if, due to some financial disaster, they had to spend the rest of their lives working only to hand the paycheck over to creditors?  That’s far worse than even indentured servitude, which at least was limited to periods of about seven years.  We value an incentivized work force because it’s more productive and it’s healthier, psychologically, than the alternative.

In this respect, consider the recent housing bubble and the cataclysm of September 2008 through March 2009.  Without the option of bankruptcy, untold numbers would be stuck paying off their underwater mortgages (while no longer living in their old houses) for, possibly, the rest of their lives.  An entire generation of productive citizens would be reduced to conduits for the transfer of paychecks to creditors.  Instead, all of us benefit by allowing these people a way OUT so that they are motivated to remain IN a productive workforce.  It’s good for the few and good for the many.

Obviously, we’ve come a long way since Henry VIII (who perhaps inspired British poet Rudyard Kipling to write, “If you can keep your head when all about you / Are losing theirs and blaming it on you …”).  And we’re talking about losing your shirt, not your head.  But to sentence the risk-taking part of the workforce to a lifetime of mindless, motivationless labor, with no inspiration and innovation, is effectively to decapitate the economy.  Fortunately, back in 1898 a lot of congressmen had a good head on their shoulders — and regarding debtors, our nation no longer has collectively lost its mind.

by Jim Erickson, Associate Attorney

Policy descriptions by John Mlnarik

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