Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Equilibrium Models of Personal Bankruptcy: A Survey

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Equilibrium Models of Personal Bankruptcy: A Survey

Article excerpt

Academic research aimed at understanding the consumer default decision has grown rapidly over the past decade. The genesis of this research is the product of three broad sets of forces. First, advances in pure theory gave economists a better understanding of the implications of allowing default for consumer welfare and credit market outcomes. Second, the relatively striking growth of unsecured consumer debt and default in the 1990s spurred the interests of applied researchers in explaining the default decision.1 Third, and most recently, advances in computational technology have allowed economists to map the insights from pure theory into models capable of confronting observed data and yielding quantitative implications.

This article documents the evolution of recent work on personal bankruptcy. The questions addressed by this research range from the role of income uncertainty in driving financial distress to the roles of statutes allowing households to shelter wealth and of decreased moral commitment to repay debts.

The extant literature consists of a variety of economic approaches to policy analysis. For example, several recent papers employ detailed analyses of observed data. Some of these analyses-notably Gropp, Scholz, and White (1997); Elul and Subramanian (2002); and Grant (2003)-cleverly exploit the near-natural experiments provided by interstate variation in bankruptcy law. At the other end of the spectrum are the so-called "equilibrium" approaches, typified in the work of Athreya (2002, 2004, forthcoming), Chatterjee, Corbae, Nakajima, and Rios-Rull (2002); Li and Sarte (forthcoming); Livshits, MacGee, and Tertilt (2003); and others. These approaches have in common settings in which households optimize, and in which equilibrium conditions such as those implied by competition, market clearing, and resource feasibility are imposed. Such researchers explicitly solve household optimization problems parameterized through "calibration" or estimation, and then employ simulation to understand bankruptcy policy. What follows documents most directly the contributions of these "equilibrium" models.

The article is organized as follows. Section 1 presents the intuition captured in purely theoretical models of default. Section 2 documents some of the empirics pertaining to personal bankruptcy. Section 3 discusses a set of quantitative equilibrium models based on the theoretical foundations discussed in the first section. Each of these models analyzes the role of default at both the individual and aggregate levels in a manner that respects salient features of U.S. data. The final section concludes.

1. BASIC THEORY

The Role of Limited Insurance

Proponents of current bankruptcy law have long argued for the role of debt forgiveness in helping those hit by unexpected hard times. The "honest but unfortunate debtor" is now folkloric. Central to this view is a belief that life is characterized by a nontrivial amount of uninsurable risk. In particular, instead of pooling risks through explicit insurance contracts, households may do some risk-management by saving in good times and borrowing in bad times. The spectre of persistent misfortune, as it may leave households in financial straits, raises the possibility that occasionally allowing default may be useful. In other words, the default option may act like an insurance policy against very bad luck.

Formalizing the insurance role of the option to default is the subject of .

several recent works. The seminal references are the papers of Dubey, Geanakoplos, and Shubik (2005) and Zame (1993), who both study outcomes in stylized two-period models in which all uncertainty resolves at the terminal date. The critical assumption made in their work is that insurance markets against second-period risk are incomplete. Of course, without this imperfection, allowing default simply corrodes the ability of borrowers to commit to repaying debts, and can therefore only make matters worse. …

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