Bankruptcy

Justifying Debt Forgiveness: Information Asymmetry and Risk Allocation

By Nathalie Martin

In my last guest blogs before quitting, I want to briefly discuss, and hopefully get a discussion going, about two topics related at the Illinois Debt Symposium. This was a fabulous interdisciplinary event, about which Mechele Dickerson has blogged extensively already.  But a couple of the topics are still stuck in my craw.

Ever since Heidi Hurd?s talk at the Illinois Debt Conference, about why we grant a bankruptcy discharge in our society, I have been unable to stop thinking about it. She attempted to justify debt forgiveness because it is the right things for a just, moral, wealthy society to do. The most interesting thing about topic is that it implicitly challenges what many of us take as a given. Is it necessary to forgive debts for people cannot pay them? On what basis? Many readers of this blog cannot imagine a world without a bankruptcy discharge, but numerous others in our society (and other societies) completely disagree. Professor Hurd (and her coauthor Professor Brubaker) ask us to justify the forgiveness of debts, something we should be able to do.

Still, the idea that we do this because it is the right and moral thing to do is foreign. I prefer commercial/ economic justifications for commercial/economic laws, to justify forgiving debts because it is good for the economy, for capitalism, for fueling commerce. I always have believed that we forgive debts because it is efficient, utilitarian, and promotes more spending and more commerce. I also prefer to avoid discussing debt in moral terms because what is deemed moral changes over time, and I can see this being turned on bankruptcy debtors who no longer seem worthy of our kindness.

While I am not ready to bring morality per se into my own debt forgiveness policy, Hurd?s paper does have me thinking about another form of blame, one with a commercial flavor, namely. blame in the  commercial law sense of allocating risks and losses by determining which party in a failed transaction was best able to avoid the loss. It is not so different than dealing with a failed international sale of goods, in which goods traveling from Bruge to Boston fall into the sea.  Law or custom will allocate this loss either to the one best able to avoid this loss or the one in the best position to spread the risk of loss. These principles apply to debt forgiveness as well.

In her article, A Theory of Discharge in Consumer Bankruptcy, Professor Margaret Howard argues that the best justification for the bankruptcy discharge is return of the debtor to productive economic participation and I agree. But perhaps there is more than one good justification for debt forgiveness.  Risk allocation is one of theories Professor Howard debunked. Professor Eisenberg  espoused applying risk allocation theory to debtor-creditor law and then argued that debtors were in the best position to avoid financial distress because they "know more about themselves and have greater control of their affairs than lenders do."  He may have  been wrong about who knew more, however, and thus about who should bear the risk.

According to Elizabeth Warren's talk at the Debt Symposium on information asymmetry, creditors now know far more about our credit habits and proclivities toward credit error than we could ever know about ourselves. Perhaps this information asymmetry, along with traditional concepts of risk allocation, suggest that it is creditors not debtors who are in the best position to avoid the loss of a failed credit transaction. This may provide yet another justification for debt forgiveness, especially if the creditor could never have reasonably expected the debtor to repay the debt.

Full post as published by Credit Slips on June 03, 2008 (boomark / email).