NCPA - National Center for Policy Analysis


May 17, 2005

Proponents of stricter bankruptcy laws argue that current laws allow many people to "cheat" creditors, hurting economic growth. That may be so, argues the Economist, but looser bankruptcy laws also encourage entrepreneurship.

Economic theory says that making it easier to shrug off debts makes bankruptcy safer for borrowers, but increases the risk to creditors. This shrinks the supply of credit; financial institutions, fearing more defaults, become less keen to lend at any given interest rate.

The Economist notes:

  • States with larger homestead exemptions (the amount of a home's value that is shielded from creditors) have less available credit.
  • Companies located in states with unlimited homestead exemptions were roughly 30 percent more likely to be denied credit than firms in the states with low exemptions.

However, difficulty in getting credit is only one obstacle to economic risk. Many potential entrepreneurs may be unwilling to risk everything for a new business. In this case, looser bankruptcy laws benefit economic growth.

According to the Economist:

  • Homeowners in high-exemption states were 10 percent more likely to own a business than those in low-exemption states.
  • Homeowners in unlimited-exemption states were 35 percent more likely to be in business for themselves.

Of course, this increased entrepreneurship may not always be a good thing. Entrepreneurs tend to be wildly over-optimistic and do not think about bankruptcy. But choosing a successful business plan is difficult. Venture capitalists spend considerable time choosing which firms to invest in and nevertheless nine of their 10 picks fail.

Source: "Life after debt," The Economist, April 16, 2005.

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