In 2005, Congress passed legislation that placed tougher restrictions on the circumstances under which an individual could file for bankruptcy protection and discharge unpayable debts.
Among other goals it was intended to accomplish, the law protected lending institutions, which were seeing a high level of their loans (including credit card debt) disappear into bankruptcy courts. Requiring more debtors to file under Chapter 13 than Chapter 7 forced them to repay higher percentages of their debt rather than simply having it forgiven by the bankruptcy court. That was a fine idea, as long as different terms made making payments possible.
That legislation wasn't intended to address the situation in which the United States (and much of the world) now finds itself. In retrospect, a better plan would have been to prevent lenders (not all of which are banks) from entering into high-risk loan arrangements in the first place, but that is water long under the bridge. Those loans have been made. Now some consumers say the 2005 legislation has made it harder for them to seek bankruptcy protection.
According to the executive director of the American Bankruptcy Institute, quoted in USA Today, "One of the primary purposes of the bankruptcy law is to provide a way to grant debt relief to the honest-but-overextended debtor, who, through no fault of his own, is burdened by more debt than he can pay."
In other words, especially at a time when the economy badly needs money to flow, there is no overriding social benefit to punishing debtors. While they should be required to pay all they can, once that level has been reached, lengthy procedural delays in acknowledging that they can pay no more hamper the economy while not actually aiding individuals or corporations.
The theory behind the 2005 legislation was that all a lender's customers benefit from a lower level of bad debt, which is passed on to other customers in a higher cost for credit. That is indisputable. What also is indisputable, says at least one former Harvard professor, is that the 2005 Bankruptcy Protection Act benefited lenders more than it did borrowers.
And, it turns out, what is bad for borrowers is also bad for the entire economy, because when they cannot pay, the house of cards comes crashing down.
Consumer debt does not, by far, make up all of the debt that the Obama administration's proposed $1 trillion toxic asset purchase program is supposed to address. Corporate debt is a huge factor, as shown by the precipitous toppling of large corporations that seemed stable and profitable not many months ago. That ripples through the economy. Part of the consumer-debt problem is that too many consumers currently are unemployed.
But the problem also is circular. Companies are laying off workers because consumption is down. Until money starts flowing more easily, none of those factors can improve, and until they all do, bankruptcy is the only solution for any entity not deemed "too big to fail."
Bankruptcy is not a moralistic process by which sinful consumers are released from their obligations only after they have suffered a sufficient amount of pain and humiliation. It is a legal mechanism to straighten out financial tangles and let everyone involved - creditors, debtors and those related in many other ways - know where they stand.
Nor was bankruptcy reform intended (at least by lawmakers) to create a technical limbo in which consumers are trapped, unable to pay their bills and with no hope of change in sight, but also unable to file for bankruptcy.
Right now, an expeditious process of getting debtors back on their feet so they can participate in the economy benefits everyone. Before the economy can recover, investors must have confidence that the bottom of this spiral has been reached, and no one can say that with any degree of certainty until the flow of bankruptcy filings currently made difficult by "reform" is allowed to reach its inevitable conclusion. Now is a time for realism.