Megan McArdle, the economics editor of The Atlantic, has a great article on bankruptcy policy in the the June 2009 issue: Sink and Swim:

McArdle writes:

Our leniency toward those with unsustainable debts helps not only profligate debtors, but the rest of us as well. Less onerous bankruptcy procedures boost rates of entrepreneurship: reduce the cost of failure, and people become more willing to take risks. America’s business environment is much more dynamic than that of Europe or Japan, for many reasons—and our generosity to capitalism’s losers is one of them…

It isn’t fair. But by the time someone is in bankruptcy, the time for fairness is already long past. Bankruptcy is the legal recognition that someone lacks the resources to meet financial obligations. Our system works so well precisely because it mostly sets aside our instinct for just deserts, and instead focuses on minimizing the costs to everyone. It lays out clear and predictable rules for lenders and borrowers, so that they can plan for disaster, and escape as quickly as possible if it arrives. Still, it’s plain as day that, in the current crisis, a whole lot of people are getting help they haven’t earned. As a result, commentators, academics, and legislators presiding over hearings have diverted much time and energy away from hashing out the ugly details of rescue efforts and toward making the one point on which we can all agree: these relief measures don’t seem fair…

Look at entrepreneurs. All of the business literature indicates that starting a business is a phenomenally stupid thing to do. Most new businesses fail, and not simply because most would-be entrepreneurs are actually no-hopers. Even people who have founded successful companies in the past still have a 70 percent chance of failing. All those business failures are costly—but the successes are the difference between us and Tanzania. We want people to take these kinds of risks, even if that means we write off a lot of bad debt.

Tougher bankruptcy laws don’t necessarily curb the kind of behavior we want to discourage: borrowing money you have no way to repay, in order to buy unnecessary consumer goods. The amount that households put on their credit cards didn’t fall after the 2005 reform; over the next two years, it rose 12 percent. According to Michelle J. White, an economist at the University of California at San Diego, many bankrupts are what economists call hyperbolic discounters—people who pay a lot of attention to current pleasures, and very little to future costs. That’s why a person’s debt, not unemployment or divorce, may be the best predictor of bankruptcy.

If you’re the kind of person who buys now and worries later, the idea that government is making your inevitable bankruptcy filing slightly more annoying won’t discourage you. Actually, a higher hurdle to bankruptcy will make things worse, because banks will offer to lend you more money if getting the debt discharged is harder for you—money that you will happily, and irresponsibly, borrow and spend. The people who are most likely to be deterred from borrowing are the people who are taking the rationally contemplated risk of starting a company or buying their first home.

Of course, we’ll at least squeeze a little extra cash out of the real deadbeats. Maybe. Most repayment plans set up under Chapter 13 fail. People who weren’t previously good at living on a budget don’t magically get better at it with a court order. Moreover, job losses or other unexpected events can derail the highly structured payment plans. And the costs of administering an ongoing plan are much higher than for a simple discharge and write-off.

Meanwhile, those payment plans lash people to their old lives, even though those lives weren’t working all that well; it’s hard to move, or get training, for a better job if a court has to approve the expense—and why bother, if a trustee might seize the extra income? In the worst case, the failed Chapter 13 proceeding leaves the most-vulnerable people mired even deeper in debt they can’t repay. Such outcomes start to sound less like “fairness” and more like “throwing good money after bad.” Look around. Do the banks seem sounder because we made it harder for people to shed their debts?

These problems are simple compared with the questions raised by the current crisis. Existing bankruptcy law has no easy formula for dealing with a behemoth like Citi, or even GM, that has international subsidiaries, and where any punitive action we take could have massive unintended consequences. But we can look to the bankruptcy law we’ve evolved for some principles about what works. And what it seems to tell us is that, regarding insolvents, we too often ask the wrong question: Who should pay? rather than Who can?

Bankruptcy’s greatest boon is orderly liquidation of past failures so that banks and borrowers and insolvents can trust in their futures, invest in them. Yet listen to the public commentary on the bailouts, and you’d think that half of America would happily gut the rule of law if doing so would let them punish a single undeserving executive. Is penalizing the traders at AIG really more important than upholding a long-standing liberal democratic tradition?

In ordinary times, we maintain a sort of society-wide doublethink about the problem of insolvency. We all agree that it is a very terrible thing that should be avoided at all costs—but once it has actually happened, we try to forget about the past as quickly as possible, and we focus mostly on providing a predictable and relatively painless way for the insolvents to get back on their feet. That strategy, developed over time through trial and error, has served us well for most of our history. Why is it now a piece of the past that we’re only too willing to abandon?