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How Does Bankruptcy Affect the Economy?

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Bankruptcy and the Economy

Ideally, the bankruptcy process should benefit the economy. Giving debtors a way to have their debts discharged theoretically encourages borrowing and spending. For consumers, this means using credit cards or mortgages to buy goods and make large purchases like homes or cars. For businesses, this means taking on more risk by investing in research and development and expanding. If debts could not be forgiven, there would be little incentive to take on debt or engage in relatively risky activity. Conversely, the bankruptcy process gives creditors an equitable means for collecting to the fullest extent possible on debts and repossessing collateral property.

Corporate and Consumer Bankruptcy

Bankruptcy Reform

The bankruptcy process was significantly reformed by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. The major thrust of the reform was to make it more difficult for individuals to qualify for Chapter 7 bankruptcy, under which debts

can be forgiven. Instead, most cases were forced through Chapter 13, where debts are renegotiated and reorganized, but not discharged. Naturally, creditors heralded this as a victory and assumed it would lead to less "abuse" of the bankruptcy system and higher rates of collection. By 2009, however, researchers at the Federal Reserve were already conceding that the reform legislation probably had the effect of making the economic downturn even worse than it might have been. Simply put, the fact that debtors cannot have their debts forgiven, does not make them any more able to pay the debts. Instead of being liberated from their burdens and allowed to return to a more normal state of earning and spending, consumers were largely saddled with monthly debt payments to insolvent lenders that prevented what income they could make in a slowing economy with rising unemployment from entering general circulation, as it would if they were able to spend on goods and services.

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