Seminar 20 January 2014

Consumer Bankruptcy Protection as Insurance against Business Cycles

Abstract
Consumer defaults in the United States are counter-cyclical, suggesting that households use bankruptcy protection as a way to smooth consumption in the presence of aggregate shocks. This paper analyses the value of the option to default in a computable general equilibrium model similar to Krusell and Smith (1998). Since bankruptcy protection allows consumers to renege on prior commitments if their current income turns out to be low, they will be more inclined to use borrowing to smooth consumption. This helps the poorest consumers maintain a more stable consumption path when compared to an economy without bankruptcy and hence borrowing. For the economy as a whole, this utility gain, however, is offset by the effects of a declining average wage, resulting from a smaller aggregate capital stock, as consumers are less inclined to self-insure against income shocks in the presence of the option to default. This hits asset-poor households in the middle of the wealth distribution.

Keywords: default, bankruptcy, Krusell-Smith model, welfare cost of business cycles, precautionary savings, aggregate shocks

Contact: Pascalis Raimondos-Møller