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Many good economic policies, such as having profits guide the allocation of resources in an economy, seem absurd the the casual observer. Even Albert Einstein said "production for use ought to replace the production for profit." But of course, Albert was wrong in this instance, and so were many other thoughtful people.

And so when well-known libertarian instapundit, ie a market-oriented person, sees current legislation weakening bankruptcy protection as anti-consumer, I feel obligated to explain why weakening bankruptcy protection helps the little guy.

First, understand that current bankruptcy reform is aimed at those able but unwilling to pay, that is, those who choose to default, as opposed to those forced by circumstances. Chapter 7 erases most debts even when borrowers can pay some of it, and so is subject to temptation. Chapter 13 puts in place a payment plan over 3 to 5 years. The new legislation will still protect those unable to pay, but for those able to pay, it will be harder for them to choose not to: they will have to go to Chapter 13 instead of Chapter 7. Consumers with income below the median for their state would still be exempt, and there are provisions related to medical costs and other exogenous adverse events. Here's the American Banker Association's executive memo.

Costs of lending are always passed on to the consumer. No one is forced to lend (well, there is the Community Reinvestment Act, but that's a quid pro quo, and an exception), so lenders will either pass increased costs along, or withdraw from the highest risk market segments. Making it harder for borrowers to not pay decreases the expected charge-off rate. As a result, the interest rate will decrease and more significantly the availability of credit will increases. For most of you it doesn't matter, because your credit score is so high and the default probability so low (around 0.2%), reducing the recovery rate does not matter. Once the default rate becomes high (between 1 and 20%), the recovery rate is material in the lending calculus. Thus those with lower credit rating, ie the "little guy", will be most affected by changes in the expected charge-off rate (lenders notice the differenc between a 3% and a 6% loss rate). Most of you reading this are good credits, and will be unaffected since your default risk is idiosyncratic and insignificant (lenders do not notice a 0.2% versus a 0.1% loss rate). While it is hard to imagine how someone would be tempted to choose bankruptcy just to save $3000, that's precisely why you and I are a good credit.

Given the stability in the rate of profit over decades and across industries, you can be certain that in the long run all costs are passed on to the consumer. Do you really want honest but poor people to pay for the whims of those who decided to not pay their debts? TINSTAAFL.

This is all very similar to cries for Third World Debt foregiveness. Sure, debt foregiveness helps the poor borrower in the short run, but in the long run those with bad credit are merely encouraged to assume they can default on debts, increasing moral hazard, and lenders become more wary of lending. Borrowing costs for those most in need of capital rise. See this Cato piece describing the the predictability of this folly.

Encouraging the bourgeois value of paying one's debts when one is able is not just good for banks, it's good for borrowers.