Ebook Financial distress, bankruptcy law and the business cycle
The interrelations between financial distress, bankruptcy law and macroeconomic fluctuations are capturing growing interest among policy makers and academics alike. For example, [13] in his analysis of the Asian Crisis argues that policy makers failed to understand these interrelations, and as a result implemented policies that exacerbated the crisis. It is implied that macroeconomic effects should be taken into consideration when bankruptcy law is designed, and that bankruptcy and distress should be taken into consideration when macroeconomic policy is implemented.
Several authors have noticed the importance of the general equilibrium implications of financial distress in the context of the ongoing debate on bankruptcy law. This debate has centered on the social desirability of soft laws, such as US’ Chapter 11, that give borrowers an opportunity to reorganize, or hard laws, like the UK Bankruptcy Code, which is essentially a procedure for the enforcement of default-contingent liquidation rights. In particular, [12] argue that once we take into consideration the “general equilibrium aspects of asset-sales ... [particularly when] the shock that causes the seller’s distress is industry or economy-wide ... the policy of automatic auctions for the assets of distressed firms, without the possibility of Chapter 11 protection, is not theoretically sound.” This suggests that, once the macroeconomic effects are considered, the merits of a soft bankruptcy law would be evident.
In this paper we offer an explicitly dynamic, general equilibrium analysis of bankruptcy law in its relation with financial distress, asset sales, and macroeconomic fluctuations. We compare the possibility of softening bankruptcy law to alternative stabilization policies such as bail-outs or an active interest-rate policy (which one might interpret as monetary policy). To keep things analytically tractable, we model bankruptcy law in a framework similar to [14]. An important characteristic of this framework is that macroeconomic fluctuations are generated endogenously, through a (deterministic) mechanism entirely due to agency problems between lenders and borrowers. In the current model, even without any external shock, the dynamics of debt accumulation and asset liquidation can push the economy from boom to bust and vice-versa; crucially, the rationality of expectations is maintained throughout.
A central element in the analysis is the contractual relationship between borrowers and lenders. We follow [8] in that debt is enforced under a threat of liquidation, and viable projects may be liquidated as a result of the agency problem between the lender and the borrower. This framework allows two simple formalizations of a softening in bankruptcy law: either an increase in the borrower’s bargaining power or an increase in the systematic ‘dilution’ of lenders’ liquidation rights by courts. We analyze both formalizations.
We obtain four main results. First, as noted above, it is possible to construct an equilibrium where the dynamics of debt, financial distress, and asset liquidation are the sole forces behind economic fluctuations. During a boom, high prices of capital goods push new business into high levels of debt and collateral. Those of them which fall into financial distress will have to liquidate assets, which will depress the prices (and production) of new capital goods and push the economy into a bust. However, the low prices of capital goods during the bust will create a favorable environment for new businesses, which will be able to start-up with low levels of debt and collateral, will be less vulnerable to financial distress, and will push the economy back into a boom. Some recent empirical results corroborate the idea that industry busts create opportunities for financially unconstrained firms.
Second, softening bankruptcy law is not a socially desirable policy. The unanticipated enactment of a softer bankruptcy law would produce a temporary debt relief (through renegotiations that would favor the borrowers) and, thus, a temporary reduction in the amount of liquidations, perhaps smoothing the immediate bust if the timing is right. However, in later periods, as lenders would rationally foresee how a softer law erodes their bargaining position or dilutes their nominal liquidation rights, they would demand larger collateralization of their debt, so as to guarantee that their participation constraints are satisfied. In some cases, the new law may lead to even larger liquidations during busts, increasing the amplitude of business fluctuations. Although we do not have an explicit political-economy analysis, these results suggest that soft bankruptcy laws may be enacted by myopic legislators who are willing to use bankruptcy law to accelerate the recovery from economic recession at the expense of long-term stability.
Third, contrary to what the previous finding might suggest, rational expectations do not make all possible policies ineffective. In fact, alternative stabilizing policies, such as bail-outs (during the bust) or an active interest-rate policy (directed to decrease interest charges during busts) may have an endurable stabilizing effect. The crucial difference between these policies and a softening in bankruptcy law is that the former systematically transfer wealth from the less to the more financially constrained, while the latter provokes a purely transitory relief and then leads to contract adjustments that, if anything, make things worse for cyclicality.
Fourth, we show that long-term equilibria are constrained Pareto efficient but, under some stabilizing policies, the gains of winners, who happen to be the most financially constrained, exceed the losses of the losers (where gains and losses are partly due to lower and greater amounts of asset liquidation). Hence, over the cycle, financial frictions can be diminished, at a gain in terms of overall expected income.
The rest of the paper is organized as follows. Section 2 presents the model. Section 3 considers the benchmark economy without financial frictions. Section 4 characterizes the equilibrium debt contract. Section 5 discusses the existence of a competitive rational-expectations equilibrium. In Section 6 we analyze the effects of softening bankruptcy law, while in Section 7 we examine the effect of other stabilizing policies. The welfare analysis is in Section 8 and the conclusions in Section 9.
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