Bankruptcy is vital to capitalism

July 31, 2012

Free Market Foundation

Bankruptcy is an orderly way to give an overburdened debtor a fresh start and to decide which creditors get paid back and which don’t. In good times, bankruptcy is a way to encourage risk-taking. After all, an economy in which everyone fears trying something that might fail is a stagnant one. But the roots of modern American business bankruptcy date to bad times like today, says Wessel:

At the end of the 19th century, nearly 20 per cent of the railroad track belonged to insolvent railroads.

With state governments unable to deal with railroads that stretched beyond their borders, and Congress hamstrung by a narrow interpretation of the Constitution, creditors turned to courts.

Judges fashioned an approach to divvy up assets among creditors that was codified in an 1898 law, the spirit of which survives today.

Consider General Motors and Chrysler, which are 21st century analogs of 19th century railroads, says Wessel. They cannot pay their debts:

The only issue now is how, not whether, their creditors take a hit.

The only difference between GM today and GM in bankruptcy court is that the president and his appointees are making the decisions, instead of a bankruptcy judge constrained by federal law.

Bankruptcy is not a death sentence. Yet, headline-making bankruptcies of several brand-name companies at a moment of severe economic crisis can so undermine confidence in the economy that avoiding them makes sense. But bankruptcy is the only way to prevent mistakes and debts of the past from hobbling an economy’s future, adds Wessel.

Source: David Wessel, Bankruptcy is Vital to Capitalism, Wall Street Journal, April 2, 2009.

For text: http://online.wsj.com/article/SB123860761117578957.html

For more on Economic Issues: http://www.ncpa.org/sub/dpd/index.php?Article_Category=17

FMF Policy Bulletin/ 07 April 2009