Consumer Bankruptcy as Aggregate Demand Management

Abstract

We study the role of consumer default policy in macroeconomic stabilization. Our economy features nominal rigidities, incomplete financial markets, and heterogeneous households with access to unsecured defaultable debt. In addition to its traditional role of balancing the ex-ante cost of credit against the ex-post benefit to defaulters, the optimal bankruptcy code features an aggregate demand management objective. Consumer bankruptcy acts as an automatic stabilizer whenever the average consumption effect of default, or “ACED” (the causal effect of default on consumption, normalized by the level of debt), is larger than the marginal propensity to consume of savers. When entering a recession, the optimal policy is lenient on past debts, but promises to be harsh on future debts to encourage credit supply. We study quantitatively the extent of business cycle amplification under consumer different bankruptcy codes, and the effectiveness of bankruptcy rules that systematically respond to the business cycle. (with Kurt Mitman)