A Suggestion of Bankruptcy, Part I

IN A RECENT article entitled “National Bankruptcy,” published in Whiskey & Gunpowder on July 26, 2006, I wrote about the origins of the legal process known as bankruptcy. In the United States, the word “bankruptcy” has a certain legal and social connotation, but its roots go back at least to the commercial dealings in ancient Rome.

What prompted my earlier article was a recent report by a well-regarded economist named Laurence J. Kotlikoff, professor of economics at Boston University. In a study published this summer, professor Kotlikoff concluded that the U.S. government is “bankrupt.” Under professor Kotlikoff’s use of the term, the U.S. government will, within just a few years, be unable to pay its creditors, who are the “current and future generations to whom [the U.S. government] has explicitly or implicitly promised future net payments of various kinds.”

Elsewhere in his article, professor Kotlikoff notes that “Unless the United States (government) moves quickly to fundamentally change and restrain its fiscal behavior, its bankruptcy will become a foregone conclusion.” In short, according to professor Kotlikoff’s analysis, the current debts and future obligations of the U.S. government are virtually unpayable. The implications are politically, and perhaps culturally, catastrophic.

A Gloomy Future

I happen to agree with the criticism of U.S. fiscal and monetary policy that is embodied in professor Kotlikoff’s report, although I should note that I would use the term “insolvent,” instead of “bankrupt,” to describe the national system of accounts. Insolvency is the inability to pay your debts as they come due. One is insolvent when the sum of one’s debts is greater than the sum of the value of all of one’s property, if the property were to be valued at a fair level.

Compared with insolvency, bankruptcy is a specific form of legal process. But whatever you want to call it, the economic future is gloomy for the U.S. federal government, because it owes more than it can ever hope to pay, even if the nation starts to sell off property like Yellowstone Park. By shining his economist’s spotlight on the long-term indebtedness of the U.S. government, professor Kotlikoff is doing us all a good service. He is highlighting the immense level of federal fiscal and monetary liability. Professor Kotlikoff is like the no-nonsense doctor who reads the X-ray, listens to your lungs, and just plain gives you the bad news and tells you to either clean up your act or get your affairs in order, and maybe to do both, because your future is grim.

The gloomy economic future that professor Kotlikoff predicts is, I regret to say, the other side of the coin of the gloomy, post-Peak Oil future that the world will encounter as the global extraction of conventional forms of petroleum soon commences its transition into an irreversible state of decline.

This is all pretty depressing, as many of you have noted in your e-mail to me. And what a mess the national affairs of the U.S. have become. How did we ever get to this point? I suppose someone could write a few books on the subject, but our editor Greg wants only a couple of thousand words. So for today’s article, and in Part II, I want to examine some of the historical record of money and bankruptcy within the U.S. and look for any insight into the cultural influences that brought the nation to the edge of the abyss where we now stand. What is the relationship between U.S. political and social culture, and what has become an unpayable level of debt?

Bankruptcy in the United States

The U.S. Constitution specifically requires that Congress enact a bankruptcy law (Article I, Section 8, Clause 4). Thus, in the U.S. today, bankruptcy is a creature of a federal statute known as the U.S. Bankruptcy Code, with associated rules of procedure.

Bankruptcy in the U.S. is a legal process governed by law and procedure. Thus, no one can be “bankrupt” until a certain set of things happens in a U.S. bankruptcy court. U.S. bankruptcy courts, actually, are possessed of great legal and equitable powers. One crusty old federal judge in Pittsburgh once said to me that a bankruptcy court “can heal the sick, but not raise the dead.” At the level of state courts, one can file a document called a “Suggestion of Bankruptcy” that advises the state court that an entity subject to a legal process in state court jurisdiction has sought the protection of the federal bankruptcy courts. A federal bankruptcy filing will serve to “stay” (or put on “hold”) many other forms of state legal proceedings. Bankruptcy is powerful medicine.

Profound Questions of the Value of Life and Work

Aside from its technical and procedural aspects, bankruptcy is the means by which society balances the need to eliminate or moderate a debtor’s debt with the protection of the creditors to whom the debt is owed. In other words, bankruptcy reflects a critical need of any commercial culture. It is and always has been a form of legally sanctioned “workout” between debtors who cannot afford to pay and creditors who cannot afford to walk away.

Bankruptcy gets into some of the most profound questions of the “value” of life and work in any culture. In this regard, bankruptcy tends to force people to concentrate their minds and to take stock of their complete list of financial dealings. What is, after all, one’s financial plan for life, whether personally or in business form? What property does one own, and what are the claims of others against that property? What is one’s income, and where does the money go? Can you determine someone’s net worth, or otherwise place a valuation on a business or other activity? What is the value of property and any future income stream in the course of a liquidation? By what means can debt be restructured or discharged? What are the equities in all of this? These are timeless questions, as applicable in Colonial America as in the world of the present.

There is a common perception (a misperception, actually) that bankruptcy is a means by which debtors can avoid repaying debts to creditors. This is sometimes the case, but bankruptcy is fundamentally intended to be a means by which creditors can get back from debtors as much as possible of what they are owed. Despite its direct association with personal and business financial failure, an orderly bankruptcy process is a necessary component of any commercial economy.

Another way of viewing it is that the intent of bankruptcy process, and the societal good that it brings, is to foster the growth of commerce and, by implication, to direct people’s behavior toward productive work, and not to promote waste and dissipation of scarce resources or assets.

Bankruptcy works at the microeconomic level, although it has aggregate macroeconomic effects. Ideally, and by means of judicially enforced bankruptcy proceedings, debtors can be made to stop piling up debt for unproductive purposes. Creditors, in turn, can make an informed (one hopes), legally controlled determination to stop extending credit to bad risks. In a world of scarce resources, both material and monetary, the bankruptcy process facilitates the nation’s (if not the world’s) productive capacity elsewhere besides into more bad debt. In a rational economic system, resource inputs will go to the highest and best use. Does it always work this way? Of course not, but that is (or should be) the goal.

Finally, the bankruptcy process is often referred to as providing a means for debtors to obtain a “fresh start.” This is because, in many instances under current law, bankruptcy proceedings can eliminate most, if not all, of the debt that a debtor owes. One can discern, in the roots of the process, a deeply Judeo-Christian focus on faith, hope, and charity. But in the ways of human life, as with the laws of thermodynamics, credits and debits must balance. The debtor’s apparent gain is a creditor’s real loss. So bankruptcy is not always pretty while it works its process. But again, the goal is to get control of the debt and put the brakes on the extension of credit. Stop throwing good money after bad. This is the idea with which we have to work.

A Long Historical Process

What we see today in the U.S. bankruptcy system is the modern end of a long and evolutionary historic process. While the U.S. Constitution specifically required that Congress enact a bankruptcy law, there was no rush to enact such a national system after the final ratification of the Constitution in 1789. In fact, as we will see, the U.S. got along for most of the next century without much in the way of a national system of bankruptcy laws.

During the first session of Congress, in 1790, some legislators of the “Hamiltonian” school of thought, which favored the interests of a “merchant class,” proposed that the U.S. enact a so-called “General System of Bankruptcy in the United States.” But despite a general political agreement on a need for some sort of bankruptcy process, there was strong opposition to any specific national legislation. Many opponents were skeptical, if not downright suspicious, of placing significant powers in the new federal system of governance. Many opponents also argued that before the federal government should set up a nationwide process of discharging debts, the nation should first develop a functioning banking system.

The need for a functioning banking system was rooted in bitter memories of Revolutionary War inflation and the sorry legacy of the worthless “Continental Currency.” This latter item was the fiat paper currency issued during the Revolutionary War. (I wrote about this in an article in Whiskey & Gunpowder published Dec. 7, 2004, entitled “Currency in Colonial America: Then and Now: Making Money in Early America.”)

In the late 1770s, the Revolutionary Congress authorized the issuance of millions of “dollars” worth of Continentals with which to pay for the fight against Great Britain. By the time of the Battle of Yorktown, in 1781, however, the Continentals had become all but worthless. But there was no alternative currency, either. In Colonial America, there was almost no “real” currency in circulation, particularly no significant gold or silver coinage, so the Continentals took on a life of their own. The subsequent use of Continental scrip in the 1780s, left over from the Revolutionary War, led to rampant monetary inflation, which severely handicapped the economic development of the nation. This monetary failure was one of the key factors that undermined the first “American” national political system created by the Articles of Confederation. It followed that, during the decade of the 1790s, absent any federal bankruptcy laws, the individual states maintained their own respective systems of laws about debtor and credit
or relations.

The Act of 1800

The first federal bankruptcy legislation was enacted in 1800. It was intended to protect merchants and creditors who otherwise would have little ability to enforce or collect debts, particularly in courts of different states. The new legislation was decidedly friendly to creditors, with almost no provision for the discharge of debt.

In a new country where money (meaning gold and silver) was scarce and capital in general was hard to come by, there was no hue and cry to pass bankruptcy laws that eased the burden of people to discharge their financial obligations. For most people, and even for people of some financial means, life was damn hard, and there was little margin for loss to deadbeat debtors. Thus, the federal bankruptcy law of 1800 closely resembled the then-current 1732 English bankruptcy laws, which were quite favorable to the interests of creditors.

Under the federal Bankruptcy Act of 1800, only creditors could commence an action against a debtor who had committed an “act of bankruptcy.” (Note the legal conclusion inherent in the definition of the process.) A discharge of debts was granted only after liquidation and distribution of almost all of the debtor’s assets. Also, the court had to determine that there was proof that the debtor had been cooperative, and the debtor had to convince two-thirds of the creditors to agree to the “plan of discharge.” Thus, bankruptcy process could be a tough bullet for a debtor to chew. Still, in an American twist that was a reflection of frontier populism, the law permitted the debtor to receive a small allowance out of the bankruptcy estate, along with modest exemptions such as for Bibles, personal clothing, limited household goods, tools of the trade, and military uniforms. Here was that “fresh start” in a nation with a seemingly boundless Western frontier.

The Bankruptcy Act of 1800 was one of the first “national” acts of legislation, passed during a time when the concept of federalism was still largely undefined. Many commentators viewed the act with suspicion and as an encroachment on the traditional sovereign powers of states. Compounding the bad perception, the new Bankruptcy Act was soon used to obtain the discharge of financial obligations by certain prominent land speculators, among them Robert Morris of western Pennsylvania. This created a public view that the act was being misused. Furthermore, in the first two years of this law’s existence, only small amounts of debt were recovered by creditors. So lacking in political support from the creditor class it was meant to protect, the 1800 act was repealed in 1803, during the presidency of Thomas Jefferson.

Three years from enactment to repeal? This is rather astonishing to the modern mind. In today’s legislative and bureaucratic culture, it would take three years just for some agency to get around to writing the first 10,000 pages of implementing regulations. And almost no law is repealed anymore. But the U.S. was quite a different nation back then. In particular, the key difference between then and now was that money was truly scarce. (Perhaps it still is, but we just do not understand as much about money as our predecessors.) There was simply not much margin within the U.S. economy to permit the issuance and sufferance of bad debt. After this first federal bankruptcy law was repealed, the states went back to administering their own insolvency and bankruptcy laws.

The Act of 1841

It was not until 1841, almost four decades later, that another federal bankruptcy law was passed. This second bankruptcy act was enacted in direct consequence of the economic depression of 1837. For the first time ever, the 1841 act empowered debtors to file bankruptcy on their own, instead of being subject to an involuntary proceeding commenced by the creditors. Again, here was American frontier populism inserting itself into a centuries-old legal process that had its roots in the protection of creditors. As no less a commentator than Alexis de Tocqueville had noted in his book Democracy in America, a nodding respect for the rights of the common man had swept across the fields of American political philosophy. No one could credibly speak against it.

Democracy or no, however, the U.S was still a nation on a gold standard. Money was scarce, and there was only so much of it to go around. Bad debt could instantly throw sand into the gearbox of commerce. The speech of Sen. Daniel Webster, during the debate over the reauthorization of the Second National Bank of the U.S. in 1832, summed up much of the American view toward money in general and was something of a consensus view of bankruptcy:

“A disordered currency is one of the greatest of evils. It wars against industry, frugality, and economy. And it fosters the evil spirits of extravagance and speculation. Of all the contrivances for cheating the laboring classes of mankind, none has been more effectual than that which deludes them with paper money. This is one of the most effectual of inventions to fertilize the rich man’s field by the sweat of the poor man’s brow. Ordinary tyranny, oppression, excessive taxation: These bear lightly the happiness of the mass of the community, compared with fraudulent currencies and robberies committed with depreciated paper.”

“Robberies committed with depreciated paper,” the man said. This was another way of referring to bad debt. In the accepted American view of the time, bad money led to excessive credit. Excessive credit led to bad debt. And bad debt was part and parcel of bad economic policy. It harmed the nation. The accumulation of bad debt was ruinous to the growth of the economy.

For all of these reasons, the 1841 bankruptcy law almost instantly proved to be unsuitable, because it was immediately perceived as being far too debtor friendly. That is, many debtors who had encountered economic misfortune during the 1837 Panic began to use the law to receive discharges from their debts. And many creditors who held bad debt from the 1837 setback received very little in the way of repayment. Legal commentators, editors, and legislators friendly to creditors argued that the 1841 act was outside the intent of the framers of the Constitution. The 1841 law was repealed in 1843, again a remarkably short time for any piece of national legislation. One might discern that neither the nation’s heart nor its political will was favorable toward the chronic debtor class, let alone would countenance the long-term accumulation of unpayable debt.

After the repeal of the second bankruptcy act in 1843, the United States serendipitously experienced a significant economic upturn. There was little demand for a new national bankruptcy bill during this time. State laws regarding collections and workouts seemed to be performing well, and the economy was growing. In particular, within the next decade, the nation experienced an era of economic and territorial growth during and after the war with Mexico.

The U.S. economy actually experienced a sort of gold-backed monetary inflation as the gold from the California Gold Rush of 1849 worked its way east and into the booming economy of pre-Civil War America. Then as now, no one needed to think about bankruptcy when times were good. Why worry when money is jingling in your pocket?

To be continued…

Until we meet again…
Byron W. King
August 31, 2006

The Daily Reckoning