Credit cards, bankruptcy, and agency costs

In the past quarter century, unsecured credit card debt has replaced other kinds of (secured) consumer debt, including retail store credit, personal finance companies, friends and family, and pawnbrokers. The graph above shows an increase in "revolving" consumer debt service (as a percentage of income); and a corresponding decline in "non-revolving" debt service.

Over this time period, the bankruptcy rate has quintupled. Colleague Todd Zywicki (visiting Vanderbilt this semester) intreprets the correlation:

...[credit cards] have increased the incentive for indebted consumers to elect bankruptcy as a response to their financial difficulties, thereby increasing the propensity to file bankruptcy.

In October, 2005, bankruptcy reform made it more difficult for borrowers to walk away from credit card debt if they had the ability to repay. Predictably, the number of bankruptcies fell from 2 million in 2005 to 600,000 in 2006.

Under Zywicki's hypothesis, bankruptcy reform lowered the cost of providing credit to consumers by allowing lenders to better penalize moral hazard (actions that increase the likelihood of default) and better guard against adverse selection (lending to borrowers who intend to default).

Note the parallel of bankruptcy reform to the use of credit history to price car insurance. A better predictor of car insurance allows insurance companies to reduce moral hazard by penalizing bad driving and to reduce adverse selection by raising prices to bad drivers.