2012/06/24

Debt and Bankruptcy Reform

Several proposals have been offered to deal with such problems as dangerous speculation in derivatives, moral hazard, and "too big to fail", but all of the ones I have seen fall short, and usually wait until insolvency occurs, which is likely to be too late to avoid systemic collapses.

Congress has broad powers under Article I Section 8 Clause 4 of the Constitution for the United States to make "uniform Laws on the subject of Bankruptcies throughout the United States". That clause has been interpreted to apply only to enterprises at the point of actual or imminent insolvency, but the language does not limit it to that, and it is a reasonable interpretation to extend it to cover enterprises or behaviors that are so risky that they pose an unacceptable threat to public safety, so great that if presented by a foreign enemy it would be grounds for war.

One such proposal by Tom Jackson that is being seriously discussed, described in an article by David Rowe, "Chapter 14: using bankruptcy law to solve too-big-to-fail", is to create a new kind of bankruptcy for insolvent financial institutions and brokers that hold or manage assets in excess of $100 billion that would be involuntary, allow a three-day stay on derivatives, and that would be adjudicated by an Article III judge, with a jurisdiction to break up the organization. There is presently a vacancy in the numbers for bankruptcy chapters for a Chapter 14.

I find this a good idea as far as it goes, but waiting for insolvency to occur is waiting too long. Milton Friedman once said in a television interview "I am in favor of free enterprise but not large organizations." The solution to having organizations "too big to fail" is to break them up before they fail, or prevent them from becoming so large in the first place. This is not contrary to having a free market, but necessary to preserve one. A free market is between independent actors, and only works if there are enough actors and new actors can enter the market. When too much of a market is brought under the control of too few actors it ceases to be a market.

The conventional approach to anti-trust is to base it on a theory of "restraint of trade" and regulate or intervene on the alleged authority of the Commerce and Necessary and Proper Clauses, but by original understanding that theory is unconstitutional. Using the Bankruptcy Clause, however, those "too big to fail" can legitimately be broken up to avoid the risk they impose on the rest of us. Restraint of trade should be left to private civil legislation.

My proposal provides for breaking up all very large organizations, not just financial institutions and brokerages, which I define using energy as a measure of value of their holdings or portfolios rather than currency that consists of debt instruments. One exajoule of energy is worth about $23 billion, so four would be $92 billion, close to the proposal of Rowe and others. However, I provide for a period of seven years to conduct the breakups, and extend the process to smaller organizations for the next seven years. Of course those periods may need to be adjusted, but they allow for such organizations to voluntarily divest themselves of holdings in advance of being compelled to do so.

But there is also a threat from herd behavior, where too many can all pursue nearly the same business strategies in ways that cause them to function like large organizations. That can pose as much of a threat, so my proposal provides for intervening to compel them to randomly diversify their business strategies as well. None would be compelled to adopt any particular strategy, only that too many of them not follow the same strategy, and that the diversification be randomized.

"Too big to fail" can, however, also take the form of entire sectors that are overleveraged using debt piled upon debt. For that another solution is needed, so I propose adding a Chapter 16 to the bankruptcy code to periodically retire debts.

The ancient Hebrews had their own constitution, to which ours owes a great deal. One of the provisions of that constitution was the rule of shmita, which required all debts to terminate each sabbath year, called shmita. It also provided for other things, like leaving the land fallow for each shmita year. The practical difficulties of this rule have led to the abandonment of strict observance of it among other than Heredi families within modern Israel, but most of those difficulties could be avoided if it was practiced by everyone, Jews and Gentiles alike.

My proposal does not apply to existing debts, only those going forward. However, it does apply to debt-based instruments like fiat currency. It makes an exception for real estate mortgages, but would require new ones to also be retired every fourth shmita year, or 28 years total.

My proposal is set forth in a proposed bill in Congress, the Debt and Bankruptcy Reform Act. Of course one could not expect Congress to pass it, or the President to sign it. It would likely get anyone who introduced it assassinated. But after global economic collapse it may acquire some legs. Until then we can only prepare what we will need then.

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