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Working Papers

November 2003, No. 03-14R

Unsecured Debt with Public Insurance: From Bad to Worse (Revised: Nov. 2004)

Kartik B. Athreya and Nicole B. Simpson

In U.S. data, income interruptions, the receipt of public insurance, and the incidence of personal bankruptcy are all closely related.  The central contribution of this paper is to evaluate both bankruptcy protection and public insurance in a unified setting where each program alters incentives in the other.  Specifically, we explicitly allow for distortion created by the default option and public insurance to affect 1) risk-taking, 2) borrowing, and 3) search effort.  Our analysis delivers two striking conclusions.  First, we find that U.S. personal bankruptcy law is an important barrier to allowing the public insurance system to improve welfare.  Second, contrary to popular belief, we find that increases in the generosity of public insurance will lead to more, not less, bankruptcy. 

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