In this paper, we develop a normative theory of unsecured consumer credit and personal bankruptcy based on the optimal trade-off between incentives and insurance. First, in order to characterize this trade-off, we solve a dynamic moral hazard problem in which agents' private effort decisions influence the life-cycle profiles of their earnings. We then show how the optimal allocation of individual effort and consumption can be implemented in a market equilibrium in which (i) agents and intermediaries repeatedly trade in secured and unsecured debt instruments, and (ii) agents obtain (restricted) discharge of their unsecured debts in bankruptcy. The structure of this equilibrium and the associated restrictions on debt discharge closely match the main qualitative features of personal credit markets and bankruptcy law that actually exist in the United States.
Our Research Focus: Consumer Finance