US economy recovers faster due to kinder bankruptcy laws

Posted 24 July 2014 Written by Daniel Gros
Category Insolvency

The US pulled out of recession more rapidly than Europe due in part to improved consumer spending. This in turn was due in no small part to more kinder bankruptcy rules, such as no-recourse mortgages in some states and the ability of insolvents to get back on their feet within months rather than years, writes Daniel Gros in Business Day.

The global financial crisis that erupted in full force in 2008 affected Europe and the US in a very similar way — at least at the start. On both sides of the Atlantic, economic performance tanked in 2009 and started to recover in 2010.

But, as the financial crisis mutated into the euro crisis, an economic gulf opened between the US and the eurozone. Over the last three years (2011-13), the US economy grew by about six percentage points more. Even taking into account the increasing demographic differential, which now amounts to about half a percentage point per year, the US economy has grown by about 4.5 percentage points more over these three years on a per capita basis.

The main reason for the gap is the difference in private consumption, which grew in the US but fell in the European Union (EU), especially in its periphery. A retrenchment of public consumption actually subtracted more demand in the US (0.8 percentage points) than in the EU (0.1 points). This might appear to be somewhat surprising in light of all of the talk about Brussels-imposed austerity.

In fact, public consumption in the eurozone has de facto remained fairly constant over the last three years, whereas it has declined substantially in the US. The same is true of public investment, though this constitutes such a small proportion of gross domestic product (GDP) that transatlantic differences could not have had a large effect on growth over a three-year horizon.

The contraction of private investment in Europe accounts for only a small part (one-third) of the growth gap.

Though the financial market tensions that accompanied the euro crisis had a strong negative effect on investment in the eurozone periphery, investment demand has also remained weak in the US, minimising the overall difference.

The resilience of private consumption in the US, the key to the growth gap, is not surprising given that American households have reduced their debt burden considerably from the peak of more than 90% of GDP reached just before the crisis. The lower debt burden is also a key reason why consumption is expected to continue to grow much faster in the US than in the eurozone this year and next.

But the crucial question, and one that is rarely asked, is how US households were able to reduce their debt burden during a period of high unemployment and almost no wage gains while sustaining consumption growth. The answer lies in a combination of "no recourse" mortgages and fast bankruptcy procedures.

Millions of American homes that were purchased with subprime mortgages have been foreclosed in recent years, forcing their owners, unable to service their debt, to leave. But, as a result of no-recourse mortgages in many US states, the entire mortgage debt was then extinguished, even if the value of the home was too low to cover the balance still due.

Moreover, even in those states where there is full recourse, so that the homeowner remains liable for the full amount of the mortgage loan (that is, the difference between the balance due and the value recovered by selling the home), America’s procedures for personal bankruptcy offer a relatively quick solution. Millions of Americans have filed for personal bankruptcy since 2008, thereby extinguishing their personal debt. The same applies to hundreds of thousands of small businesses.

Of course, there has also been a surge of bankruptcies in the eurozone’s periphery. But in countries such as Italy, Spain, and Greece, the length of a bankruptcy proceeding is measured in years, not months or weeks, as in the US. Moreover, in most of continental Europe a person can be discharged of his or her debt only after a lengthy period, often five to seven years, during which almost all income must be devoted to debt service.

In the US, by contrast, the corresponding period lasts less than one year in most cases. Moreover, the terms of discharge tend to be much stricter in Europe. An extreme case is Spain, where mortgage debt is never extinguished, not even after a personal bankruptcy.

This key difference between the US and Europe explains the resilience of the US economy during the collapse of its credit boom. The excessive debt accumulated by households has been worked off much more rapidly; and, once losses have been recognised, people can start again.

Read rest of article.


The views expressed herein are those of the author and do not necessarily reflect those of Acts Online. Acts Online accepts no responsibility for the accuracy, completeness or fairness of the article, nor does the information contained herein constitute advice, legal or otherwise.