By Roberta Kwok

When a major recession hits, many consumers have the same thought: cut spending. Around them they see layoffs, plunging house prices, income stagnation, and a shrinking credit supply. Their collective belt-tightening fuels the economy’s downward spiral, leading to even more unemployment.

Paul Goldsmith-Pinkham, an assistant professor of finance at Yale SOM, wondered if debt relief served to stabilize the economy during events such as the Great Recession in the late 2000s. Would the lightened burden allow people to spend more? Perhaps “if we had just forgiven debt, things would have been better off,” he says.

While it was mortgage debt that sparked the financial crisis during the Great Recession, Pinkham’s team decided to investigate unsecured debt—loans such as credit card debt that aren’t tied to specific assets. The researchers found that states with more generous consumer bankruptcy policies suffered less severe local job losses. And they estimated that nationwide, additional debt relief during the recession boosted employment by as much as 2 percent.

“Debt relief plays this important stabilizing role,” says Goldsmith-Pinkham, who collaborated with Adrien Auclert of Stanford University and Will S. Dobbie of Princeton University on the study.


Read the study: “Macroeconomic Effects of Debt Relief: Consumer Bankruptcy Protections in the Great Recession”

Goldsmith-Pinkham notes that the United States offers an unusually generous bankruptcy policy, allowing consumers to wipe out most unsecured debt after giving up assets above an exemption threshold set by each state. “You really get a fresh start,” he says. 

While the bankruptcy system isn’t generally seen as a social insurance program, when Goldsmith-Pinkham and his colleagues compared it to such programs, they found that the amount of unsecured debt discharged through the bankruptcy system was on par with that of unemployment insurance payouts. From 2008 to 2010, the Chapter 7 bankruptcy process allowed more than $263 billion of debt to be discharged, while unemployment insurance payouts reached $319 billion. Since economists think that unemployment insurance stabilizes the economy, it seemed possible that debt forgiveness might do the same.

Debt relief started a “virtuous cycle,” increasing spending, which boosted jobs, which allowed workers in those jobs to spend more, and so on.

To test that hypothesis, the team took advantage of the fact that different states’ bankruptcy laws have varying levels of generosity. When a person files for Chapter 7 bankruptcy, they must surrender assets to a trustee, who sells them and distributes the proceeds to creditors; most remaining debts are then forgiven. But some assets are exempt, meaning that they don’t have to be given to the trustee. For instance, exempt assets could include a certain amount of home equity or savings. Some states allow more exemptions or put higher limits on them, allowing the debtor to keep more assets.

One consequence is that creditors in more generous states know they won’t recover as much money from debtors in arrears, so they’re more likely to write off debts rather than take the trouble to chase down payments. “They may just say, ‘Okay, it’s not worth it,” Goldsmith-Pinkham says.

Not surprisingly, the researchers found that in states with more generous bankruptcy policies, more debt was discharged during the recession. Those debts could have been forgiven either because the person filed for bankruptcy or the creditor wrote off the debt. For every one-standard-deviation increase in bankruptcy policy generosity, an average of $55 more per person was discharged per year from 2008 to 2010. That amount is equivalent to 44% of the total national increase in debt write-downs during the recession.

Next, the researchers examined how debt forgiveness affected employment. They expected that when people were relieved of debts, they would spend some money on local industries. This spending would boost “non-tradable” employment—that is, local jobs such as those at restaurants and retail stores. However, the team didn’t expect to see a difference between states in “tradable” employment. Those jobs are driven largely by national rather than local demand—for instance, positions in the auto or software industries.

The data bore out those expectations. A one-standard-deviation increase in bankruptcy policy generosity was linked to a 0.4-percentage-point increase in local employment. And generosity didn’t appear to affect tradable jobs.

These results revealed only relative differences between states. To figure out the overall effect on the country’s economy, the team developed a model that represented spending, employment, and debt relief. The model suggested that debt relief started a “virtuous cycle,” leading to increasing spending, which boosted tradable jobs, which allowed workers in those jobs to spend more in their local economies, and so on. “There’s this big knock-on effect that we see in the tradables sector,” Goldsmith-Pinkham says. The team estimated that the additional debt write-offs during the recession increased employment by nearly 2% in late 2009.

During a crisis, implementing more uniform, generous bankruptcy policies across the country could help slow the downturn. But this approach comes with downsides. Creditors would likely increase interest rates or lower credit limits, making it harder to borrow money during good economic times.

And the study doesn’t necessarily imply that forgiving more and more debt will continue to yield benefits. Discharging a small amount per person helps the economy because people tend to spend it right away. But if they receive a lot of money, they’re likely to save some. “It has less and less of an impact,” Goldsmith-Pinkham says. “It’s not obvious that we can scale it up dramatically and continue to have impressive knock-on effects.”