Overoptimism and Overborrowing

Brigham Young University Law Review, 2004 by Hynes, Richard M

Abstract: Scholars have long argued that overoptimism causes consumers to overborrow-to borrow more than they would if they accurately perceived the risks they face. Although this argument serves as a central justification for policies designed to reduce consumer borrowing, scholars have not carefully defined overoptimism. This Article demonstrates that the term overoptimism is vague and that different forms of overoptimism yield sharply different implications. Paradoxically, some forms of overoptimism may actually cause consumers to borrow less than they would if they accurately perceived the risks they face. Therefore, generous terms of debt relief that are designed to reduce lending to overly optimistic consumers by making it more difficult for creditors to collect may actually reduce consumer welfare.

I. INTRODUCTION

Bankruptcy and related laws serve as a form of insurance by providing consumers a benefit-debt relief-when they suffer misfortunes that makes repayment difficult or impossible.1 If markets functioned perfectly,2 we would have no need for such laws. Consumers would simply purchase insurance against risks, such as unemployment, that lead to financial distress. The consumer could purchase this insurance from her creditors, either in the form of credit insurance or in the form of explicit limitations on collections, just as she could negotiate any other term of the credit contract with her lender. Yet well-recognized forms of market failure, such as contracting costs,3 asymmetric information,4 externalities,5 or cognitive failure,6 may prevent consumers from purchasing the appropriate level of insurance.7 As a consequence, the government mandates this insurance by enacting laws that limit the ability of creditors to collect their debts.

Laws mandating debt relief restrict the freedom of contract; consumers are not allowed to bargain for lower interest rates or other desirable terms by waiving their right to relief. While most scholars now accept the need for some debt relief,8 some argue that our current laws may unduly raise interest rates or restrict access to credit.9 This argument has little normative appeal for those who believe that lenders are currently too eager to lend. Perhaps in part because of this, our nation's bankruptcy law professors overwhelmingly oppose pending bankruptcy reforms designed to make consumer bankruptcy less generous for many consumers.10 Of course, even an overly eager lender must find consumers willing to borrow, but scholars have long argued that consumers suffer from a host of failings that cause them to succumb to the siren song of easy credit.11 The prescription for this overborrowing has remained roughly constant: provide generous debt relief by limiting the enforcement of contracts so that lenders will restrict consumer access to credit by an appropriate amount.12

Defenders of the freedom of contract have traditionally rejected these claims of consumer failings as unsupported by evidence.13 Over the last few decades, scholars have begun to look to psychology literature to justify their claims of cognitive failure in a variety of contexts.14 Drawing on this literature, bankruptcy scholars argue that consumers utilize various decision heuristics that make them systematically overly optimistic and lead them to borrow too much.13 More frequently, scholars advance a less formal version of this claim: consumers borrow too much because they fail to consider the misfortunes that they will face on the trail of life.16

Although scholars have challenged the claim of systematic overoptimism,17 this Article demurs as to the validity of this claim and asks if, by alleging that consumers are overly optimistic, bankruptcy scholars have stated a case for generous debt relief.18 In brief, the argument that overoptimism implies a need for generous debt relief suffers from the same criticism that has long plagued arguments in favor of paternalistic intervention: the nature of the consumer's irrationality (in this case overoptimism) is not sufficiently defined to support a meaningful policy prescription. Specifically, if the overly optimistic consumer underestimates the likelihood of moderately adverse events, she will in fact borrow too much and the government can improve her welfare by adopting policies that discourage borrowing. If, however, the overly optimistic consumer underestimates the likelihood of severely adverse events, events that would cause her to default even if she borrows a reasonable amount of debt, she will borrow too little, and the government can improve her welfare by adopting policies that encourage borrowing. While the former effect may dominate the latter, no one has shown this empirically. Moreover, this argument is difficult to reconcile with much of the scholarship favoring generous debt relief.19

Part II describes the standard argument for why overoptimism leads to excessive borrowing: consumers underestimate the cost of additional debt because they underestimate how difficult it would be to repay this additional debt if they were to suffer some misfortune. This argument assumes that by incurring additional debt the consumer increases the amount that she must repay after she suffers some misfortune. Part III demonstrates that this assumption is not always true; once the consumer defaults, the amount that she owes will not affect the amount that she must repay. Part IV demonstrates that overoptimism, or the underestimation of the likelihood of adverse events, can lead to either over- or underborrowing and discusses the implications for bankruptcy reform. Part V concludes that until further study can prove that one effect of overoptimism dominates the other, normative arguments for generous debt relief should rely on other forms of alleged market failure.