Evaluating Default Policy : The Business Cycle Matters

Legislation dealing with consumer default has consistently struggled with an important trade-off: more debt forgiveness directly benefits households but indirectly makes credit more expensive. Complicating the issue is that part of the risk households face is aggregate risk. This paper asks, "How does aggregate risk affect the consequences of eliminating or restricting default?" I find aggregate risk substantially reduces the welfare benefit of eliminating default, but its effect on restricting default depends crucially on the restrictions in place. In a calibrated general equilibrium life-cycle model, eliminating default results in an ex-ante welfare gain of 1.8% of lifetime consumption in steady state. Once the business cycle — the type of aggregate risk considered in this paper — is added, this gain drops to .5%. With or without aggregate risk, eliminating default greatly expands credit availability; however, when a protracted recession is possible, households use less credit unless they have a default option. While aggregate risk reduces the welfare gain of eliminating default this is not necessarily true for restricting default. A policy that pushes earnings-rich households into partial debt repayment (like a major 2005 reform) generates a gain of 2% with or without the business cycle. Moreover, with the policy instituted, eliminating default produces a welfare loss of .1%, which aggregate risk deepens to 1.5%. The reform improves credit markets while still preserving most of the insurance value of default. A different type of policy that restricts default to only be in recessions or expansions sharply reduces welfare relative to always allowing default (a loss of 1.4%) or never allowing it (a loss of 1.9%). The policy introduces uncertainty that makes credit expensive and keeps households from relying on the default option