The Economy: 14. Bankruptcy and Insolvency

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Welcome to Understand the Economy, the podcast that takes you back to basics to explore and explain how economics affects our everyday lives.

And today's topic is at the very sharp end of exactly that.

We're taking a look at bankruptcy.

It's not much fun for the individual, but what impact does it have on the economy and on everybody else?

I'm Felicity Hanna, and you don't need an economics podcast to tell you that times are tough just now.

The cost of living crisis is putting more pressure on more people.

But what happens when that pressure becomes too much?

If you owe money and you can't repay it, you may have fantasised about wiping the slate clean and becoming debt-free.

And that is what bankruptcy does.

Although it's not a very easy process to go through and it has a huge impact on your life.

It's not even cheap.

You might be surprised to hear that it costs £680 to declare yourself bankrupt.

But it's not just people.

Businesses are struggling as well.

So what happens if my imaginary company, Fliss's Fruity Jam, becomes insolvent?

What happens if a person or business doesn't pay the money they owe?

And are these simply distressing personal stories or do they have a wider impact on everyone?

Here to explain all is Professor Diane Coyle, the Bennett Professor of Public Policy at the University of Cambridge.

Diane, thank you for joining us.

It's my pleasure.

Hello.

Hello, let's strip this right back to basics.

What is bankruptcy?

It's a legal process that individuals and small traders can go through where the money they have coming in is consistently less than the money that they have to pay out.

So they've gone into debt to try to cope and then that becomes too much.

And so you can then go through this process, declare yourself bankrupt, and the debts are wiped out, but you then have a different kind of problem to face up to in the future.

What's the different type of problem to face up to in the future?

It's restrictions on what you can do in terms of borrowing again.

For example, your credit score is going to go down, and then it's even much harder to borrow because your credit score's gone down.

And if you can borrow at all, your interest rate goes up.

That's going to make things worse.

And we should say as well, shouldn't we?

It's slightly different in Scotland.

It's sequestration.

Scotland has a different legal system.

It's a different term, isn't it?

Not bankruptcy.

It's a different term for businesses.

Businesses, it's called insolvency, and the legal process is different.

And there isn't the same opportunity for wiping the slate clean of debts in the same way.

But the basic story is the same.

Now, I actually looked up the origin of these words because they're not usual words.

I bankrupt, I found, comes from Italy, and it means broken bench.

That's when moneylenders who worked from benches, if they couldn't pay their own debts, their bench would be broken.

And then insolvent was it wasn't as much fun, truthfully.

It was just Latin for not paying.

The first is much more graphic, isn't it?

Yes.

Now, there are two types of insolvency for business: are there balance sheet insolvency and cash flow insolvency?

Can you explain those?

Cash flow is: you look at a certain period of time, it could be a month or a year,

and you're looking at how much cash is coming into the bank account and going out of the bank account.

And that will be quite volatile for most businesses.

You know, if you're selling your imaginary jam, maybe that will sell better, or you'll have more stocks to sell after the autumn when you've made all the jam.

And so, cash flow matters for a business.

But in terms of their long-term viability, you'd look at their balance sheet as well.

And that's what assets do they have that they could either use to make more revenues in future or they could sell if they have to.

Do you have a nice building?

And if you need to cut costs, you could sell that building and move into a cheaper location.

And investors, for example, or lenders will often overlook short-term problems for a while if they can see that there's a strong balance sheet.

Okay, so cash flow insolvency.

My jam business owes £5,000 for fruit.

I've got £5,000 worth of jam, but I can't sell it in time.

I go out of business.

Balance sheet insolvency, my liabilities just far exceed my assets.

So my jam company owes £5,000.

I've only got product and kit worth £500.

I'm insolvent.

Exactly.

It's not automatically bad for a business to get into debt.

No, indeed, many businesses have debt, and they would go into debt or alternatively raise money in the stock market if they're a big company.

But you need the money to invest because that's how you're going to make your revenues in future.

There are tax advantages in taking on debt as opposed to doing it in any other way.

So it's standard.

Okay, the Office for National Statistics does keep an eye on how many of us, individuals and businesses, are defaulting on our debts completely.

How do they measure that?

Darren Morgan is Director of Economic Statistics, Analysis and Production at the Office for National Statistics.

Here's what he said.

In England and Wales together, more than 20,000 businesses went insolvent in the first 11 months of 2022 as businesses continue to grapple with economic headwinds.

And that is 60% higher compared with the same period in 2021.

And this is actually in contrast with the situation during the pandemic when government support measures helped keep a lid on insolvencies.

And looking a bit further afield, it's the highest since the financial crisis in 2009.

Diane, why is it important to keep track of the number of bankruptcies and insolvencies?

Well, it's a useful temperature gauge for the economy.

Bankruptcy is a very immediate sign of what's happening around the country in different sectors of the economy.

It's a signal of might the economy be going into recession or not.

And it's a good canary in the cage, if you like, for what might be happening to the economy as a whole.

It's time for a bit of history.

Here's Dr.

Victoria Bateman of Cambridge University.

In the 16th century, when Henry VIII was on the throne and European ships were beginning to traverse the globe, more and more people were getting involved in buying and selling.

Everything from ale to cloth.

Some businesses kept their head above water, or if they were lucky, even made a small fortune.

But others found themselves increasingly in debt.

Unsurprisingly, those who were owed money wanted action.

So in 1542, Henry VIII introduced the Statute of Bankrupts, and this gave the authorities permission to forcibly remove the property of anyone who'd fallen into sizable debt and who was unable or refused to repay.

Anything they owned, from their home to their spoons and their harpsichord, could be auctioned off, with the proceeds being divided up between those who were owed money.

For those who were actually in debt, then this, of course, was a very traumatic process, especially since the 1542 Act also gave the authorities the ability to physically imprison them.

Professor Diane Coyle, debtors prison.

It's quite a shocking idea.

It's not what happens now.

I mean, obviously, we've got bailiffs, we've got the possibility for lenders to enforce the sale of some of people's assets.

So if you declare bankruptcy, that will happen.

People will look at the assets that you have available and can they be sold off to cover some of the debts?

I was surprised to see that you can still technically go to prison for not paying certain debts like council tax or criminal fines.

It's incredibly rare, but it can happen.

When you look at the wider economy, are there any economic benefits to having bankruptcy and insolvency as an option, as something that's spelled out and happens in this particular way?

Obviously, it's not good for people to be going bankrupt.

It's not good for an economy to have a recession.

But there is one small silver lining, which is that it does mean that the average level of productivity and profit in the rest of the economy goes up.

Why?

Well, it's taking out the lowest performers, so the average goes up.

It's just as simple as that.

Oh, it's cold, Diane.

It's cold, isn't it, talking about people's businesses and livelihoods this way.

That's economics for you, I'm afraid.

And one of the reasons that productivity is thought to be quite low in the UK at the moment is that both the financial crisis and the pandemic saw businesses that might otherwise have gone under being saved by the bans about loan schemes and so on.

And so they're called zombie companies in the economics literature.

They're managing to struggle on, but they're not really as productive and innovative as we might like.

So they're sort of lurching forwards, not quite dead, but definitely not alive.

Again, that's a pretty harsh way to think about it, especially for all the individuals involved and the ones that are struggling on, but that's the way it works.

Okay, so productivity rises when some companies go bankrupt.

If we're staying with our cold and calculating economist hats on, it's a bit like weeding a garden then to pull out the plants that are maybe blocking the others from thriving.

That's a very nice analogy because you want to get rid of the weeds and when you do, what's left there looks much nicer and healthier.

But on the other hand, you'd rather have the garden environment be such that you've carefully tended it and you don't have so many weeds growing in the first place.

I'm going to go into business with you, Diane.

I think that you could be what Fliss's fruity jam needs to progress to the next level.

Like you say, bankruptcy does provide a number of protections.

Is that important?

Does that help our economy if it's safer for people to take risks and use debts?

There's a kind of of Goldilocks level of risk-taking.

Obviously, if nobody took risks, we'd never have any new products or innovations, and that's what transforms people's lives for the better over the long term.

But we don't want too much of it because those are going to be risks that just are never going to work out.

So, the balance between the risk and the return has to be the right one.

We want a little bit of risk, but not too much.

So, just like Goldilocks and the porridge.

Not too hot and not too cold.

If people are not paying their debts, if you go bankrupt or if a company goes insolvent, insolvent, some of the debts might be repaid by selling assets or seizing income.

But a lot of those debts, as you said, get written off.

That must be bad for someone.

What happens to those debts?

The burden of that is borne by the lender, be it a credit card company or a bank or somebody else.

So when they are setting the interest rate they charge everybody, they will look at how risky they think that loan is going to be and set the interest rate accordingly.

If they have a high level of default on what they've lent to people previously, they're going to charge more in interest to cover those losses.

So it does have an effect on everybody else and it's one of the reasons for keeping the overall level of bankruptcy down.

When it comes to business, is there a risk of a domino effect?

Because it might not be a lender that my business owes money to.

It might be the company that makes my jam jars.

Absolutely can cascade like that, particularly for small businesses supplying other companies.

They send whatever it is they're providing your jam jars and don't get paid for that.

Very hard for them to then recover that debt from the jam maker who's not paid them.

There is often, isn't there, particularly for individuals rather than businesses, there is shame attached to the notion of going bankrupt.

It's almost like it's a moral failing.

Why do you think that is?

Well, people do feel that money is a moral issue, actually.

We economists talk about it in very cold terms, as you've pointed out.

But it used to be the case that people felt a moral shame about going into debt at all, never mind going bankrupt.

But there have always been this morally weighted, value-laden discussion about people's relationship with money because that's about people's relationships with other people, really.

How do you fit into your society?

And do you discharge your responsibilities?

And I was thinking, particularly with the term bankrupt, the only real other time you use that is in the phrase morally bankrupt.

So it does suggest there is this sort of hangover of, well, morality pinned to it.

Now, a lot of people listening, they will never, I hope, personally experience bankruptcy, but can you summarise how it might affect them?

What the economic consequences are for all of us?

It's a much bigger deal for the individual than for all of us.

For all of us, maybe the interest rate that the rest of us pay goes up a tiny bit if we borrow some money.

Maybe because there are people who are very constrained in what they can spend afterwards, the economy does a little bit less well than otherwise it would.

But it's really an individual tragedy.

And I think that individual story is more important than the broad economic story.

Professor Diane Coyle, thank you very much.

So, too many bankruptcies is a sign of a struggling economy, but if we have the right number, it can be like pruning or weeding a garden to make the whole thing healthier.

And while that might be good for the garden in general, it's always going to be pretty unpleasant for the individual leaves.

And speaking of unpleasant, no one is enjoying energy bills just now.

So, next time, we'll be understanding the price of gas and electricity.

Remember to subscribe to our podcast Understand the Economy.

It's available now on BBC Sounds.

Understand the Economy was presented by me, Felicity Hanna, produced by Louise Clark Robotham.

The researcher is Beth Ashmead Latham and the editor is Claire Fordham.

It was mixed by Nikki Oppens.

With the Wealthfront Cash Account, you can earn 4% annual percentage yield from partner banks on your cash until you're ready to invest.

The cash account grows your money with no account maintenance fees and free instant withdrawals whenever you need it.

Money works better here.

Go to Wealthfront.com to start saving and investing today.

Cash account offered by Wealthfront Brokerage LLC member FINRA SIPC.

Wealthfront is not a bank.

The APY on cash deposits as of December 27, 2024 is representative, subject to change and requires no minimum.

Funds in the cash account are swept to partner banks where they earn the variable APY.

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