Bankruptcy Law, Bonded Labor and Inequality

Should the law restrict liability of defaulting borrowers? We abstract from possible benefits arising from limited rationality or risk-aversion of borrowers, contractual incompleteness, or lender moral hazard. We focus instead on general equilibrium implications of liability rules with moral hazard among borrowers with varying wealth. If lenders are on the short side of the market, weakening liability rules lower lender profits, may cause additional exclusion among the poor, but generate additional rents for wealthier borrowers. For certain changes in liability rules (such as a ban on bonded labor, or weakening bankruptcy rules below a wealth threshold) they also raise productivity among borrowers of intermediate wealth. Hence they can be interpreted as a form of efficiency-enhancing redistribution from lenders and poor borrowers to middle class borrowers. Our model provides a possible rationale for why weaker liability rules are observed in wealthier countries.