Sir Keith Joseph said in 1975 that Britain needed “more millionaires and more bankrupts”. Both are natural consequences of financial risk-taking, something that Britain, then a near-communist country, was seriously short of. By 2003 the matter was not so clear. Having just witnessed the dot-com absurdities, you may have thought that Britain suffered from an excess of entrepreneurialism.

Not new Labour. It was sure we still needed coaxing out of our financial cowardice (recent converts are always the most fervent). If the prospect of financial ruin were not so dreadful, it figured, more people might be willing to risk starting a business. So it changed the law to make personal bankruptcy less painful, reducing its duration from three years to one.

For once a new Labour policy has had its intended effect. Fear of bankruptcy is in fast retreat. The number of personal insolvencies has quadrupled since this legislation came into force, from 30,000 in 2002 to almost as many in the third quarter of 2006 alone. Experts expect 120,000 insolvencies this year. A brilliant success, except for one problem: the number of business start-ups has not increased at all.

The policy need not have failed in vain. If the Government learnt its lesson, it could see where so many of its policies go wrong. It could better appreciate the perils of compulsory insurance.

Bankruptcy limits a debtor’s downside if he defaults. Suppose you default owing your bank £200,000 when your assets are worth only £50,000. By declaring bankruptcy you walk away worthless but debt-free. The bank loses £150,000 and has no claim on your future earnings or the right to sell you into slavery, as the Romans did.

Do not pity the banks. They recover these losses by charging higher rates of interest. Bankruptcy laws mean that borrowers pay a small premium on their interest in return for limiting their losses should they default. In other words they compel borrowers to buy, and lenders to sell, a small amount of credit insurance.

All but insanely confident borrowers will consider this insurance a good deal. Most people dislike carrying even small risks of a nasty outcome, such as irrecoverable financial ruin, and will gladly pay a reasonable price to be rid of it. That is why bankruptcy laws encourage borrowing and the enterprise that depends on it.

This much the Government understood. But from here it seems to have been misled by the idea that you cannot have too much of a good thing. It is not true of chili powder, and it is not true of compulsory insurance either.

Insurers cannot assess risk with perfect accuracy. To a bank, Safe Sam and Risky Ron may seem equally likely to default on their loans. The bank knows their identical incomes, ages, duration of homeownership and so on, but it does not know that Sam is a Presbyterian and that Ron has a gambling problem. So it charges Sam and Ron the same “risk premium” (the average required for borrowers with their known characteristics), even though Sam’s true risk is only a tenth of Ron’s. The bank’s imperfect information means that Safe Sam ends up subsidising Risky Ron.

When the insurance cover is small — that is, when bankruptcy laws are tough on defaulters — the risk premium and cross-subsidy are also small. Sam may neither know nor care that he is paying a little over the odds. But as bankruptcy laws become more forgiving, so the number of defaulters increases. Not only do risky borrowers become more willing to borrow, borrowers generally become riskier. Just as accident insurance causes reckless driving, credit insurance causes reckless spending. Banks’ losses increase, risk premiums increase and the subsidy Sam pays Ron increases. Borrowing becomes a better deal for Ron and a worse deal for Sam.

Extending bankruptcy protection does not universally encourage borrowing and enterprise. Rather, it encourages risky borrowers and entrepreneurs who are likely to fail at the expense of those who would more probably run successful businesses and repay their debts. In short, it perverts the allocation of capital.

In this respect there is nothing special about bankruptcy. Compulsory insurance always causes such perversions. Consider the risky business of reproducing. This increases your family’s running costs. If you lose your job, having children will exacerbate the pain. To protect people against this misfortune, the Government guarantees unemployed parents a certain income. And it funds this protection through taxation.

Yet the tax we pay is not correlated to our chance of becoming unemployed. Quite the reverse. So this insurance is a good deal for those with a high chance of unemployment and a bad deal for everyone else. It creates a cross-subsidy that perverts the “allocation of reproduction”, away from those with a reliable income and the virtues that go with it, and towards those with characteristics conducive of unemployment, such as indolence and stupidity. The cost of this cross-subsidy is not only the growing number of children raised by single parents: up from 6 per cent in 1970 to 24 per cent today. It is also the reduced fertility of responsible couples.

Labour and Conservative governments over the past century have constructed a comprehensive system of compulsory “social insurance”, covering every misfortune that may befall us, from having children we cannot afford to retiring with no savings. The system, they explain, is required by “social justice”, “compassionate conservatism” or some other moral imperative. But subsidising degeneracy by taxing the Protestant virtues is a strange way of promoting morality.





Jamie Whyte is the author of Bad Thoughts: A Guide to Clear Thinking

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