In the spring of 2020, as the Covid-19 pandemic shut down economies around the world, pressure arose for governments to respond to the growing threat of pandemic-related market distress. In the United States, the initial proposals for government action varied in nature and focus. Some proposals targeted the financial system while a few targeted small businesses and individuals. Others were intended to bail out large businesses and specific industries. Still other proposals took a more institutional focus. In the context of bankruptcy law, many experts imagined building up the bankruptcy system as a primary bulwark against a seemingly imminent wave of economic and financial distress.

With the exception of measures related to financial markets, the actual responses formed a chaotic mix of disconnected half-measures that neither stabilized the economy nor provided meaningful relief to those most affected. While that failure may be attributed in part to general government dysfunction and legislative gridlock, a large part of the problem arises from the lack of a clearly identified framework to guide government responses.

The main lesson here is that the appropriateness of tools deployed to alleviate a crisis depends on the nature of the problem at hand, and scattershot approaches are unlikely to work. As obvious as that principle may seem, it was largely ignored in 2020. Much of the confusion in the pandemic responses is attributable to attempts to use the wrong tools and from implementation of measures that lacked any clear purpose.

In particular, governments and commentators lost sight of two important distinctions in deciding how to act. First is the distinction between tools appropriate for addressing economic distress and those appropriate for addressing financial distress. Second is the distinction between a systemic crisis where distress is spreading and an instance of firm-specific distress where the harm – though perhaps large – is contained.

These distinctions present four types of market distress: specific economic, systemic economic, specific financial, and systemic financial. Each type is distinct from the others, and for each there is a category of appropriate government responses (respectively): direct subsidies, general stimulus, bankruptcy proceedings, and financial bailouts. We thus have this matrix:

The importance of understanding these classifications is most evident in the flawed proposals for pandemic-related fixes to bankruptcy law and in the lack of a centralized economic plan to support failing small businesses around the country.

In a new article, I layout this framework for identifying the right tools for responding to different forms of market distress.  I describe the relationship between the category of tools and the type of distress. Having presented the framework, I then use it to closely examine the interaction between pandemic responses and bankruptcy law. This analysis is particularly important because the bankruptcy system’s role in a systemic crisis provides the starkest example of confused analysis during the pandemic and because a striking decline in bankruptcy filings in 2020 has puzzled many commentators.

Bankruptcy law is a system of proceedings designed to alleviate the problem of firm-specific financial distress. Before the pandemic, this was an uncontroversial view. Its importance for crisis policy lies in its negative corollary. Bankruptcy law is not a tool for solving economic distress. It cannot pay future bills. Nor can it create new demand. If a restaurant has no customers, the bankruptcy process will not create new revenue to pay employees or make rent.

This is evident in the fact that many small businesses that try to use bankruptcy to save their business fail and end up liquidating. Moreover, most economically failing firms do not even bother with the process. It is not so surprising then that small business bankruptcy filings have decreased since the pandemic began. When faced with economic distress, small firms will either fail or survive. Some have already failed and skipped the bankruptcy process because it had nothing to offer them.

On the other hand, large firm filings have increased. Again, this is not surprising. For these firms, economic distress is temporary. It will consume assets and equity value, but the bulk of their assets will still be available when the pandemic eases. A small restaurant’s creditors may liquidate its assets while a large airline’s creditors might downsize by selling a few airplanes and then take ownership of the remaining firm, keeping the bulk of assets together. The airline resolves its financial distress by shifting ownership to creditors in a bankruptcy proceeding whereas the small restaurant ceases operation.

Similarly, bankruptcy law is a particularly bad tool for any form of systemic distress. When distress is spreading through the system, looking for a solution in a decentralized process makes little sense. Bankruptcy law provides a case-by-case system where each judge is focused on one debtor. That judge lacks systemic information and is not in a position to collect policy input on the state of systemic financial markets.

Despite these fairly uncontroversial principles, experts spent much of last year looking to bankruptcy law for a systemic solution. Part of the story is that we – bankruptcy lawyers and scholars – had lost sight for a moment of the real limitations of corporate bankruptcy and the distinction between financial and economic distress. While bankruptcy law does have a role to play, it is a role in addressing the individual financial stress of large firms. But the appropriate remedy for an individual firm is different from the appropriate remedy for the system as a whole. To use an analogy to public health, bankruptcy proceedings are like a doctor’s actions in treating an individual patient. While they are crucial to resolving that patient’s issues, they can do little to address the danger throughout the community. Just as a public health crisis requires coordinated systemic action and not ad hoc individual treatments, a systemic crisis requires a coordinated systemic response. The bankruptcy system does not provide that response.

This post comes to us from Professor Anthony J. Casey at the University of Chicago Law School. It is based on his recent article, “Bankruptcy & Bailouts; Subsidies & Stimulus: The Government Toolset for Responding to Market Distress, available here.