Revisiting Hungary's Bankruptcy Episode

We take a retrospective look at Hungary's experiment with a particularly draconian bankruptcy law. For an eighteen-month period in 1992-93, the Hungarian bankruptcy code contained an unusual automatic trigger that required the managers of firms that held overdue debts of any size to any creditor to initiate reorganization or liquidation proceedings to avoid prosecution under the civil code. We analyze the impact of this "legislative shock therapy" on the economy during the period and examine its effects on resource reallocation and institution building. We argue that, although a key motivation for introducing the automatic trigger was to harden the budget constraints of firms, the empirical evidence suggests that hard budget constraints were already being imposed by banks and by other firms, and the effect of the automatic trigger was rather the exacerbation of a credit crunch and disruption of economic activity. We also suggest that other features of the Hungarian bankruptcy framework not connected to the automatic trigger provide the more important lessons. In particular, it is possible to introduce a bankruptcy track in a transition economy that can both transfer control of the firm from management to creditors and maintain the firm as a going concern while restructuring takes place.