This is a slightly edited version of an article originally published in the September 2000 issue of Economic Affairs, the journal of the Institute of Economic Affairs, London. The pdf of the article can be downloaded by clicking the image on the right, and that issue of the journal can be ordered directly from the IEA.
Deregulation of western economies and the freer operation of self-
I believe that many of these problems persist because they are tackled in ways that do not stimulate or reward self-
Social Policy Bonds
My proposal is that a new financial instrument be created that rewards people only when they actually achieve targeted social goals. Social Policy Bonds (SPBs) would be issued by local or national government and auctioned to the highest bidders. Government would undertake to redeem these bonds for a fixed sum only when a specified social objective has been achieved. The bonds would be freely tradeable after issue, and their market value would rise and fall. With an uncertain redemption date, and because they would not bear interest, SPBs would be quite different from conventional government bonds.
What sort of social problems can SPBs solve? In principle, any that can be reliably defined and quantified. Key criteria for policy areas within which SPBs would show the most marked improvement over current programmes are:
there is no obvious, single way of achieving the desired outcome,
existing policies have objectives that are unstated, uncosted, obscure or conflicting, and
financial rewards to those involved in achieving objectives are uncorrelated to their effectiveness in doing so.
Unfortunately there are many such policy areas, including:
Air, water or noise pollution
Violent political conflict (war and civil war)
How would the bonds work? They would create a group of people, bondholders, who have a strong interest in achieving the targeted social objective efficiently, or in paying others to do so. Consider an example. Assume that an urban authority is prepared to spend a maximum of say £10 million to reduce the crime rate within its borders by 50%. It issues one million bonds that become worth £10 when the crime rate falls below 50% of current levels for a sustained period -
Who would buy the bonds?
Many people would purchase these bonds with the idea of holding on to them until they could sell them at a profit. These passive investors would have no intention of doing anything to reduce crime. They would want to become 'free-
Consider some of the measures that bondholders could put into operation:
encouraging neighbourhood watch schemes;
encouraging parents to monitor their children's activity more closely;
subsidising recruitment of unemployed workers;
complementing police patrols with private security patrols; or
subsidising widespread use of window locks or burglar alarms.
Many of these activities are, to some extent, undertaken by local bodies or some arm of government nowadays. The crucial difference is that, under a Social Policy Bond regime, people have incentives to seek out and develop those ways of reducing crime that are most cost effective. A police force, a bureaucracy, or an environmental health department, however well-
Of course, the bondholders need not participate directly in any crime reduction projects. Their role could be one of financing such projects, on the strength of the redemption value of their bonds, or on the strength of any increase in the value of their bonds. Their motivation arises from the anticipated supernormal profit arising from early redemption of the bonds.
Trading the bonds
Social Policy Bonds, once issued and sold, must be readily tradeable at any time until redemption. This is critical to the operation of the SPB mechanism. Many bond purchasers will want, or need, to sell their bonds before redemption -
But there is another important reason for requiring a healthy secondary market in the bonds: active investors may be able to speed up only one, or a few, of the processes necessary for the targeted objective to be achieved. Once these investors have contributed what they can, and seen the capital value of their bonds in line with the increased probability of the bonds' early redemption, they may have no wish to speculate on the speed at which the remaining processes will be carried out. Other groups of active investors, who will have greater expertise in performing these later processes, must be given an incentive to use their expertise to accelerate attainment of the targeted objective. The possible capital appreciation of bonds bought from previous owners and sold at a still higher price [or redeemed] provides this incentive. The new owners will, if they are successful in these later stages, realise this capital appreciation.
Bonds therefore could therefore flow towards those who are most able to help solve the targeted social problem. In fact, though, it is not necessary for there to be any actual flow of bonds. Large bondholders might simply decide to subcontract out the required work to many different agents, while they themselves hold the bonds from issue to redemption. The important point is that the bond mechanism ensures that the people who allocate the finance have an incentive to allocate their finance efficiently and to reward successful outcomes, rather than merely to pay people for undertaking an activity. At the limit we can conceive of just one single buyer of all the bonds. If this buyer were determined to hold on to the bonds until redemption, then the bonds would function as a sort of performance-
Too large a number of small bondholders would probably do little to help solve certain targeted social problems by themselves. It is likely then that the value of their bonds would fall until there were aggregation of holdings by people or institutions large enough to initiate effective problem-
Definition and operation
For the Social Policy Bond regime to be effective, the targeted objective must be carefully defined, so that its achievement correlates strongly with what society wants to achieve. For instance, numbers of reported crimes could be targeted, if the objective is to achieve a safer urban environment. But this indicator may be unsatisfactory if, for instance, the crime rate becomes so high that people don't bother to report minor assaults or burglaries to the police. A more appropriate indicator might be derived from responses to victim surveys. Remember also that the objective will be a sustained lower level of crime.
Once an objective is close to achievement, the issuing body can float a new set of SPBs aimed at maintaining the achieved outcome, or at further improvements. The benefit per unit outlay of a second bond issue is likely to be higher than that of the first issue because, during the lifetime of the first issue, people would have probably developed more efficient methods and systems for solving the targeted social problem.
Advantages of a Social Policy Bond regime
The main advantage of Social Policy Bonds is that, by injecting self-
Government and markets
Government spending in Britain today amounts to about 42 per cent of Gross Domestic Product. Much of the debate about this spending economic theory, and on all the evidence, markets are the best way of allocating scarce resources to achieve prescribed ends. Social Policy Bonds would allow both governments and markets to do what each is best at doing -