How Social Policy Bonds minimise costs

Issuers of Social Policy Bonds would have to know the maximum they are prepared to pay to achieve an objective, but they would not have to calculate how much the actual cost would be with any accuracy. That would be done by bidders for the bonds in the open market. For example: say a city government targets a 50 per cent reduction in its crime rate, and it issues one million 'Crime Reduction Bonds' each of redemption value $10.00. If the market decided that the issue value of these bonds were $1.00, the net cost to the issuers of achieving the targeted objective (ignoring administration costs) would be $9 million. In other words, the market at the time of issue believes that the cost, including its profit margin, of achieving the objective would be $9 million.

Now suppose the bond issuers are completely in the dark about how much it will cost to achieve a targeted objective and instead of issuing one million bonds they issue ten million with the same redemption value, $10.00. They would then be liable for a maximum cost of $100 million. However, the market would still reckon that it could achieve the objective for around $9 million. So instead of valuing the bonds at $1.00 competition between potential investors would bid up the issue price of the bonds to around $9.10. (Social Policy Bonds would be an unusual financial instrument, in that the more that were issued, the higher would be their value!) The issuers therefore would not have to estimate with any accuracy how much a targeted objective might cost to achieve, and they would put a cap on their total liability by limiting the number of bonds issued.

So the Social Policy Bond mechanism ensures that the market, which means people other than a handful of government employees, would decide roughly how much it will cost to reach a specified social outcome. They would do this when they bid for the bonds at issue and at all times afterwards. This fact, and the would-be bondholders' incentive to minimise their costs, contrast with the current system in which the costs of achieving particular outcomes, if they are calculated at all, are not widely known, nor subject to competitive bidding. Indeed, under the current system, many of the people charged with achieving social goals (or, more likely, with supplying certain outputs) have every incentive to inflate the projected cost of their doing so. Under a bond regime, however, the awesome information-processing power of the market would be channelled into minimising the costs of achieving social and environmental goals.