Event Loss Swaps

In an earlier earlier post I mentioned the similarity of Social Policy Bonds to Catastrophe Bonds. Readers might be interested to hear of an initiative by Deutsche Bank which, according to the Financial Times, “has begun making two-way markets in what it calls event loss swaps (ELS), which work in a similar way to credit default swaps and allow investors to buy or sell protection against insurance industry losses from large natural catastrophes.”

These derivatives, as with catastrophe bonds themselves, do not a seek to modify behaviour, but in principle there is no reason why they need not encourage a movement toward projects aimed at preventing the losses resulting from those ‘large natural catastrophes’. With larger funds at stake, and a broader definition of catastrophe than insurance losses, cat bonds and their derivatives could be equivalent in effect to Social Policy Bonds.

Don't rely on government

One of the disadvantagess of a large public sector is that it crowds out our natural, organic, bottom-up way of doing things. Whether it be care of the elderly or the sick, maintaining our physical environment or defining our cultural identity; the temptation for many of us is to let government do the work. This is not all bad: there are things that only government can do efficiently; but it does tend to reduce our own faith in our problem-solving abilities. It’s also an excuse for laziness in the face of urgent challenges. We think that, since we are giving more than a third of our income to the government, we don’t really owe society very much more.

Unfortunately, government inefficiency is legendary, and the recipients of its largesse (wealthy landlords, multinational corporates, the military etc) are not always those in most urgent need. But if our priorities are significantly different from government, we can actually do something to solve our social and environmental problems – even if we don’t know exactly how.

Philanthropists can issue their own Social Policy Bonds to achieve a specific goal with which they identify closely. They can back the bonds with their own funds, to be placed in an escrow account. Once their objective has been achieved these funds would be used to redeem the bonds. The philanthropists, once having got the ball rolling, could solicit funds from members of the public, who could contribute directly into the escrow account, and so increase the incentive for the targeted objective to be achieved quickly.

For those interested, I have written a small handbook, taking as an example female literacy in Pakistan: click here for a pdf file on how philanthropists could issue Female Literacy Bonds. I have tried and tried to communicate with philanthropic organizations and publications directly but, understandably perhaps, they do not seem to respond to my unsolicited emails.

What politicians think of us

On the rejection of his proposed constitution for the European Union:

It was not France that said ‘no’ to the constitution, it was 55 per cent of French people. Valery Giscard d'Estaing, quoted in the Brussels Journal.

There's a lot that can be read into this that one sentence: the arrogance of a member of the French political elite; that elite's disdain for voters; the concept of a France that is not some representation of a vision shared by the French, but one that is actually in conflict with the French people's wishes. I will just say that the statement represents the logical end point of a policymaking process that has nothing to do with outcomes that are meaningful to real people. The EU constitution on which the French voted was largely incomprehensible. More generally, policymaking is an arcane excercise to the non-specialist, where decisions are about changes to institutional structures or funding arrangements, and are driven by ideological concerns or the need to buy off various interest groups. Matters, in short, that have little relevance to the outsider. Indeed, they help create and widen the distinction between outsider and insider.

Giscard is the consummate insider. The outsiders used to be those who didn't bother to vote at all. But as far as Giscard is concerned, even those who do vote should be considered outsiders if they don't agree with what he and the other members of his priesthood think is best for us.

Killing with kindness, killing with complexity

Not, in this instance, literally:

More than five million Britons now rely on state aid to live and the number of younger people claiming sickness benefit is higher than anywhere else in the industrialised world, a major new study has found. ... Around £64 billion per year — more than 10 per cent of all public spending — is handed out free of obligations. Spending on benefits, not including pensions, amounts to nearly £80 billion a year, more than is spent on education and twice as much as is spent on law and order. ... The central problem has been the way [Finance Minister] Mr Brown has structured the system to keep a strong central grip on welfare. His design for tax credits means that the UK has the highest penalties for increasing income or increasing hours worked – the poverty trap – of any developed country. Five million Britons on state aid 'Daily Telegraph', 27 November

Anybody who's been on a vacation of more than a couple of months will be familiar with the problem. We return and, after switching the power back on, we have to re-learn how to set and use the finer features of the microwave, the telephone answering machine, the VCR or DVD recorder...and so on. All this electronic equipment was designed by specialists for people (apparently) who will be using it every day and who have the time and energy to consult the voluminous instructions if they take a break.

It's similar to the composers of modern serious music, whose audience consists entirely of other musicians, or the highbrow novelists who write exclusively for the novelists on prize committees. And so it is with the welfare industry. The experts who construct welfare policy are several stages removed from their supposed beneficiaries. The econometrics is elegant, the proliferation of new features is technically impressive, but the result of all the complexity - if the policymakers but cared about it - is a fiscal, social and pyschological disaster.

Here's an idea: why not say, explicitly, what welfare policy is designed to achieve? Express your targets in terms that can be easily monitored and that are meaningful to real people. And if you don't know how to achieve your stipulated goals, don't be embarrassed: just contract the whole process out to a motivated and efficient private sector. Perhaps the UK Government is actually coming round to this way of thinking. The 'Telegraph' article continues:

The report proposes the outsourcing of welfare provision to voluntary and private sector organisations which would be paid on results, in particular for getting claimants into sustained employment.

Milton Friedman and the public sector

Since 1989, the year Ronald Reagan, the American president most in tune with Mr Friedman's ideas, left office, and the Berlin Wall came down, America's government has grown just as fast as its economy—an economy which has barrelled along for much of that time. The state's slice of GDP is forecast to be 36.6% in 2006, up from 36.1% 17 years ago. The public sector has also swollen in Europe's three biggest economies—Britain, France and Germany—and in OECD economies as a whole.

This excerpt from an editorial in the current Economist reflecting on the achievements of the late Milton Friedman. The point being made is that there is still a lot of work to be done. I don't quite share the assumption that the rising influence of the state is necessarily bad. Sure it means that people have less to spend on what they themselves want but might it not be that they want more spending on public goods and services of the type that only government can supply? Sadly, the answer is probably 'no'. Governments keep getting bigger largely through deception, obfuscation and inertia. Deception, in that it knows and has known for a long time that its subsidy programmes do nothing to help the people whom they are represented as benefiting. So massive farm subsidy programmes, sold as essential to maintain family farms, actually do no such thing: they overwhelmingly go to the largest landowners and massive agribusiness corporates. Obfuscation, in that government (with very few exceptions) does not target explicit policy outcomes, such as universal literacy, low crime rates, or basic health or employment goals. Instead it allocates public funds according to criteria that have little to do with people's considered wishes: media appeal or political expediency. Its decisions concern spending, rather than publicly accessible outcomes. Existing institutions, especially government agencies, and their ways of doing things are taken as a given.

And inertia, because many government programmes are self-entrenching. Subsidies to corporations, or protection for public sector workers, strengthens the forces of resistance to any meaningful reform. The Economist editorial goes on:

Governments are as convinced as ever that they know best how to spend their citizens' money.

But it's just as true to say that they may not be so convinced; they may see quite clearly that socially unjust, economically wasteful, and environmentally destructive subsidies (for example) are stupid. It's just that they lack the courage to end them.

It doesn't really matter...

...what is causing climate change. By the time we definitively identify the cause it may be too late to do anything about it. From a letter to the [UK] Guardian by Piers Corbyn of Weather Action:

The global warmers' claim that current extra CO2 causes warming which gets dangerously magnified through the greenhouse effect of extra water vapour in the atmosphere, consequent to the temperature rise, also fails. The sea absorbs extra CO2. Furthermore, increased transpiration-cooling by enhanced growth of plants, which is caused by extra CO2, cancels out the extra greenhouse warming of that same CO2. Increased greenhouse heating due to doubling CO2 is 3.7 watts per sq metre. This is negated by about the same amount of enhanced transpiration-cooling of plants, all of which grow faster in extra CO2. Therefore there is no CO2 driven net heat flow and surface temperature rise. Temperature and climate change in our epoch is therefore driven by other factors, especially solar particle and magnetic effects.

Fine: there appears to be reasonable doubt about whether greenhouse gas emissions cause climate change. Should we therefore wait several decades before mitigating the effects of climate change or taking steps to stabilise the climate? In general, do we have to find root causes of a problem before we try to solve it? We can do both, but allocating resources between the two courses of action needn't be done at the initial stages. We strongly suspect, for instance, that smoking causes cancer. But we don't give up all research into prevention and cure of cancer until that particular causal relationship has been proven. Similarly with climate change: let's focus on mitigating its worst effects, however caused. And let the market decide, via Climate Stability Bonds, how to allocate scarce resources between prevention and mitigation: something that the market, with its built-in incentives, can do far more adaptively and less divisively than the absurdly expensive, ineffectual bureaucratic testimony to 1990s science that is Kyoto.

Subsidising environmental destruction (continued)

A reminder: we're not just destroying the planet, but we're subsidising its destruction:

House Democrats also are shying away from tampering with more than [US]$1 billion worth of oil- and gas-related tax breaks, enacted last year. Source: Washingpost.com

Compliance costs discriminate against small business

A revealing graph from the current Economist:




I don't know about the 'tax burden' element, represented by the height of the bars. I can't imagine that Italian companies pay nearly 80 per cent of their actual profits to the government. Eighty per cent of declared profits maybe. But the figures in the rectangles, which is the number of hours per annum that businesses have to spend preparing and filing tax payments are interesting. They give some idea of how complex tax (and regulatory) regimes tend to favour large businesses over small. They range from about 80 minutes per week for businesses in New Zealand and Switzerland, to more than 11 hours per week in Spain. Time costs of compliance with other regulations, such as health and safety concerns, employment documentation etc, are likely to be equally high. Such costs obviously fall disproportionately heavily on smaller businesses. In fact most government interventions, however well meaning and high sounding in principle, tend to favour the large and global at the expense of the small and global.

Dirty energy is subsidised too

This week's 'Economist' says (Green Dreams, 16 November) that '[a]lmost all clean energy ...relies on government subsidies to make it competitive with fossil fuels.' Recent figures are hard to find, but in 1997, the World Bank estimated annual fossil-fuel subsidies at US$ 48 billion in twenty of the largest developing countries and US$10 billion in the rich countries. (Source) Add in taxpayer-financed road construction and non-pricing of the negative environmental impacts of fossil fuel consumption, and it's clear that dirty energy too is heavily subsidised.

The same article also says that 'government subsidy is a wobbly foundation on which to build a business'. I wish that were so. But subsidies on such a large scale are self-entrenching: they fund the very interest groups that are so successful in lobbying against their withdrawal.

I don't know

Every year, 35,000 children in England - 6% of all 11-year-olds - leave primary school without basic literacy skills. This casts a shadow over their own future and has huge costs for society as a whole. Rapid Response, 'The Guardian', UK, 7 November

[Christopher Monckton] has a degree in classics and a diploma in journalism and, as far as I can tell, no further qualifications. This is a dazzling debunking of climate change science. It is also wildly wrong, George Monbiot, 'The Guardian', 14 November

I know even less about education than I do about climate change. But I know that when policy is being made in both areas outcomes are almost irrelevant to the debate. Allegiances are bought and sold, insults are traded, activists use their support as a quid pro quo for more power and deep down, at the very heart, is either personal ambition or - which is very much the same thing - the drive to validate an ideological position. The losers are those of us with no input into policymaking; that is, ordinary members of the public and our children. While the politicians and think-tanks debate local control of schools, literacy standards suffer. While they debate greenhouse gas emissions, the global climate may or may not be changing catastrophically and irreversibly.

Policies and ideologies; ambitions and systems; all should be subordinated to targeted outcomes. It doesn't matter who controls schools, as long as basic educational outcomes are achieved. And it doesn't matter what happens to greenhouse gas emissions, as long as the climate is stabilised. Some sort of humility is called for: the ability of policymakers to say 'I know what I want, but I don't know how to get there. Let the private sector decide: that's what it does best.'

Why bother to think?

The New Zealand Government will make all your decisions for you.

One snippet from this week's issue of Brian Harmer's admirable WYSIWIG News:

Simon Collin of the Christchurch City Council says depending on which scientist you speak to, disposables can take between two and 500 years to decompose and the human waste in them contributes to greenhouse gasses. He says in a bid to reduce the amount going to the rubbish dump, they have decided to subsidise washable nappies, as the cost of them is thought to be prohibitive to many families. Mr Collin says they have put aside ten thousand dollars to subsidise 500 starter packs.

In fact, it's not at all certain that cloth nappies are kinder to the environment:

If in a drought, it's best to use disposable diapers. If the area has landfill problems, it's best to use commercially laundered cloth diapers. If there are air pollution problems, resort to disposable diapers. The best diaper ultimately depends on the community's situation. Source: Institute for Lifescycle Environmental Assessment

...which is why I always stress that it is environmental outcomes that are important, not the alleged ways of achieving them, however trendy or superficially attractive those might be. Besides, the best ways of achieving outcomes are prone to change with time as scientific relationships change, and as knowledge expands.

A second excerpt from WYSIWIG News:

The [New Zealand G]overnment is injecting close to $2 million into a regional initiative to strengthen Wairarapa's international food and wine reputation.

And a third:

A showcase of New Zealand-made products at Parliament later today, is expected to be tinged with sadness as it coincides with the first anniversary of the death of Rod Donald. The invitation-only event is the first of six regional showcases and kicks off the Government's Buy Kiwi Made programme.

As Brian Harmer rightly comments:

These kinds of jingoistic programmes are understandable at one level, but are not logically sustainable in a country whose economic lifeblood is exporting products to other countries. How would we react to our products being shunned as a result of similar programmes in those countries. Protectionism like this will bite us in the posterior sooner or later.

Yet another item discusses Auckland's proposed waterfront sports stadium, which could cost up to NZ$1 billion. Much of this will come from central and local government funds.

Things will change

Of course the mid-term election results will change American politics. The Democrats are beholden to a slightly different set of interest groups than the Republicans.

David Lange

An excerpt from David Lange’s engaging autobiography:

“It was often remarked that I had no education in economics. This is somewhat ironic. In the early 1980s, nobody was better qualified than a lawyer to understand the New Zealand economy. It was a legal construct. Only the law could allow farmers to earn an income by killing sheep and burying them…. There was a ramshackle wall of legal protection around the economy…. [Prime Minister] Muldoon’s regulatory excesses were increasingly absurd. You did not need to be an economist to understand that; the question was what to replace them with.” My life (page141), David Lange

Unleash the private sector - a little!

As seemingly in all the industrialized countries, in the UK health care is in crisis. For reasons of ideology it does not charge at point of use. Inevitably, demand is unsatisfied. One response – see this post by NHS Blog Doctor – is to ration by bureaucracy. Integrate inefficiency into the system so inextricably that patients either die, or pay for private sector treatment. Another approach is to ration according to the more-or-less random factor of media appeal: the British national health care system’s terminal-care budget seems to be allocated on that basis: 95 per cent of it is allocated to the 25 per cent of the UK’s population who die from cancer, and just 5 per cent to the 75 per cent who die from all other causes. (See Alternative endings, [UK] Radio Times, 13 July 2002. This was the subject of a [UK tv] Channel 4 documentary Death: you’re better off with cancer broadcast on 16 July 2002.)

These are not necessarily consciously inhumane processes, but they do raise the genuine question as to the role that government should play in health care.

I have long argued in favour of government targeting broad, basic, health outcomes. Instead of micro-managing particular bureaucratic processes, or rationing on the basis of mind-space or celebrity affliction, government could set up well-thought out, meaningful indicators of health, such as quality-adjusted life expectancies at different ages, infant mortality, and ideally some reliable measures of mental health. At basic levels there will be a strong correlation between the numerical value of well-chosen indicators and social welfare. Included in such indicators could be the universal availability of insurance against catastrophic health costs.

Once chosen, government could contract out improvements in these indicators to the private sector, via a Social Policy Bond regime. Bonds could target any or all of the chosen health indicators. A fruitful division of labour would be the result: government would define its chosen health care outcomes. And precisely because it targets such outcomes, rather than bureaucratic processes or meaningless micro-targets, it will attract greater public buy in – extremely helpful for a universal scheme. Government would also be the ultimate source of finance for achieving these outcomes. It could perform both these functions – defining targets and raising funds to achieve them – very efficiently and with maximum public support. But under a bond regime the actual achievement of these outcomes will be done by the private sector, which will maximise its profits only by maximising the efficiency with which it achieves society’s health goals, as defined by government.

Archives available again

The problem with this blog's archives (thank you anonymous commenter) has been fixed.

Markets better than Kyoto at minimising costs

Markets are good at allocating scarce resources. This is not just a conclusion from economic theory, but accords with all the historical evidence. That said, it’s unfortunate that policy decisions that entail the expenditure of colossal resources, are taken without reference to the market.

Take climate change: under the Kyoto Protocol the resources spent on trying to prevent it will be decided largely by national governments. They will be a negotiated outcome based partly on today’s current knowledge of the scientific relationships, but mostly on what politicians think they can get away with. The political process will attenuate any the relationship between the magnitude of the climate change problem and the global response.

Now consider what would happen were Climate Stability Bonds to be issued. The main decisions about the likelihood of climate change, the magnitude of the efforts required to prevent it, and the probabilities of doing so successfully would be taken by the market, when it decides how much the bonds are worth. This, in my view, is vastly superior to the bureaucratic process. As with central planning, bureaucrats make mistakes. Their systems are cumbersome, uniform and cannot adapt – even if the bureaucrats are well meaning. Contrast this with a Climate Stability Bond market: there, the decisions as to how much need be spent on stabilising the climate will be taken by those with powerful incentives to minimise the cost. They will be people (or institutions) who stand to benefit if they get their sums right and particularly, if they are cost-effective in reducing climate change. Contracting out the achievement of climate stability in this way vastly expands the pool of people with an interest in researching and minimising its costs.

Tying it all together

Conversations with friends over the weekend have encouraged me to tie together the strands of my thinking on policy. Social Policy Bonds are an attempt to address certain policy problems: what follows is my explanation of the origin of these problems.

Essentially, corporations have too much power. As James S Coleman, in the Asymmetric Society describes, the major influence on our society has changed from natural persons to corporate actors. The two parties might have nominally equal rights, but they have vastly different resources, which in any actual transaction can be decisive. Corporations have drifted apart from natural persons, partly by default. Their objectives are not necessarily congruent with those of society. Through a vast array of subsidies and trade barriers, through their unpriced negative social and environmental impacts, and through manipulation of the regulatory environment, they can and do entrench their power, and make live worse for natural persons. (To some degree offsetting these impacts, and seldom mentioned in the literature, are their unpriced positive externalities.)

Corporations and governments support each other in creating ideal conditions for corporate growth. They protect, foster and subsidise the large and global at the expense of the small and global. The large scale of social organisation, and the very high degree of specialisation and complexity of our economies, while helpful to corporations, does not therefore arise from undistorted market forces, and do not therefore originate in decisions made by natural persons; though they are certainly maintained by such decisions, as viable alternatives become ever more scarce.

Big corporations and big government go hand-in-hand. A large scale of aggregation tends to go with remoteness: people feel they have nothing to contribute to decision-making and tend to disengage from the political process: another self-reinforcing trend. The big losers from all this are natural persons and the commons.

Social Policy Bonds are an attempt to redress this balance. Their starting point would be explicit, verifiable outcomes that are meaningful to natural persons. At a local or national level their goals could be things like: universal literacy, or high levels of health and housing, low levels of pollution and unemployment. At a global level, targets could include reduced levels of violent political conflict and climate stability. Social Policy Bond regimes would inject market forces into the achievement of such social and environmental goals. Perhaps equally important, their emphasis on meaningful outcomes would draw more public participation into the policymaking process. No longer would policymakers get away with protecting their corporate friends (and paymasters) with policies whose principles sound well-meaning, but whose effects will be obscure and as far as real people are concerned, entirely wasteful. Policymakers’ goals would of necessity be transparent right at the start.

Thank you Anatole Kaletsky

Commenting on the Stern report on climate change in the [London] Times Mr Kaletsky makes a point that deserves emphasis:

Global subsidies for energy research are now running at a pitiful $10 billion annually, compared with the $250 billion spent on subsidising the extraction of fossil fuels (mainly on the most polluting of all energy sources, coal). A new slogan for the environmental pressure groups: Some Gain, No Pain, 2 November.

Does anyone believe that our political system can meet the urgent environmental challenges we face, when our leaders haven't even the courage to stop subsidising their corporate buddies in the energy business? I don't.

Subsidising environmental destruction

My suggested response to climate change, which applies regardless of whether it is actually happening, is Climate Stability Bonds, which would reward who stabilise climate, however they do so. (Something has gone very wrong with blogger.com's html links: for a short article on Climate Stability Bonds please see http://socialgoals.com/ieakyototext.html .)

A bond regime would need no prejudging of what is happening to climate, what is causing it to happen, or how best to stop it happening if it is, indeed, happening. I'd rather a bond regime replaced Kyoto, which would be inadequate even if it weren't failing - which it is. But Climate Stability Bonds could also complement such efforts to cut back on greenhouse gas emissions as are being made.

Actually, the human species could go a long way to cutting such emissions simply by withdrawing subsidies for the extraction and use of fossil fuels. These can take the form of direct subsidies or tax breaks to the oil and road construction industries. Or they arise from the unpriced negative environmental impacts of fossil fuel use.

You'd think that such first steps would be the easiest to take, at least in comparison to the heroic demands of Kyoto. But we are not taking them. Perverse subsidies continue to wreak environmental havoc. Given these facts, is there anyone who genuinely believe that we are capable of making the sacrifices necessary to comply with Kyoto - as divisive and ineffectual as it is? Climate Stability Bonds would need a lot of discussion and refinement before they can be deployed. But to my mind it's essential that they, or some other scheme that directly targets a stable climate in ways that people can support, be considered - urgently.