28 December 2006

Costing policy targets

The primary source isn’t entirely clear, but according to an article in the current ‘Economist’ (subscription) around 6 per cent of UK children leave primary school each year unable to read properly. Clearly more government resources could reduce that figure. But, as with all social and environmental problems, the question is: where to draw the line?

I have my own preconceptions. For instance, I strongly believe that an excellent use of government funds would be to buy some low-cost law enforcement that could reduce the number of people killed on New Zealand’s roads from its current rate of 400 per annum - along with tens of thousands of serious injuries. We all have our own priorities about where scarce resources should be allocated. But unfortunately we, and policymakers, are very much in the dark as to the costs of our predilections. It’s in few people’s interests to calculate disinterestedly how much return, in terms of welfare, would be saved by more funding on, say, traffic policing as against (for example) funding of women’s refuges or literacy for schoolchildren.

A Social Policy Bond regime would be an improvement over the current system of allocating social funds, but also because it market prices of the bonds would constantly generate information of great value to policymakers about the total costs of their policies.

Take, for example, the objective of lowering some index of water pollution from 50 to 40 units. Assume that a national government issued one million bonds targeting water pollution, each redeemable for $10 once this lower level has been attained. The maximum cost to the government of achieving this objective would then be $10 million. But if the bonds, when issued, fetched $5 each, then the market would be saying that it thought it could achieve this objective for just $5 million. It wouldn’t say when it thought it could achieve that objective, but that could be inferred from market behaviour and the market value of the bonds compared with other financial indicators. But what if the bonds sold for virtually nothing, and the market value of the bonds failed to move from that floor? That would mean that the government had miscalculated: in the market’s view there would be no realistic chance of the objective being achieved for an outlay of $10 million in the foreseeable future. The government could respond in different ways:

  • It could wait for new technology to arrive, or for circumstances to change in other ways, such that the market would see the objective as becoming more easily achievable, and the value of the bonds would consequently rise. Or,
  • It could issue more bonds, with the same specification, also redeemable for $10. It might do this in stages, gauging the market reaction to each new tranche of bonds, which would tell the government the maximum cost of achieving the objective.
Either way, the government could be reasonably sure that it would be getting the best possible deal, expressed as ‘reduction in water pollution per unit outlay’. Valuing the benefit of achieving a targeted social or environmental outcome is bound to be an uncertain, and to some extent, subjective task, whichever policy instrument is used. But minimising the cost of whatever outcome is targeted is a different matter. A government issuing Social Policy Bonds could determine the maximum cost of achieving the objective because that would simply be the total number of bonds issued multiplied by the redemption value plus administration costs minus any revenues gained on floating the bonds. And, under a Social Policy Bond regime, it would be the collective wisdom of those in the market for bonds that determines how much the government (that is, taxpayers) would actually pay to achieve the targeted outcome: they will have every incentive to minimise that cost.

The prices of Social Policy Bonds are even more beneficial in that they would not merely minimise the total cost of achieving a specified objective. They would also indicate the marginal cost of achieving further improvements. But that discussion is more technical, and I will not go into it here.

Instead: two snippets from Harper’s Index (taken from ‘Harper’s’, October 2006):

  • Minimum amount of USDA [US Department of Agriculture] farm subsidies since 2000 that have been paid out to people who do not farm: $1.3 billion.
  • Minimum value of “small business” contracts given out by the US last year that went to Fortune 500 firms: $1.2 billion.

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