27 May 2008

Free riders?

One of the questions I get asked about Social Policy Bonds is about the free rider effect. The bonds most probably will rely on holders collaborating after in objective-achieving projects. Those holding large numbers would do best to co-ordinate their activities with each other. But why then would they not collude before the bonds are floated, in the bond market itself, holding off their purchases so that they pay less for the bonds than they would in a competitive market? This can certainly a problem under the current system where contracts to supply services are put out to tender. But existing corporations are structured around the sale of goods or the provision of services – not the achievement of outcomes. Social Policy Bonds are best applied to broad policy areas where the question of how best to achieve a specific social goal cannot be easily answered at the time the bonds are issued. For example, take a broad objective like reducing air pollution in a region. There will be a wide range of ways in which the bonds can increase in value. These can involve: lobbying for higher tax on petrol, subsidising the sales of catalytic convertors to cars-owners, subsidising buses and bikes, pedestrianising streets and a wide range of other possibilities. Most probably, the optimal approach will be a combination of many diverse activities, and this combination itself will be changing over time, in response to new events and expanding knowledge. There will be a kaleidoscopic continuum of optimal approaches, which will vary markedly according to the value of the bonds. So, for example a bond that can be redeemed for $100 may be floated. The optimal combination of possible bond-price raising measures when the bonds are priced at $50 will be quite different from when the bonds are priced at $48, and so will the range of corporations interested in buying the bonds. Remember too, that bondholders can profit without holding the bonds till redemption. There will be a range of potential purchasers all with different time periods in mind. Some will have little interest in holding the bonds for a long time, adding to the competitiveness of the bond market.

The likelihood then is that there will be intense competition for the bonds before they are floated, but collaboration between the large holders - tacit or not - afterwards. Of course, we can't know for certain what would happen, until Social Policy Bonds are actually issued.

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