More on free riding

My previous posts have discussed points raised at an OECD meeting in Paris when the environmental application of the Social Policy Bond concept was discussed. I am collating these criticisms and my responses, and uploading them onto a Criticism page on my website. I will now go into more detail about free riding, often cited as a reason not to consider the concept further.

Free riding

Much of the criticism of Social Policy Bonds has centred on the free rider problem. I should make clear at the outset is that Social Policy Bonds are intended to be the best possible way of achieving many of our complex, long-term social and environmental goals for which there are currently no successful, efficient policies, and many of which are thought to be intractable. This is the over-arching aim of the bonds: the aim of the bonds is not to eliminate the possibility of free riding. 

The goals that Social Policy Bonds are best suited for are those that are:

•    long term;
•    broad;
•    require diverse, adaptive approaches and, quite likely, a mix of these; and
•    resistant to any current or envisaged efforts by policymakers to their achievement.

If Social Policy Bonds are to be of value, then, they need not be elegant in an economic sense. They just need to better than alternative approaches, including the approach of not doing anything. Which is all to say that, even if free riding does occur under a bond regime, it need not be so significant as to detract from the bonds' ability to tackle some of our most challenging social and environmental problems.

The first thing is to note that free riders gain only if the value of their bonds rises; that is, if the goal is seen to be more likely to be reached, which usually means that something is being done to achieve the goal. The real problem arises if so many bonds are owned by passive investors (would-be free riders) that nobody does anything or, rather, that the goal remains unachieved as a result of their passivity. 

The more bonds in the hands of would-be free riders, the less likely that the targeted goal will be achieved quickly. The market value of all the bonds will therefore fall. As it falls, so the potential rewards from holding the bonds rises, so that more people would become interested in buying the bonds. If the price keeps falling, the would-be free riders will be tempted to sell their bonds to these buyers. Some might be tempted to become active investors themselves, rather than sell to such investors. The bonds are worth most to those prepared to do something to help advance the targeted goal. Nevertheless, there will certainly be some who will hang on to their bonds, and it is likely that, yes, there will be an irreducible number of bonds in the hands of free riders, who will profit as the targeted goal comes closer to achievement. The question is whether these holdings would be sufficiently large to make Social Policy Bonds less efficient than alternative policies. 

Because large quantities of the bonds held by a single passive investor would be big enough to devalue the bonds, it's unlikely that a passive holder will want large quantities of the bonds. More likely the bonds held by would-be free riders will be distributed amongst a large number of people with small holdings. It's possible that would-be active investors, if the bonds are falling in value, eyeing the total number of these bonds, would make offers greater than the current value to these small, passive, investors, and that the result would be aggregation of holdings into a holding sufficiently large, and bought at sufficiently low cost, to encourage the holder to be an active investor.

The goal is not to minimise free-riding, or to create policies that generate no free-riding. Indeed, most policies can be interpreted as rewarding free riders, in the sense of people taking advantage of the efforts others have made to supply some collective good without actually contributing themselves. Society accepts even spectacularly egregious cases of free riding, such as the rewards reaped by property owners when transport infrastructure is extended to their locale.

But to repeat, the over-arching goal of Social Policy Bonds is to set in place the most efficient practical way of solving humanity's social and environmental problems. Free riding is problematic only if it so blights the Social Policy Bond concept that it becomes less efficient or less effective that any other policy, including the policy of doing nothing. 

Writing in this year, 2023, when global tensions are high and there is a non-negligble chance of nuclear conflict, I feel certain that most people would accept the price of a few passive investors benefiting from holding the bonds in exchange for a new approach to reducing the probability of say, nuclear conflict; especially given the obvious and frightening inadequacy of current efforts.

One other point

In chapter 5 of my book I discuss issues of bonds that are failing to achieve their intended purpose. That could be because of insufficient funding. If progress is obviously too slow, the funders (government, usually) could simply increase the size of the redemption funds. But that would have the effect of immediately raising the value of all existing bonds, which would lead to 'moral hazard' in that free riding would be rewarded: people could hold a large number bonds hoping that by doing nothing to achieve the issuers could increase the redemption value of each bond, or issue more bonds, which would have the effect of raising the value of these passive investors' holdings. My thinking now is that the issuers might be better invalidating existing bond issues, perhaps stating in advance that if no significant progress is made toward goal achievement within, say, ten years, then that bond issue will be invalidated. They could then issue new bonds targeting the same goal, with greater funding.