Incentives for development

After 43 years and $568 billion (in 2003 dollars) in foreign aid to the continent, Africa remains trapped in economic stagnation. Moreover, after $568 billion, donor officials apparently still have not gotten around to furnishing those 12-cent medicines to children to prevent half of all malaria deaths. With all the political and popular support for such ambitious programs, why then do comprehensive packages almost always fail to accomplish much good...?....

The biggest problem is that the rich people paying the bills do not share the same goals as the poor people they are trying to help. The wealthy have weak incentives to get the right amount of the right thing to those who need it; the poor are in no position to complain if they don’t. William Easterly, The Utopian Nightmare, Foreign Policy, Sept/Oct 2005

Exactly. I have been seen saying for years that our social and environmental problems are caused by perverse incentives. The big financial rewards in today's world are for those who can cater to the whims of the rich, by which I mean those who constitute much of the population of the developed countries and a tiny minority of those in the poor countries. One example: only 1 percent of all new medicines brought to market by multinational pharmaceutical companies between 1975 and 1997 were designed specifically to treat the tropical diseases plaguing the third world. In numbers, that means thirteen out of 1,223 medications. This is not a problem of lack of ingenuity or even compassion. It is a problem of incentives.

Social Policy Bonds would rejig the incentives on offer. Not blindly, so as to favour one set of people over the others, but in accordance with the wishes of those who put up the funds to redeem the bonds. The current mismatch has more to do with lack of transparency and deliberate deception than the wishes of those who put up the cash. Governments pay out hundreds of billions of dollars annually in explicit and indirect subsidies to (for instance) large agribusiness corporates, multinational energy companies, and arms manufacturers. If consumers and taxpayers were told explicitly that they were subsidising these bodies they would, I am certain, do so with less enthusiasm. Under the current system, this whole system of corporate welfare is fudged. Under a Social Policy Bond regime, the first thing taxpayers and government would decide would be: what are our goals? All spending decisions, all programmes, projects and initiatives, all institutional establishments and structures, would be subordinated to these goals.

A mirror image, in other words, of the current setup.

Environmentally harmful subsidies

In my current work, I'm citing the existence and persistence of environmentally harmful subsidies - similar to perverse subsidies - as solid evidence that government is inefficient. Though anecdotes abound, it's difficult sometimes to get an idea of just how inefficient, on a global scale, government is. But a workshop given by the OECD attempted to quantify environmentally harmful subsidies. The sums are staggering:

Subsidies probably total over $1 trillion per year. Around two thirds of the subsidies occur in OECD countries. Those OECD subsidies are heavily concentrated in agriculture, mining, road transport and manufacturing. Non-OECD countries mainly subsidise energy, water, fisheries and some agriculture. Relative to GDP, subsidies are twice as large in non-OECD countries. As a percentage of world GDP, global subsidies account for a staggering 4 per cent. Perhaps most notable of all, agricultural subsidies in OECD countries account for over 30% of all subsidies.

The workshop was done in 2002, but the dollars referred to are in 1994-98. It's not just the financial sums that matter: these are environmentally harmful subsidies, most generally paid to increase production. In agriculture this means switching to intensive production techniques and expanding production onto marginal lands and environmentally valuable areas such as woodlands, ponds and hedgerows.

Apart from OECD work, another useful source is Earth Track.

On the commons

A good post on Peter Barnes's blog from OnTheCommons.org makes these points:

Common wealth, as we’ve seen, is immensely valuable. Common illth — the shadow side of private wealth — is likewise vast. But while mainstream economists acknowledge the existence of common wealth and illth, they don’t bother to measure them or include them in their models. They assume the commons side of the ledger is trivial, or ignore it because dollar signs are hard to attach. This is tantamount to professional malpractice. ... They count America's sales (a.k.a. GDP), but not our expenses (the negative ex­ternalities of those sales). They keep track of private income and wealth, but not common wealth or illth. As a result, they miss at least half the story.

I agree with the thrust of this post, though (as I posted in a comment), I think most economists don't necessarily assume the negatives arising from economic development are zero, but rather that they are less than or equal to the positive externalities. The point being that there are positive externalities of wealth generation beyond those that appear in company accounts and GDP. These could be the positives, important to society, of employing people, such as a reduced crime rate, and a reduced poverty rate - which itself has important positive spin-offs for the commons. My point, in other words is that just as almost all the negative externalities of economic development are ignored, so too are some of the positives.

Social Policy Bonds are one way of dealing with the negative externalities of our way of life. Because they do not prejudge how a particular negative externality shall be eliminated, they would reward the most efficient way of solving the problems they cause. If we take climate change as an example, reducing anthropogenic greenhouse gas emissions a la Kyoto, may be necessary but, on the other hand, there may be far more cost-effective solutions that deserve investigation. Efficiency, not ideology, would be the sole criterion.

Goals for a bond regime

Social Policy Bonds are versatile in that they could deal with any quantifiable social or environmental goal. That said, broad objectives would be ideal. To see this take, as an example of a narrow goal, that of reducing burglaries in a small locality. Bondholders could solve this problem merely by laying on taxis to transport burglars to areas outside the scope of the bond regime. Or they could offer courses that would upskill burglars so that they could become white-collar criminals instead. Either way, the bondholders would achieve their objective and cash in. But society's broader goals would not be helped. It would be far better to issue bonds targeting all crime in as large an area as is feasible.

Similarly with other goals. It would be better to target all forms of pollution simultaneously than a single pollutant. It would be better to target a broad definition of poverty than a narrow definition.

That said, if a Social Policy Bond regime is to get off the ground, it is most likely to be by social entrepreneurs or philanthropists with fewer resources than government, who will issue their own bonds to achieve a specific goal with which they identify closely. Careful specification of the goal will be crucial. Any readers interested in issuing their own Social Policy Bonds could first visit the Social Policy Bond website. Then feel free to contact me directly.

Social Policy Bonds - an overview

(This is a first draft of an article intended to introduce Social Policy Bonds to a wider audience.)


Outcomes: a better policy driver than ideology

Most policy issues are now so complex, so voluminously documented that each side of any argument can be certain to find a very large quantity of supporting evidence. Whether it is war in Iraq, smoking in bars, capital punishment, gun control, or provision of day-car facilities for three-year olds; there are so many facts and seemingly valid interpretations of facts, that ‘there are arguments on both sides’ is about the only useful thing to say.

Those who are involved, those who have a position, are predisposed to select only the information that suits their ideology, or the bottom line of the institution that pays their bills. It is not just on matters like the Arab-Israeli conflict. Even scientific issues, which should be more amenable to objective analysis, are controversial and inconclusive to those who try to follow the propositions made by Bjorn Lomborg in The skeptical environmentalist and the rebuttals, counter-rebuttals, and counter-counter- rebuttals that have ensued. Rather than one’s position being in the middle of a Bell-curve, it is more like that at the centre of a dumbbell with hefty but equal weights at each end: a new fact favouring one side can tip the balance markedly.

War, terrorism, climate change: our most urgent problems are too complex for any except specialists fully to comprehend. There are so many relationships, so many variables, and such large distances of time and space between cause and effect, that to disinterested observers, there are good cases to be made on both sides of such concerns as the Kyoto Protocol or conflict in the Middle East.

Should we, as ordinary members of the public, and voters, therefore give up trying to work out what is the best line to take, when even the highly qualified experts disagree with each other? Or should we take the lazy way out and choose one political faction – left, right, conservative or socialist – and look to them to do the thinking for us? Or should we turn away from policy issues altogether and become cynical or despairing? We do all these things, with and the result is that policy is decided less by engaged members of the public, more by special interests, including the politicians, corporates and media. If this sounds far-fetched, look at the figures for election turnout.

Rather than wait till such scientific arguments are resolved, or to pursue some abstract notions of justice in matters of human conflict, we might do better on efficiency grounds, to subordinate all our activities to our intended outcomes: climate stability, for example, or conflict reduction. This would take the form of rewarding all actions – and only those actions – that lead to achievement of the desired outcome.

Currently, governments that are supposedly interested in a particular goal finance institutions, or people, or activities that have as their stated objective the solution of these problems. But another, much simpler but also much rarer, is to reward people for actually solving the problems. That’s what they used to do in the Wild West when they wanted to eliminate problems caused by particularly nasty individuals. They put together a cash reward, printed some ‘Wanted - Dead or Alive’ posters, and let the private sector do the rest. It is the targeted outcome – the killing or capture of the public enemy – that determines who shall be rewarded not current institutional structures or activities. The same principle, more or less, underlies an innovative new financial instrument that can channel the market’s incentives and efficiencies into the achievement of social and environmental goals.
Social Policy Bonds

Social Policy Bonds would reward people only when they actually achieve targeted social or environmental goals. A fixed number of Social Policy Bonds (‘bonds’) would be issued. The bonds could be issued and backed by local or national government, or by non-governmental organisations (NGOs), or by private individuals. They would initially be auctioned to the highest bidders. The bonds’ backers would undertake to redeem these bonds for a fixed sum only when a specified social objective has been achieved. The bonds would not bear interest. They would be freely tradeable after issue, and their market value would rise and fall. Social Policy Bonds would therefore differ from conventional bonds in that they would have an uncertain redemption date which, in combination with a fixed redemption value, implies an uncertain yield: holders would raise their bonds’ yield by achieving the targeted objective quickly. Once the targeted outcome had been achieved, whoever backed the bonds would redeem them.

How would Social Policy Bonds work? They would create an interest group — bondholders — who have powerful incentives to achieve the targeted social objective efficiently and quickly, or to pay others to do so. Consider an example. Assume that an urban authority is prepared to spend a maximum of say $10 million to reduce the crime rate within its borders by 50 per cent. It issues one million bonds that become worth $10 when the crime rate falls below 50 per cent of current levels for a sustained period — say one year. Because the market would see this objective as unlikely to be achieved in the near future, it would put a low value on the bonds when they are floated. Assume successful bidders pay as little as $1 for each of the bonds. (This sum would be held by the issuing authority partially to offset the cost of redemption of the bonds.) Now, they hold an asset that could appreciate in value by 900 per cent if a sustained halving of the crime rate were achieved. This provides the motivation for bondholders to do what they can to reduce the crime rate.

Social Policy Bonds could in principle, be used to solve any social or environmental problem that can be reliably defined and quantified. Key criteria for policy areas within which Social Policy Bonds would show the most marked improvement over current programmes are:

• existing policies have objectives that are unstated, uncosted, obscure or conflicting;
  
  
• financial rewards to those involved in achieving objectives are uncorrelated to their effectiveness in doing so;
  
  
• a wide array of diverse approaches may be necessary; and
  
  
• our knowledge of the problem, its causes and solutions, is scanty and improving all the time.

That is the approach taken by Social Policy Bonds. Without presupposing whether climate change is happening, what is causing it, or how best to stop it, Climate Stability Bonds can be issued that would encourage people to stabilise the climate. Similarly, Conflict Reduction Bonds that focus on, say, the Arab-Israeli conflict could aim to reduce the numbers of people killed, injured or made homeless in that conflict. People’s need and wish for peace is more important than trying to bridge the gaps between the ideologues, the historians, the militarists and those in authority. A bond regime could bypass, co-opt or undermine those who stand in the way of peace.

Targeting specified outcomes that are meaningful to natural persons, as the US Results Act begins to do, is a necessary first step, but it is not sufficient. The other necessary step is to ensure that resources are allocated in ways that can most cost-effectively achieve these outcomes. This is where market incentives come into the picture.

A symptom of this malaise is the disengagement of many from the political process. Even the United Kingdom’s Labour Party’s ‘landslide’ majority in the British House of Commons is not what it seems. Labour received just over 40 per cent of the vote in 2002, with a 60 per cent turnout. So only 24 per cent of the electorate actually voted for Tony Blair’s party. In the US President George W Bush received votes from fewer than a quarter of the voting age population. It is the same in most other western democracies. We have begun to accept that whichever party receives 25 per cent of the popular vote has ‘won’ the election. In most countries, this represents a dramatic decline in popular engagement with politics over the past few decades.[i]

Perhaps one reason for this is that people are sceptical about the ability of the different political parties to deliver. In the absence of any great ideological divide, most parties have approximately the same manifesto at election time, and seem equally (in)capable of achieving results that are meaningful to electors. If such voter apathy co-existed with satisfaction or optimism about the political environment it would not be a worry. But unfortunately it goes hand-in-hand with deepening dissatisfaction, cynicism and even despair, at the ability of our politicians to deal with urgent domestic and global concerns.


[i] Democracy disconnected from the electorate, Ralph Dahrendorf, Project Syndicate, 2004.

New Public Management

'The state is denoted primarily by its monopoly of power, force, and coercion on one side and its orientation towards the public good, the commonweal or the ben commune, on the other; the business world legitimately focuses on profit maximization. N[ew] P[ublic] M[anagement], however, as it has been said, "harvests" the public; it sees no difference between public and private interest. The use of business techniques within the public sphere thus confuses the most basic requirements of any state, particularly of a Democracy, with a liability: regularity, transparency, and due process are simply much more important than low costs and speed.' Wolfgang Drechsler, The Rise and Demise of the New Public Management post-autistic economics review, issue no. 33, 14 September 2005

There is much of interest in the article. At first sight, Social Policy Bonds would appear to suffer from the problems Drechler correctly identifies as afflicting conventional attempts to replicate in the public sector the profit maximisation imperative of the business world: a narrow definition of efficiency isolated from context; and, on all the evidence, failure to deliver on its promises. 'Contracting-out has proven to be excessively expensive and often infringing on core competences of the state as well as on the most basic standards of equity.'

Since Social Policy Bonds embody the contracting out principle, how would they square up against Drechsler's, in my view, legitimate strictures against New Public Management?

The most important consideration is that a bond regime would be entirely subordinated to 'transparency and due process'. Indeed, the agreement on explict, transparent, outcomes would be the starting point of a Social Policy Bond issue. Formulating policy in terms of outcomes, (rather than, as at present, inputs, outputs, activities and institutions) would draw more people into the policymaking process. Outcomes would have to be meaningful to real people to attract consensus and support, rather than government agencies or corporate bodies. A government-backed Social Policy Bond regime would therefore aim to achieve broad social goals. Profit maximisation fails when, as in NPM, it tackles narrow objectives, where non-quantifiable social and environmental externalities can be safely offloaded onto wider society.

A Social Policy Bond could explicitly tackle some of the social and environmental problems created by profit-maximising private entities. Instead of targeting the ever-proliferating array of micro-objectives that characterise New Public Management, it could target meaningful societal goals, like better basic health and literacy outcomes, reduced crime, and a cleaner environment.

NPM fails, I believe, because of the narrowness of its vision; itself a result of its ideological origins. Social Policy Bonds, on the other hand, would be compatible with a large state, a small state or anything in between. Governments would articulate society's wishes about what people want to see done; they would issue Social Policy Bonds as a way of making sure not only that social goals would be achieved efficiently, but that they would be genuine goals defined and agreed upon by all.

Price stability is not a goal

Much confusion in, for example, the UK Government about price stability, in this case the price of petrol. One of the first benefits of a Social Policy Bond regime is that it would clarify what are ends and what are means to ends. Price stability is not, or should not be, a goal of government policy. Market prices are signals that allocate resources efficiently. They embody masses of information that cannot be assessed by planners. If the price of some essential commodity is too high for some people, then government should give financial assistance to those people to enable them to make their own decisions about how much of the commodity to buy. Today's agricultural subsisidies should be a lesson to all politicians: like a drug habit, they are easy to start and hell to give up.

Memo to Government: make sure my milk is fresh

This letter appeared in today's International Herald Tribune in response to the story published yesterday (see below):

As a French-American who opened a retail store in Rome four years ago, I read with interest your report "Rules, rules, rules: Germans fed up" (Sept. 7). ...

Special milk containers required by law are meant to protect consumers from spoiled milk. Haven't you ever had a restaurant serve you milk with your coffee only to find that it was spoiled after pouring it into your cup?

Is this what we expect of government? It's ok to destroy our physical and social environment, just so long as it makes sure the milk is fresh?

The EU: 'Regulations R Us', continued

The European Union's main priority is not prosperity but planning. A small restaurant owner in Germany speaks:

It is not allowed to serve a small jug of milk with the coffee. You are supposed to serve these awful tiny plastic containers of milk because you can see the expiry date. I refuse to do that. Source: International Herald Tribune

Maintaining the status quo

In the aftermath of Hurricane Katrina it's worth stating that maintaining the status quo - avoiding loss of life, keeping cities functioning, etc - are goals that can be targeted by Social Policy Bonds. The expensive way of dealing with a natural disaster like Katrina may, or may not, be to cut back on anthropogenic emissions of greenhouse gases. The way I advocate is to contract out the maintenance of the status quo to the private sector, via a Social Policy Bond issue. The value of such bonds, if issued by, say, the state of Louisiana, would have collapsed at exactly the same time as the levees were breached. There would have been a powerful, unambiguous and direct incentive on bondholders to maintain the levees.

We see now the unedifying alternative: spin-doctoring and the real underlying motivation of many senior officials the world over: doing everything possible to avoid being publicly identified as incompetent. Financial incentives, inextricably correlated with performance via Social Policy Bonds would, I suggest, be more effective.