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.

Futures, options and perverse incentives

I continue to look at concerns raised by delegates at an OECD meeting that discussed a paper I presented on the environmental application of Social Policy Bonds. My previous post was the first; this is the second. 

Perverse incentives could arise from trading of Environmental Policy Bond derivatives. For example, one could make financial killing by selling bonds short (or by purchasing put options) and then dumping a million tons of manure in the Chesapeake Bay, or simply by not following through with promised abatement activities.

Futures and options markets in Social Policy Bonds would enable people to benefit from a falling bond price, so giving them an incentive to delay achievement of the targeted goal.

It is quite likely that there would be futures and options markets for large bond issues, and it is almost certain that the price of any particular Social Policy Bond would not always be rising monotonically from its float price to its redemption value. It would be justifiable, as well as efficient, if bondholders could hedge against consequent falls in the value of their assets. People who do not hold bonds might want to participate in markets for derivatives of bonds, some of which would rise in value as the targeted goal became more remote. This in turn means that speculators and short sellers could certainly profit from short-term bond price falls, and the question is whether these people would then take steps to impede progress towards any targeted goal.

There are two main reasons why they would probably not. The first is that, in the long term, the weight of money would be against them. Provided sufficient funds were allocated to achieving the targeted objective, there would be a net positive sum of money payable if the targeted objective were to be achieved, and a net zero sum paid as long as the goal were not achieved. All the long-term incentive would be to achieve the targeted objective. Those who, for whatever reason, would suffer from achievement of the objective could be compensated by bondholders, or bribed to change their ideas. Note also that for every buyer of a ‘put’ option there would be a seller, and that for every futures contract bought on the expectation that the bond price would fall, there would be an equivalent futures contract sold on that basis, so that the net incentive generated by derivatives would be in line with the incentive created by the underlying financial instrument, the Social Policy Bond: in the long run, this would favour achievement of the targeted objective.

The other reason that short sellers, or holders of ‘put’ options, in Social Policy Bonds might not take actions aimed at interfering with achievement of the goal is that such actions might well already be illegal or, again given the incentives that the bonds would generate, be made illegal – or have their provenance more enthusiastically investigated – once the bonds had been issued. Some miscreants might be tempted to sell bonds targeting water pollution short (or buy ‘put’ options) then dump a million tons of manure into Chesapeake Bay. But they would know that such an act is illegal – and that there will be people at the other end of their transactions who will be highly motivated to see the law enforced to its fullest extent.

Environmental Policy Bonds would not obviate the need for governmental regulators to monitor pollution levels and abatement activities of individual firms. Just like financial market need accountants, auditors and regulations to ensure Enron-like episodes remain an exception rather than the norm, Environmental Policy Bond markets will require similar oversight. The costs of this would reduce the efficiency of the bonds.

Government would need to monitor aggregate pollution levels under a bond regime, as these would be the measures targeted by the bonds. They would not need to monitor the pollution or abatement activities of individual firms. Bondholders would have incentives to monitor the activities of the largest polluters and either bring them to the attention of the authorities if they are breaking the law, or to find ways in which they would reduce their polluting activities. Bondholders would act as efficient enforcers of the government’s regulations by bringing the worst cases to the government’s attention. 

Arguing for and against Social Policy Bonds

Over the years Social Policy Bonds have discussed in many forums. I tried to address some concerns raised in these forums in my book, but that is several years old, so I am now going into more detail. This post looks at some concerns that delegates raised at a meeting of the OECD during which I presented a paper on the Social Policy Bond idea applied to the environment. I will eventually collate these arguments and responses and upload them onto the Social Policy Bond website. 

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If the polluters are few enough to overcome the free rider problem, then why are they not enough to collude in the bond market and thereby pay too cheap a price for the bonds issued?

The question is not about numbers of polluters. It’s about the number of bonds. Bidders for the bonds will compete to buy the bonds, then collude to achieve the goal that the bonds target.

The free rider problem arises when people own the bonds and do nothing to help achieve the goal. The more bonds in the hands of would-be free riders (passive bondholders), the lower the incentive for active bondholders to do anything. The value of the bonds on the market would keep falling. At some stage most bonds will end up in the hands of active investors. There might be few or many such investors, but they have every incentive to collude when they own bonds. They will, though, not necessarily collude to buy the bonds: the bonds will be sold on an open market, and, because anyone can buy them, collusion won’t be possible at that stage. So, there is always competition to buy the bonds, which maximises the returns to the issuing body. And there is always collusion between the shifting cast of bondholders, which maximises efficiency.

A more careful analysis is required about how governments would regulate information signals stemming from bondholders’ pollution abatement efforts and environmental measures on which bond payments are indexed.

The ‘environmental measures on which bond payments are indexed’ would be chosen to be, or to be inextricably and strongly correlated with the targeted goal. They would also be chosen to minimise the need for governments to regulate the associated information signals.

The idea needs a more careful analysis of the pros and cons of bond payment structures. Why do bonds simply pay a lump sum upon attainment of a fixed goal? Why not issue bonds that yield regular payments commensurate with pollution levels? If the bonds an all-or-nothing deal, the risk associated with the return could limit trading.

I agree. But the Social Policy Bond concept remains untried. Refinements can come later. Of course, separate ‘all-or-nothing’ bonds could be issued with targets of varying magnitude along the same scale.

Adysforemenon-cracy

The title of this post I intend to mean: rule by the insecure. ChatGPT says that the Greek term for 'rule by the insecure' is 'τυραννία των αδυσφορημένων' (tyrannia ton adysforemenon), which is probably more correct, but less snappy. (If you know the correct term, please let me know.)

Isaac Chotiner writes about the President of Turkey:

[T]he Gezi protests, which were really about an environmental issue initially, were meant to overthrow him. He sees everything in that vein. How Erdoğan Set the Stage for Turkey’s Disastrous Earthquake Response, newyorker.com, 14 February

The Economist writes about the ruler of India:

After the prime minister’s many victories against his domestic critics, going after foreign ones is the logical next step. After silencing critics at home, Narendra Modi goes after foreign media, the Economist, 18 February

It's unfortunate that the politicians, having attained power, are so desperate to avoid losing it. It's also inevitable: one cannot now ascend the political ladder unless you really, really want to do so. The desire for power trumps all other qualifications, including competence and the wish to improve the well-being of one's citizens (see Anything except outcomes). Maybe it was different when there was a born-to-rule class, but the relevant message now is that our political systems are increasingly dysfunctional, as shown by the widening gap between our rulers and the people they are supposed to represent.

Social Policy Bonds would do something to cut out the middleperson: under a bond regime, politicians wouldn't have the power to allocate funds between competing bodies; their role would be limited to that of articulating society's goals and raising the funds necessary for their achievement. Funding would be decided by bondholders, whose sole criterion would be the efficiency with which society's scarce resources could be deployed to fulfil its wishes. Cutting out the middleperson might not be so necessary if our leaders were honourable, competent and caring. Unfortunately, more and more, and whether or not we live in a democracy, our leaders are not selected for those qualities. They possess one quality above all others: a thirst for power - and they are pathologically insecure about losing it. This doesn't make for effective governance.

Where's the vision?

I've long stressed the most obvious feature of Social Policy Bonds: their efficiency, which would be measured as the increase in social (or environmental) well-being per pound spent. Under a bond regime, bondholders would have incentives to achieve our social goals as efficiently as they can. Also, I've talked about the stability of the goals that a Social Policy Bond regime could target: there's more consensus about such goals than there is about the means of achieving them, the most efficient of which would anyway change over time. And I've mentioned the transparency of a bond regime, which would target explicit, verifiable goals. All these attributes are beneficial. They allow us to take a long-term approach to dealing with complex social problems that require a wide array of diverse, adaptive approaches to their solution. 

It's also important that the goals we can target with a bond regime are comprehensible and meaningful to ordinary citizens. Taking health, for example, most of us have little idea about the relative merits of certain interventions, and recent events have seen a growing distrust of corporations and governments who, we'd like to believe, are acting with good intentions. My (long) essay on applying the bond principle to a country's health discusses the possible use of Quality Adjusted Life Years as one way of measuring the physical well-being of the population that could be targeted. Such  measures have their technical difficulties but they would be broadly understood by citizens with an interest in health outcomes. This is a benefit in its own right, but also a stimulus to greater public engagement with health policy and, therefore, greater buy-in. 

Sadly, but not unexpectedly, the essay languishes on my website, and current policymaking in the UK at least, continues to be an incoherent and incomprehensible (to outsiders) mix of arguments about funding and structures, and short-term kludges. Where is the vision? The strategy? The buy-in?

Actuarially...

It concerns me that our biggest, urgent social and environmental problems are never going to be solved under our current political arrangements. The problems include global environmental depredations, the risks arising from ever-greater access to weapons of mass destruction and extreme poverty.

Their features make them ideal for targeting with Social Policy Bonds:

• they require many diverse approaches, depending on geography. So reducing the likelihood of war, say, in the Middle East requires a wholly different approach to reducing the chances of war originating in the Korea peninsula, or the horn of Africa.
  
• they are long term problems that require sustained attention - not necessarily from the same people; and
  
• they will take years or decades to solve, so they require adaptive approaches, which respond to changing circumstances.

It is the last two points that require that the bonds must be tradeable, so that bondholders have incentives to do what they can to achieve our targeted goal in cooperation with other bondholders, and then realize the consequent rise in value of their bond-holdings by selling to investors who can better continue progress towards the goal. 

But all these features of our global problems show just how inadequate are our current attempts at solving them. Our politicians' purview is temporally or geographically extremely narrow. Our supra-national organisations do some good work, but cannot attract the people they need, nor the resources necessary to match the scale of our problems. As well, their structures and composition cannot respond to changing circumstances. We need a new sort of organisation whose structure, composition, and every activity are subordinated to its goal of solving a targeted social problem.

Social Policy Bonds have been in the public arena since 1988 (pdf). Others have taken the idea, made the bonds non-tradeable, and issued Social Impact Bonds, about which I am ambivalent. Actuarially, I'm unlikely to see my original concept deployed, despite the initial flurries of interest it has provoked over the last 34 years. I'll carry on, however, because I see no sign of any better way of addressing the multiple calamaties towards which we are heading.

Yet another post about nuclear war

The Financial Times discusses the ruler of North Korea:

In his New Year's address, he declared he would "exponentially increase" nuclear weapons production in 2023 and stressed his willingness to use his nuclear arsenal for offensive as well as defensive purposes. North Korea's nuclear threat (subscription), Financial Times, 9 January

He is certainly acquiring the capability:

[A recent test brought the North Korean] regime a step closer to acquiring a solid-propellant intercontinental ballistic missile that, unlike liquid fuel missiles, can be fuelled in secret before they [sic] are deployed, giving adversaries far less time to conduct a preventive strike.one of many recent examples of Pyongyang approaching or crossing key technical thresholds that are making its nuclear arsenal increasingly versatile and difficult to destroy or defend against. 

 How should we address such a possibility? The experts have no idea:

[S]ome analysts worry that a strategy to meet strength with strength risks making conflict even more likely. 

So whether the world does or does not suffer a nuclear exchange depends on the state of mind of the ruler of a hermit kingdom who is not renowned for a willingness to accept the status quo, nor a predisposition to negotiate in good faith. There are, of course, other potential nuclear flashpoints in our world. How are we going about dealing with these threats not only to millions of people, but to an already parlous physical environment? Well, we have international bodies such as the United Nations and numerous other organisations, staffed by hard-working, well-meaning employees with very limited resources doing their best to try to bring about peace, either regionally or globally.

Sadly, in comparison to those who benefit when tensions are high and rising, the people working for these organisations have little to work with. There are fewer incentives to achieve and sustain world peace than there are to foment war. People, especially on the left, don't like the idea that we should pay people for doing idealistic things and really dislike the idea of paying them more for doing an excellent job. But even if we share their disdain for paying people cash for success in performing a public service, we can see that giving such people and their organisations more resources with which to work can be helpful in bringing about their goals - which, in the case of nuclear conflict, are the goals of almost the entire world population. 

Yes, incentives matter. But there is no known way of reducing the likelihood of nuclear conflict: we need an array of diverse, adaptive approaches, many of which we cannot foresee in advance. So my proposal is to issue Nuclear Peace Bonds, which would reward the people who bring about nuclear peace for a sustained period, whoever they are and however they do so. I've written copiously about this idea both on this blog and on my main site: see here. Nobody's taken it up, probably because it's radical, possibly because it doesn't emanate from one of our esteemed institutions or highly acclaimed academics or celebrities. Yes, some wealthy people might become even wealthier if they succeed in bringing about thirty years of nuclear peace. Is that so bad, though, when compared to the alternative? The unfortunate fact is that our current policy choices are leading humanity and our physical environment to disaster.

Peace on Earth; worth paying for

Applying the Social Policy Bond concept to conflict reduction means, in effect, paying people not to kill each other. It doesn't sound very edifying, but I'll make the case for it anyway.

Of course, it is less than ideal that people don't freely choose to live in peace; and frequently invade and kill in pursuit of their goals or those of their leaders. Throughout the centuries, we haven't found ways of ending war. Conflict has so many causes and it's widely believed that war is an inevitable, intractable aspect of humanity. Given the human and resource cost of war and preparing for war, I think it reasonable to allocate funds to eliminating it for a sustained period. A Conflict Reduction Bond regime would aim to do this and, importantly, if it were to fail, no government funds would be lost. 

A misconception of those who disdain the Social Policy Bond principle is that they think paying for results means huge cash prizes for the already wealthy. It's true that, under a bond regime investors in the bonds would benefit if the targeted social goal are achieved quickly but, in the long run, what's more likely is that more people would be attracted to working to achieve achieve the targeted goal. The most efficient of these should see some higher financial rewards but, more importantly, they will have more resources with which to work. It's my impression that, if there were bodies with a proven record of bringing about peace in a wide range of circumstances, they'd enjoy very high levels of funding.

Underlying all this reasoning, though, are two points:

• Incentives matter. Weapons manufacturers, ideologues, military bodies all respond rationally to the incentives on offer. Not all these are financial incentives, but there are sufficient monetary rewards to those who manufacture and use weapons to make sustained periods of world peace unlikely. A Conflict Reduction Bond regime would offset such rewards, to a degree dependent on their backing.
  
• While it would be lovely if people's humanity alone were sufficient to ensure peace on earth and goodwill to all, the Conflict Reduction Bond option of making explicit, taxpayer-funded payments in exchange for world peace would be preferable to the situation we have today.

The benefits of relinquishing power

The problem with philanthropy is that philanthropists and their employees are reluctant to relinquish control over how their goals shall be achieved and who shall be seen to be achieving them. (Politicians are similar in that respect, but we have higher expectations of wealthy individuals with noble intentions spending their own money.) Sadly, this wish not only to be a benefactor to humanity, but to be seen to be such a benefactor means that our biggest, most urgent challenges are being neglected. Philanthropists - and politicians - want to be identified with successful initiatives. It's a natural human tendency, but it's holding us back. Society is too complex for most of our serious social and environmental problems to be to be traced to a discrete set of causes. Insecticide-drenched bed nets might be the best way of dealing with malaria somewhere at some time - but not everywhere, and not always. We need a policy environment that encourages initiatives that are capable of adapting to differing and changing circumstances, and that have a long term focus on achieving outcomes.

Which is where the Social Policy Bond idea can play a role. Under a bond regime the role of philanthropists - or government - would be limited to supplying and raising funds to be used to redeem the bonds, and defining the outcome that they wish to achieve. They would not stipulate how that outcome is to be achieved, nor who will achieve it. By relinquishing those powers, groups of philanthropists or governments could greatly expand the range of goals they could target to include such global goals as sustained periods of world peace or climate stability - goals that have no single, identifiable cause, and that will necessarily take many years to achieve. It would be unfortunate if, solely because of people's wish to be publicly identified with successful initiatives, our most urgent problems depend for their solution on a small number of dedicated people with pitifully inadequate resources.