Most government programmes in western countries satisfy one or other of these criteria. The European Community's Common Agricultural Policy is a spectacular example of a programme that satisfies both. Social Policy Bonds, by focusing on quantifiable objectives, and limiting their maximum costs, would pose a formidable first hurdle for policies as expensive and wasteful as the CAP. Under a bond regime, indirect ways of achieving policy objectives would be implemented only if they were efficient. Importantly also, even if the bonds were to stimulate inefficient projects, the costs of these inefficiencies would be borne by the private sector, not taxpayers.

Social Policy Bonds and social goals

Crime prevention

Currently touted methods of combating crime are longer sentences for convicted criminals, and more money for the police force. Social Policy Bonds would home in directly on what society actually wants to achieve: they would become redeemable only when crime and the fear of crime had fallen to low levels.

Employment

Social Policy Bonds targeting unemployment could replace a wide range of measures including protectionist barriers to imports of labour-intensive manufactures, which are aimed at maintaining employment in certain industries. Here the efficiency gains from bonds that target unemployment directly could be dramatic.

Health

Priorities for health services are strongly influenced by groups of medical specialists with little incentive or capacity to see improvements in the general health of the nation as an objective. So funding of medical specialities depends on the strength of their lobby groups. And what is arguably the most efficient way of spending the taxpayer's health dollar - preventive medicine - receives derisory funding, because it has no powerful lobbyists.

Targeting general indicators of well-being - life expectancy, infant mortality, disability - would ensure that scarce resources are allocated in ways that would directly achieve society's health objectives. The bonds would divert, impartially, government funds into those areas of the health service that would most efficiently use them to achieve the targeted objectives.

Housing

Social Policy Bonds could target the numbers of homeless, or the number of new approved housing units completed, or occupancy rates of the existing housing stock.

Education

Bonds could target results achieved in basic literacy and numeracy tests taken by schoolchildren.

Pollution

Bonds could target nationally averaged levels of water or air pollution [see Investing for the future: Environmental Policy Bonds].

In all these examples there would be difficulties in the specification of the objective to be attained. 'Approved housing units' for instance, or 'reported crimes' could be subject to varying interpretation, or to deliberate attempts to falsify the information required to monitor achievement of the objective in question. But these difficulties are not insuperable, so long as the following three processes are soundly carried out:

Quantification

The objective must be capable of being quantified, or there must be a strongly correlated proxy for the objective, whose targeting would inevitably result in the objective being achieved.

Definition

Careful thought will have to be given to the definition of each objective targeted by the bonds. Consider the unemployment example. It would be unsatisfactory to redeem the bonds when unemployment was down to a certain level for a short time only. The objective is a sustained level of low unemployment, and this is how it would have to be defined when the bond is issued.

Monitoring

All bond issues will require reliable and accurate monitoring of the targeted problem so that progress toward its solution can be reliably and unambiguously assessed. This surveillance must also be seen to be independent of the government or interest groups, both of which could benefit unfairly from dubious data collection. The nature of the monitoring [whether it is carried out at local, regional or national level, for example, or the level of aggregation at which independent organisations are involved] would depend on the objective being targeted and, to some extent, on the amount of government money at stake.

The market for Social Policy Bonds

For the bond mechanism to work it is essential that active investors purchase the bonds and help to solve social problems. But there is no need artificially to boost investor interest in the bonds: the anticipated supernormal profit arising from early redemption of the bonds generates the required self-interest and so supplies the motivation for achieving the government's objective provided there is a buoyant market for the bonds.

Social Policy Bonds, once issued and sold, must be readily tradeable at any time until redemption. This is critical to the operation of the SPB mechanism. Many bond purchasers will want, or need, to sell their bonds before redemption - which may be a long time in the future. If there were no secondary market, these holders would not be able to realise any capital appreciation experienced by the bonds. This would remove much of the incentive to purchase the bonds in the first place.

But there is another important reason for requiring a healthy secondary market in the bonds: active investors may be able to speed up only one, or a few, of the processes necessary for the targeted objective to be achieved. Once these investors have done their bit, and seen the capital value of their bonds in line with the increased probability of the bonds' early redemption, they may have no wish to speculate on the speed at which the remaining processes will be carried out. Other groups of active investors, who will have greater expertise in performing these later processes, must be given an incentive to use their expertise to accelerate attainment of the targeted objective. The possible capital appreciation of bonds bought from previous owners and sold at a still higher price [or redeemed] provides this incentive. The new owners will, if they are successful in these later stages, realise this capital appreciation.

Bonds therefore would, as from would-be free riders, tend to flow outwards from those who had helped as much as they can to achieve the targeted objective. In fact, though, it is not necessary for there to be any actual flow of bonds. What would flow could be bonds, but it could also be finance from bondholders. The important point is that the bond mechanism ensures that the people who allocate the finance have just as much incentive to allocate efficiently as those who receive it have to solve the targeted social problem efficiently. At the limit we can conceive of just one single buyer of all the bonds. If this buyer were determined to hold on to the bonds until redemption, then the bonds would function as a sort of performance-related contract, with the government paying only when the objective has been achieved. The buyer could contract out most, or all, of the work required to achieve the objective, with the incentives given by the bonds for speedy accomplishment cascading down from the bondholder to those subcontracted to do the work.

The secondary market is also necessary from the government's point of view. Government could, as a competitive supplier of objective-achieving services, participate as an active investor in Social Policy Bonds. Note that, unlike in industry, even if the operations of government were successful only because they were subsidised, the private sector would be unlikely to cry 'unfair competition'. This is because its bonds would also appreciate as a result of government [or government-inspired] activity. It may be necessary, for some objectives, for government to give some assurances about it future behaviour, if it is thought that without such assurances there would be too much uncertainty for markets in the relevant bonds to operate.

Anther source of efficiency is that the market for Social Policy Bonds will generate extremely valuable information for policymakers. They will do so even as the bonds are issued: the price they fetch will be an important indicator of how remote the market believes is the targeted objective. Thereafter bond prices, and the way in which they change, will supply continuously updated information on which policy programmes and events are, in the market's view, likely to be most effective at achieving the targeted goal.

Government, while it may profit from appreciation of the bonds it purchases, will also be interested in the cost of its social policies. The Social Policy Bond principle is superior to existing budgetary mechanisms in that the cost of each scheme is not only inexorably linked to attainment of its objective, but its maximum cost can be decided in advance. The number of bonds is limited, and the most the scheme could cost the government would be the cost of redeeming the bonds very soon after they are issued [this assumes a negligible issue price] plus all the administrative costs. Even then, though, the objective will have been achieved before any cost is incurred.

The efficiency of the bonds could be tested by allocating the same sums of money as are currently allocated for a particular social objective to the redemption of bonds targeting the same objective. The maximum cost to the government of the issue could then be set so as not to exceed the expenditure that would anyway have been incurred in pursuit of the same objective.

We should note too that Social Policy Bonds allow for the complexity of social problems. No single approach will solve them, so a wide variety of approaches to their solution is essential. Social Policy Bonds will encourage and reward the most efficient of these approaches. This occurs because of the nature of the bond mechanism, and requires no selection or supervision by government [or government agency] of the most efficient policy. Only the objective, not the policy, is dictated by government. This feature tends to stabilise the political environment. Obviously the objectives will have to be carefully defined, but there is near-unanimity over most social goals. A government is unlikely to repudiate such universally desired objectives, even if the associated bonds had been issued by ruling parties with a different political outlook. The risk that it might, and so become the first government openly to support higher unemployment, worse standards of health care, etc, would not be much greater than that of a government refusing to redeem fixed interest stock issued by any of its predecessors. This risk, always present, in now way impedes the operation of bond markets.

Advantages

1. The main advantage of Social Policy Bonds is that they make the achievement of social objectives more efficient by injecting self-interest into every stage of the process. Thus, efficiency in the attainment of distributional aims is improved. For the same government expenditure, therefore, more could be achieved in the social policy area. Additional gains accrue for other reasons:

2. The bonds guarantee stability of policy objectives. Policy instability is an important reason why people do not undertake projects or activities that could benefit society. Objectives with a necessarily long lead time [for example: to halve levels of water pollution] could be targeted by a bond issue, and holders of the bonds would not be deterred from taking measures to achieve them by fears of a reversal of government policy - or indeed, a change of government. In the current policy making environment, decisions about projects are plagued by policy uncertainty arising from government decisions that are subject to all the whims and inefficiencies of political expediency. Uncertainty also surrounds the behaviour of the aspiring political parties, which differ not so much in their stated objectives, but more critically in the ways they will strive to achieve them.

3. The bonds make policy objectives more transparent. Apologists for current policies often point to benefits that can result only haphazardly - if at all - from their implementation. Social Policy Bonds would ensure that objectives are explicitly identified, and that indirect methods of achieving them would be encouraged only if they were efficient.

   Also, note that explicit targeting of objectives is likely to lead to explicit calculation of the value of their achievement - a useful discipline, but one rarely followed by today's politicians.

4. A less obvious distributional benefit would arise from the existence of a means of acquiring wealth with which private gain is strongly correlated with public benefit. Many bondholders would be rich and, if their bonds were redeemed early, they would become richer. But this would be a socially acceptable way of acquiring wealth. And the existence of such a way of accumulating wealth would allow other, less socially beneficial ways [inheritance, for instance] to be taxed more heavily.

The biggest potential problem of Social Policy Bonds is probably the incentive they will give bondholders to achieve specified objectives at the expense of other societal goals. For instance, assume that the concentration of atmospheric lead is targeted in a bond issue. It might be that targeting lead in this way would cause people to increase their use of substitutes - which could be more dangerous than the original levels of lead. One way of anticipating this problem could be to aim initially at unambitious reductions in the lead level. Depending on the effects of this reduction on the use of offending substitutes, other bonds could then be issued targeting these substitutes, or further targeting the level of lead.

A better approach though would be to target, more comprehensively, atmospheric pollution. This could be expressed, perhaps, as an index of atmospheric pollutants weighted according to their lethality and other factors. In general, objectives that are complementary and that, if not pursued jointly, could conflict, should be targeted by a single bond issue.

Another safeguard against legal, but negative activities undertaken in pursuit of a targeted objective, could be provisos on the bonds specifying indicators of social welfare which, while not explicitly targeted by the bond issue, must be satisfied for the bonds to be redeemed. Thus Social Policy Bonds targeting unemployment could embody provisos to the effect that the bonds would not be redeemed if the inflation rate exceeded a certain limit.

Illegal activities could, of course, be dealt with by existing laws, possibly backed by a system of bondholder registration, which would identify those with the biggest incentive to commit them.

Another possible problem arising from the integration of the bonds into the current policymaking system arises from the government's role as creator of statutes. Laws affecting the bond price could be passed. For instance, government could come under great pressure not to increase unemployment benefits from holders of bonds targeting unemployment. Note though, that the source of the pressure, and the motivation for it, would be easy to identify. In any case, the threat of such pressure has a positive aspect: for bond issues to be as successful as possible, governments would have to give assurances as to their future behaviour. This could be another means by which Social Policy Bonds stabilise political objectives.

These problems should not be overstated. Existing laws, careful choice and specification of targeted objectives, and tighter rules on investments and declarations of interest by Members of Parliament would probably circumvent them.

And the question of how well Social Policy Bonds would achieve societal goals needs to be considered alongside current policymaking methods. In today's environment policymakers can escape or deflect censure because the adverse results of their policies are difficult to relate to their cause. If the bonds were to lead to negative effects, the relationship between these effects and their cause would be identifiable, and the filtering out of negative effects would be a simple matter compared to the methods available to today's policymakers.

Conclusions

Resources are always going to be limited and Social Policy Bonds will not change that. Priorities and choices will always have to be made: under the SPB principle, the choice of problems to be targeted, and the funds allocated to their solution, will remain in the hands of governments, with all the limitations - and guarantees - that that implies.

For while democratic governments are good at representing and articulating their people's wishes, they are not so successful at working out the most efficient ways of achieving these goals. This achievement is really a matter of allocating scarce resources: in economic theory, and on all the evidence, markets are the best way of allocating scarce resources to achieve prescribed ends. Social Policy Bonds allow governments to do what they are best at - prescribing ends - and markets to do what they are best at - allocating resources to meet these ends. In so doing, the bonds can achieve society's distributional objectives more efficiently and less randomly than the current combination of ad hoc policies and trickle down.

In the long run the widespread acceptance of the fact that self-interest can benefit the poor could have more far-reaching implications, transcending national boundaries. Global problems - war, famine, disease and the planet's environmental depredations - could be made the targets of internationally backed bond issues.

All this, though, is a long way into the future. Even at the national level, the surrendering of policy instruments to the private sector, albeit with the aim of achieving social objectives, will be politically difficult, and must be a gradual process. But the potential benefits should not be ignored. Western governments' spending on education, health, the justice system, the environment and other items continues to grow, despite all efforts to restrain it. Even relatively small gains in efficiency in this spending could greatly benefit those who are most in need.

© Ronnie Horesh

If you would like to read more about the Social Policy Bond concept and its applications, further papers are available via the Social Policy Bonds home page. For information on longer treatments, click on "Books and e-books".