Human development - Social Policy Bonds

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This paper takes as its starting point the Human Development Index, which aims to measure well-being in developing countries. It is about 4150 words long

Abstract

A new financial instrument Human Development Bonds is described. Its objective is to reward the achievement of a higher Human Development Index (HDI) in targeted developing countries. Private or public sector bodies would back the bonds and float them on the open market. The bonds would not bear interest, but instead would become redeemable only when a targeted rise in the HDI of selected countries had been achieved and sustained. The bonds would be freely tradable, and have the effect of contracting out the achievement of a higher HDI to the market. In such a way, the bonds’ issuers would be responsible for stipulating the human development target and would also be the ultimate source of finance for its achievement; but it would be the market, with its incentives and efficiencies, that would actually bring about the human development goal. Apart from greater efficiency, Human Development Bonds would bring more stability and transparency to the development process.

Targeting wellbeing: Human Development Bonds

No single measure can encapsulate all the variables that make up human wellbeing. But, at the low levels of wellbeing prevailing in many developing countries, the Human Development Index (HDI) is an excellent indicator of a society’s achievement. The HDI comprises three basic components: a long and healthy life, as measured by life expectancy at birth; knowledge, as measured by the adult literacy rate and the combined gross enrolment ratio for primary, secondary and tertiary schools; and a decent standard of living, as measured by Gross Domestic Product (GDP) per capita in purchasing power parity US dollars. The index is constructed from indicators that are readily available, using a methodology that is simple and transparent.

This essay is not going to suggest ways in which the HDI can be raised. Nor will prescribe who shall raise it. Indeed, it recognises that no single agency, government or otherwise, can ever have all the answers. While articulating development targets and raising revenue to help achieve them probably do require a single global or national body, actually achieving the targets requires pluralism, not central planning. Raising the HDI of poor countries is a complex and ever-changing challenge. What works for the people in one country, region, town or village might not work in another. What works one year might not work the next. So what is needed is a range of diverse and adaptive solutions; the sort of solutions that no single institution or ideology, however well resourced or well intentioned, finds possible to implement effectively.

Markets are pluralist. They encourage people and firms to try different approaches and to assess the results of these approaches. Markets also hold people accountable for the results and, crucially, ensure that ineffective or counterproductive approaches are terminated once they are seen to have failed. They elicit phenomenal information-processing power that central planners simply cannot emulate. They are the most efficient means yet discovered of allocating society’s scarce resources. Many, however, believe that market forces accentuate extremes of wealth and poverty or accelerate the degradation of the environment. Whether or not this has happened in the past, it need not be inevitable. It is largely historical accident that market forces serve public goals only as a by-product of their achievement of private goals. So there is no necessity for socially concerned, non-profit bodies, including government agencies, to eschew the market’s efficiencies (though that is what they tend to do). Market forces can serve public, as well as private, goals. The rest of this essay will describe a way of channelling the market’s incentives and efficiencies into one of our most urgent social goals: raising social wellbeing of the developing countries, as measured by the Human Development Index.

Human Development  Bonds

Human Development Bonds would be a new financial instrument, designed to channel the market’s efficiencies and incentives into raising the Human Development Index of a selected country or group of countries.

Governments of all countries in the world would, in concert with aid agencies and other bodies raise funds that would be put into an escrow account at a trusted financial institution. They would then issue bonds on the open market that would become redeemable for a fixed sum, only when the HDI of targeted countries reached an agreed, higher, level.

Normal bonds are redeemable at a fixed date, for a fixed sum, and so yield a fixed rate of interest. Human Development Bonds would not bear interest and their redemption date would be uncertain. Bondholders would gain most by ensuring that the HDI is raised quickly. There would be no need for the bond issuers to make assumptions as to how to bring about the targeted in increase in HDI.

Once issued, Human Development Bonds would be freely tradable on the open market. Owning such bonds, whose value would rise when the HDI goal became closer, would give bondholders an incentive to try to achieve that goal. They would have every motivation to choose and invent ways of raising the HDI that are cost-effective and efficient. Human Development Bonds would have the effect of contracting out the achievement of higher HDI to the private sector. Importantly, though, the backers of the bonds, whether they be public or private sector or some combination of both, would continue to set these objectives and to be the ultimate source of finance for their achievement. The bonds would inextricably link rewards not to carrying out activities, but to raising the Human Development Index of the targeted countries.

The rest of this essay looks in more detail at the Human Development Bond concept.

Who would back the bonds and what would be their goal?

The issuers and backers of Human Development Bonds could be government bodies, non-governmental organizations, charities, philanthropic organizations, or any combination. They would collectively decide on the exact specification of their HDI objective and contribute the funds that would be paid out once that objective had been achieved. Refinements to this objective could be made, in consultation with development and educational professionals. The targeted HDI objective should be defined so that all of the HDI’s components shall have to meet or exceed stipulated minimum values before the bonds can be redeemed. Of course, it would be unsatisfactory to redeem such bonds as soon as the targeted HDI objective had been achieved: the objective would be sustained rise in the level of HDI, and that is what must be achieved before the bonds can be redeemed.

Operation

Human Development Bonds would be issued by open tender, as at an auction; those who bid the highest price for the limited number of bonds would be successful in buying them. Each bond would become redeemable for, say, $1 million once the HDI of each targeted country, as certified by reliable and accurate measurements made by independent bodies, had been achieved and sustained. Assume that such bonds have been issued, and that they each sell for just $100 000. People or institutions now hold an asset that can give them a return of 900 per cent once the targeted HDI has been achieved. It is this prospect of capital gain that gives bondholders a strong interest in raising the level of the HDI.

Once floated, the bonds could be bought by anyone and would be freely tradeable. Such tradeability is, in fact, critical to the way the bonds work. Many bond purchasers will want, or need, to sell their bonds before redemption—which may be a long time in the future. Tradeability allows these holders to realise any capital appreciation experienced by their holdings of Human Development Bonds, whenever they choose to do so: it would therefore make the bonds a more attractive investment in the first place.

As the bonds are traded, they would tend to flow towards those who are most able to help raise the HDI. In fact, though, it is not necessary for there to be any actual flow of bonds. Large bondholders might simply decide to subcontract out the required work to many different agents, while they themselves hold the bonds from issue to redemption. The important point is that the bond mechanism ensures that the people who allocate the finance have an incentive to do so efficiently and to reward successful outcomes, rather than merely to pay people for undertaking an activity.

Who would buy bonds?

Many organizations already working in development might be tempted to invest in Human Development Bonds. They would benefit, most probably in a small way, from the rising value of their bonds as their efforts to raise the HDI succeed. But each organization’s overall impact might be too small to affect the market price of the bonds. Too large a number of small bondholders could do little to bring about increases in the HDI. So if there were many such small holders, it is likely that the value of their bonds would fall until there were aggregation of holdings by people or institutions large enough to initiate or finance effective HDI-raising projects. As has happened with share privatisation issues, the bonds would mainly end up in the hands of large holders - probably specialized financial institutions.

What would bondholders do?

Large bondholders could actively undertake HDI-raising projects, or they could function as brokers, allocating funds to HDI-raising programmes or bodies. They would do so quite differently from current institutions, because they have powerful incentives to make sure the funds are allocated cost-effectively. The bondholding bodies would gain most when targeted HDI level is achieved as quickly as possible.

Even then, each such body might not be big enough, on its own, to achieve much without the cooperation of other bondholders. But they will have a strong incentive to cooperate with each other, and to do so as cost-effectively as possible. If they did not, the market value of their bonds would fall. Their common interest in raising the HDI quickly means that they would share information, trade bonds with each other and collaborate on HDI-raising projects.. They could set up new types of organization, subordinated entirely to the goal of a higher HDI. They would also set up payment systems to ensure that people, bondholders or not, would have an incentive to perform efficiently. Large bondholders, cooperating with each other, would be able to set up such structures and systems cost-effectively. Bondholders could also lobby relevant governments to, say, give a higher priority to the literacy of schoolgirls, or relieve infrastructure bottlenecks, or sponsor preventive medicine programmes. They might finance or undertake any of such projects themselves, or finance their setting up or maintenance. They might borrow funds to finance HDI-raising initiatives on the strength of the expected rise in the value of their bonds It would be up to bondholders to decide on those programmes that would generate the highest increase the HDI per unit outlay.

Regardless of who actually owns the bonds, aggregation of holdings and the mutual co-operation of large bondholders would ensure that those who help raise the HDI are rewarded in ways that maximize the increase in HDI per unit outlay. If at any time others thought that they could do a better job than the current bondholders they would bid more for the bonds than they are worth to the current holders and accumulate them.

What will determine the price of the bonds?

The market prices of Human Development Bonds, and their changes over time, would supply helpful information as to how fast the objective is being achieved. These prices would be publicly quoted, just like those of ordinary bonds or shares.

What would determine the market value of  Human Development Bonds? Most obviously, the market’s assessment of how close the HDI targets are to being achieved. The bonds would sell for small fractions of their issue price if people thought there were virtually no chance of the HDI reaching the targeted level in their lifetime. People’s views will change as events occur that make achievement of a higher HDI a more or less remote prospect. But the bonds, once issued, would be transferable at any time. Bondholders, having done their bit to raise the HDI, would see the value of their bonds rise as the target became closer. They could sell their bonds, realising the capital gain arising from the higher market price of their bonds.

Advantages

Efficiency

Human Development Bonds would be more efficient than conventional means of raising the HDI. Their efficiency advantages arise from several sources.

First, the Human Development Bond approach would encourage diverse, adaptive HDI-raising initiatives. There are many ways of trying to raise HDI but we cannot know in advance which is the most cost-effective for any particular time or place. With technological changes occurring so rapidly, a bond regime, because it would not prescribe methods but only the goal, would encourage focused experimentation and innovation.

Of course, many governments and numerous non-governmental organizations are already carrying out HDI-enhancing activities. But there is a crucial difference: under a Human Development Bond regime the bondholders’ self-interest would give them an incentive to seek out those ways of achieving the targeted level of HDI that would give them the best return on their outlay. Their funding, if they are successful, ultimately comes from the bonds’ backers. And only when the HDI target is achieved would the backers actually have to pay for it. Until then, their funds would earn interest in an escrow account and it is bondholders who have to finance the initiatives that they think will raise the HDI. So it is bondholders who bear any risk of failure or undershooting the HDI target. In effect, the bonds’ issuers would be contracting out the achievement of a higher HDI to the bondholders. But it is the issuers who would set the desired HDI outcome, and, by undertaking to redeem the bonds, be the ultimate source of finance for that achievement.

A second source of the bonds’ efficiency arises from the prospect of large financial gains, which would not only motivate people working on HDI-raising projects to work more effectively, but also enlarge the pool of people interested in such work.

Another source of efficiency arises from the information a Human Development Bond regime would convey through the market price of the bonds. To see this consider how much the bonds’ backers would have to spend on the HDI objective. Their maximum outlay would equal the total number of bonds multiplied by their redemption value, minus any revenues gained on floating the bonds. But while the issuers would have to decide on the maximum cost of achieving the objective, they wouldn’t have to calculate the actual cost with any accuracy - that would be done by bidders for the bonds in the open market.

The crucial point is that it is not necessary for the bond issuers to estimate how much the targeted increase HDI will cost to achieve. Instead, potential investors in the competitive market for the bonds would do this, and they have every incentive to minimise this cost. They would do this when they bid for the bonds at issue and at all times subsequently.

If, once the bonds are issued, progress is too slow, the bonds’ backers can issue more at any time. They could do this by asking members of the public all over the world to contribute to the goal by making deposits into the escrow account, so swelling its value.

In sum competitive bidding would work to minimise the cost to the bonds’ backers of raising the HDI. The implication of this goes beyond reducing the costs to the backers: it will make contributions more forthcoming. People will be more willing to make donations when they know they will not be wasted.

Stability

Human Development Bonds would have goals that are more stable than any ways of achieving it that we can currently foresee. A significant rise in the HDI could take many years. During the time it takes to achieve development goals, new and unforeseeable techniques or technology, or new ways of applying existing techniques will become practicable. As well, policy priorities change and it is possible that any political commitment to any of the HDI goals could waver. A Human Development Bond regime, however, would to a large degree be insulated from such uncertainty. The stability of the targeted outcome means that potential investors in the bonds would hardly be deterred from taking measures to achieve it by fears of a change of government policy—or, indeed by changes of government.

Transparency

Another significant advantage of Human Development Bonds is their transparency. The bonds would make clear to everybody exactly what are the objectives of those governments, non-governmental organizations, philanthropists and charities that back the bonds. The objective of a Human Development Bond issue is clear: to increase the HDI in the targeted countries. There is no hidden agenda.

Other advantages

Further advantages of a Human Development Bond regime are:

  • Funds for increasing the HDI could bypass corrupt or inefficient people in position of authority or, by appealing to their financial self-interest, could effectively modify their behaviour in favour of achieving the HDI targets.


  • The bonds’ backers would incur significant expenditure only when definite outcomes had actually been achieved. In the meantime their funds would be earning interest. This means that the risks of failure are borne by bondholders, not those who contribute financially to the HDI. This is important, because it enhances the attraction of making a contribution in the first place.


  • A  less obvious benefit of a bond regime would arise from the existence of a means of acquiring wealth whereby private gain would be strongly and inextricably correlated with public benefit. Many disaffected people view with suspicion or alarm the very high incomes of people or corporations engaged in activities of little obvious net social benefit. They are unconvinced that ‘trickle-down’ occurs to any meaningful degree. Wealth, in these people’s eyes, is the result of exploitation. HDI bonds, by encouraging entrepreneurs directly to achieve society’s goals, could make for a more cohesive society.


Practical aspects

Defining the redemption terms

The Human Development Bonds’ redemption terms must be carefully defined. So as to reduce to a minimum the scope for manipulation it is important, for instance, that surveys undertaken to monitor progress toward the HDI target, be undertaken by disinterested bodies. The sample of, for example, the adults whose reading is to be tested for the literacy component should not be known in advance. Statistical protocols and procedures should, in other words, be robust.

Nor should bondholders be tempted to lobby in favour of, for instance, easier reading tests. Again, judicious specification of the targeted objective could forestall the problem: the bonds could in this instance stipulate, at the time of issue, the exact reading tests that will be used.

The Free Rider question

Could ‘free riders’ undermine the workings of the Human Development Bond mechanism? If purchasers of a significant number of the bonds hold them with no intention of doing anything to help raise the HDI that could undermine the potential of a bond regime.

There are, though, grounds to believe that free riding would not be a serious problem, mainly because it is unlikely much free riding would occur and partly because, even if it did,  it would not impede the operation of the bond mechanism. Free-riding would be a self-cancelling activity: if most of the bonds were held by would-be free riders, then little would be done to help achieve the targeted objective. As the objective became more remote, the value of the bonds would fall. And as the bonds’ price fell,  they would make a more attractive purchase for people who could help bring about the targeted HDI increase. So free-riders would be tempted to sell, even at a loss, to active investors, rather than see the value of their bonds continue to fall. Or they could be tempted to become active themselves, and work toward achieving the HDI target.

Note also that even if free riders were to gain from holding Human Development Bonds, they would be doing so only because their bonds rise in value when the targeted objective becomes closer to being achieved. Attempted free riding could have a positive effect: it would add liquidity to the Human Development Bond market.

Existing institutions and the transition to a Human Development Bond regime


Few bodies that currently undertake HDI-raising projects are currently paid in ways that correlate directly with their performance. Nevertheless these bodies are the main repositories of expertise, and some of them are certainly efficient in raising the HDI, or capable of becoming so. It would be unwise as well as unfair and unnecessary to divert their funding at short notice into funds allocated to redeem Human Development Bonds. The answer would be a gradual transition. While the guaranteed funding of institutions and activities could decline by, say, 5 percent a year, there would be a corresponding increase in funds allocated to redeem Human Development Bonds.

But as well as supporting existing bodies, it is likely that investors in Human Development Bonds would explore completely new ways of achieving raising the HDI; ways that currently receive no, or very little, funding. For example, they might find that in some circumstances the best way of achieving the targeted life expectancy and literacy objectives is to increase women’s access to family planning supplies. Following this logic, they might find that one of the most efficient ways of doing this is to support non-governmental organizations that already work toward this objective.

Interaction with existing programmes


Though changes in the source of funds would be gradual, those already funding, or working for, the many HDI-raising bodies might well react by quickly reviewing how all their existing programmes and projects operate. If bondholders see existing programmes as being particularly effective in achieving the targeted outcomes they would want to invest in them. On the one hand, the switch in funding would tell existing institutions that they could expect to see their relatively ineffective operations receive diminishing funds in the future. On the other hand, their effective operations could look forward to higher—possibly much higher—funding. Even a gradual transition could bring about a rapid change in the way existing bodies select and conduct all their programmes. They might have to devote some of their resources into persuading bondholders of the cost-effectiveness of their activities; but this would not represent a radical difference from the way these bodies lobby for funding nowadays.

What would happen once the initial HDI goals are achieved?

Assume that Human Development Bonds had been issued, that the targeted increase in the HDI has been achieved and sustained, and we are approaching the time at which the bonds can be redeemed. What should the bonds’ backers do? They could float a new set of Human Development Bonds aimed at maintaining the new level of  HDI or at further improvements.

Sustaining the outcome beyond the period specified in the original bond issue would most probably be cheaper than achieving it, while further improvements targeted by a second bond issue are likely to cost less, in terms of benefit per unit outlay, than those achieved by the first issue. There are two linked reasons for this:

Bondholders may have invested in HDI-raising systems or capital assets that cost less, per unit benefit, to keep running than they did to set up. For example, the initial training of healthcare workers or literacy teachers would generate HDI-raising benefits well into the future.

Bondholders, in a similar fashion, would have learned from their experience of achieving the objective targeted by the first bond issue. They would have looked for, and experimented with, different methods of raising the HDI, and be able to choose the most efficient ones for subsequent bond issues.

A new policy instrument

Resources are always going to be limited and Human Development Bonds will not change that fact. Priorities and choices will always have to be made. Whoever backs and issues Human Development Bonds will still decide on the exact definition of the health, education and income targets, and on the sums allocated to their achievement. In economic theory, and on all the evidence, markets are the best way of allocating scarce resources to achieve prescribed ends. Human Development Bonds would allow both the bonds’ backers (be they public or private sector) and markets to do what each does best: respectively: prescribing and raising the finance needed to achieve these ends; and allocating resources to meet these ends efficiently.

By injecting market incentives into the achievement of its goals a Human Development Bond regime would be more effective than conventional ways of bringing about a healthier, wealthier and better educated population and, ultimately, a population with a higher stake in a stable and prosperous future.

Ronnie Horesh, 2007


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