Saturday, May 19, 2007

Social policy bonds

Two earlier posts (one on DRM, the other on amortizing development cost) deal with cases where today's free market does a poor job of compensating somebody for something of value. I think these are what economists might call "missing market" problems -- it's not that a free market couldn't work in this situation, it's simply that we don't have the right market mechanisms in place yet.

One more approach to the missing market problem is the social policy bond, invented by New Zealand economist Ronnie Horesh. It works a bit like the X Prize or the Methuselah Mouse Prize, in that when something good is accomplished, somebody gets money. But with the X Prize, all the money goes to the winner (in that case Burt Rutan, who won the prize in 2004 flying SpaceShipOne), and none goes to the runners-up, or to the subcontractors who helped the winner win. The incentives in a one-winner prize therefore punish anybody who doesn't win.

Social policy bonds spread the winning money more fairly. Everybody who puts in time or money can get something back. In Horesh's vision it works like this. A deep-pocketed government announces that attaining some goal is a desirable social good. Tax money is put aside to bring about that goal in an economically efficient way. The government prints bonds which are redeemable for some large-ish amount of money when the goal is accomplished, and sells those bonds at a lower price to anybody who wants to buy them. The free market does the rest -- compensations will arrange themselves so that people work toward bringing about the goal, so that they can collect on the redemption of their bonds. People who would be potential prize winners (if the government were using a prize) can use the bonds as loan collateral to pay subcontractors.

This strikes me as a brilliant idea, although Horesh recognizes a potential free-rider problem with the scheme. When social policy bonds have been used in real life a few times, we'll have a better idea how big a problem that will be.

I like the idea that a social policy bond could be issued not by a government, but by an individual or private organization. There are two potential problems. One, an individual can't command the huge sums of money that a government can, so it might take thousands or millions of people each issuing privately-backed bonds to make something happen. Two, the issuer of a bond needs to have people believe that he/she/it will make good on the redemption, and there isn't an obvious mechanism how an individual can do this. Maybe there is some trustworthhy organization (like a bank? or Lloyd's of London?) that could hold the money in escrow. I've discussed the notion of privately-backed social policy bonds with Horesh in email, and he feels these two problems are prohibitive, but I still think it's worth a shot.

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