Why Second-best Macroeconomics is usually adopted?

It has been a while since this blog pointed to some writing by prof. Krugman.

Here is a nice one on Second-best Macroeconomics:

There’s a paradox about economic policy since the Great Recession, one that is often acknowledged implicitly but rarely stated directly. On one side, the economic problems facing both the United States and Europe have been quite straightforward and comprehensible. On the other side, the debate over actual policy has been tortured and confused, with a general sense even among aficionados that the tools being deployed are inadequate and come with troubling side effects.

Specifically, the whole western world has spent years suffering from a severe shortfall of aggregate demand; in Europe a severe misalignment of national costs and prices has been overlaid on this aggregate problem. These aren’t hard problems to diagnose, and simple macroeconomic models — which have worked very well, although nobody believes it — tell us how to solve them. Conventional monetary policy is unavailable thanks to the zero lower bound, but fiscal policy is still on tap, as is the possibility of raising the inflation target. As for misaligned costs, that’s where exchange rate adjustments come in. So no worries: just hit the big macroeconomic That Was Easy button, and soon the troubles will be over.

Except that all the natural answers to our problems have been ruled out politically. Austerians not only block the use of fiscal policy, they drive it in the wrong direction; a rise in the inflation target is impossible given both central-banker prejudices and the power of the goldbug right. Exchange rate adjustment is blocked by the disappearance of European national currencies, plus extreme fear over technical difficulties in reintroducing them.

As a result, we’re stuck with highly problematic second-best policies like quantitative easing and internal devaluation.

In case you don’t know, “second best” is an economic term of art. It comes from a classic 1956 paper by Lipsey and Lancaster, which showed that policies which might seem to distort markets may nonetheless help the economy if markets are already distorted by other factors. For example, suppose that a developing country’s poorly functioning capital markets are failing to channel savings into manufacturing, even though it’s a highly profitable sector. Then tariffs that protect manufacturing from foreign competition, raise profits, and therefore make more investment possible can improve economic welfare.

The problems with second best as a policy rationale are familiar. For one thing, it’s always better to address existing distortions directly, if you can — second best policies generally have undesirable side effects (e.g., protecting manufacturing from foreign competition discourages consumption of industrial goods, may reduce effective domestic competition, and so on). There’s also a political economy concern, which is that in a complicated world you can come up with a second best rationale for practically anything. Somewhere the Chicago economist Harry Johnson wrote (this is from memory) that in practice “second best policies are always devised by third-best economists working for fourth-best politicians” — harsh, but you can see his point.

🙂

I mean it is harsh reality as well. Politicians have lots of constraints and hands are tied most of the times.

Prof Dani Rodrik defended second best institutions and found them to be as good…

The focus of policy reform in developing countries has moved from getting prices right to getting institutions right, and accordingly countries are increasingly being advised to move towards “best-practice” institutions. This paper argues that appropriate institutions for developing countries are instead “second-best” institutions — those that take into account context-specific market and government failures that cannot be removed in short order. Such institutions will often diverge greatly from best practice. The argument is illustrated using examples from four areas: contract enforcement, entrepreneurship, trade openness, and macroeconomic stability.

One Response to “Why Second-best Macroeconomics is usually adopted?”

  1. Anil Says:

    Hi Amol Sir, Prof Thoma has even intresting take on the article. He says “Paul Krugman wonders if he has been advocating for the right type of policies”
    http://economistsview.typepad.com/

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