View source for Making the second best of it

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{{DES | des = "To say that we live in a second-best world is just to say we live in the real world, not a blackboard model. Good policy advice in the real world is at least as much applied moral philosophy, psychology, and anthropology as it is applied economics. And if piecemeal policy advising is an art, then a useful wonk is a sort of artist, but in the way a good surgeon is an artist, not the way a novelist is." | show=}}
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HARVARD'S Dani Rodrik, a favourite of this blog, made waves earlier this month by arguing that economists eager to get the government's hands on the economy appreciate the logic of the "theory of the second-best", while the benighted free-marketeers are in the grip of  a lovely but illusory ideal. As Mr Rodrik makes it out, what's going on is that empirically-minded economists such as Joseph Stiglitz, George Akerlof, and Mr Rodrik face squarely the manifold imperfections of real-world markets, in sharp contrast to the laissez faire crew who blithely ignore these flaws, lest they be forced to concede the need for corrective government guidance in economic affairs. This analysis confused me, for a number of reasons, not least being that Mr Rodrik's application of the "theory of the second-best" did not conform to my understanding of it.

The theory of the second-best was first laid out in a 1956 paper titled, sensibly enough, "The General Theory of the Second Best", [paid access] by Richard Lipsey and Kelvin Lancaster. Roughly put, Lipsey and Lancaster pointed out that when it comes to the theoretical conditions for an optimal allocation of resources, the absence of any of the jointly necessary conditions does not imply that the next-best allocation is secured by the presence of all the other conditions. Rather, the second-best scenario may require that other of the necessary conditions for optimality also be absent—maybe even all of them. The second-best may look starkly different than the first best.

Consider a frivolous analogy to cookie-baking. If the optimal cookie contains chocolate chips and coconut flakes, but you have no chocolate chips, chances are you don't need the coconut either. The second-best cookie may be the gingersnap. If ingredients (or logical conditions) do their work through a certain combination or complementarity, you may have to aim for something completely different even if you're missing just one of them.

So what's the upshot for ideology and policy? Well, insofar as we are thinking in terms of mathematical models of idealized economies, it seems that there is no obvious upshot at all. As Marc Blaug once wrote of the welfare theorems, "...these beautiful theorems are mental exercises without the slightest possibility of ever being practically relevant." And as the moral philosophers like to say, "ought implies can"—we are obliged to strive only for the possible. Likewise, a social ideal is worth aspiring to, and worth using as a standard of policy evaluation, only if we can get there from here. Then why should we care whether the conditions for a fantasy of ideal efficiency are present in the real world? The answer is that we shouldn't care. Furthermore, why should we care whether a given policy is "second-best" relative to our fictive efficiency norm? Again, we shouldn't.

Suppose that I told you that in the absence of the necessary conditions for teleportation, the next best thing is to forget all about the conditions for teleportation and instead fly at near the speed of light. Would you find this helpful if what you actually had was a Toyota and a half-tank of gas? Many "second-best" policy recommendations are a bit like that: the ideal market is a fantasy, so here is an ideal government to fix things. Obviously, this is not very helpful. If we are going to be hard-headed empiricists on the lookout for real-world imperfections, then we must admit imperfections equitably and not blanch in the face of the often appalling failures of government to operate as intended.

However, one needn't press the government-failure point at all to see that the theory of the second-best hardly implies a program of vigorous government intervention—or much of anything substantive, for that matter. In a new paper [free .pdf here] reflecting on the theory of the second best after fifty years, Richard Lipsey writes:

The upshot is that in practical situations, as opposed to theoretical models, we do not know the necessary and sufficient conditions for achieving an economy-wide, first-best allocation of resources. Achieving an economy-wide second-best optimum allocation looks even more difficult than achieving the first best. Without a model of the economy’s general equilibrium that contains most let alone all of the above sources, we cannot specify the existing situation formally and so cannot calculate the second-best optimum setting for any one source that is subject to policy change. This is an important point since much of the literature that is critical of second-best theory assumes that economists know a distortion when they see one and know that the ideal policy is to remove the distortion directly, something that is necessarily welfare-improving only in the imaginary one-distortion world.
The methodological insight at the heart of the theory of the second-best is that in a complex world we must rely on well-confirmed generalizations and an artful application of economic sense, not high theory, when designing and evaluating policy. Lipsey recommends verbal or "appreciative" theorizing in the style of Adam Smith, Thomas Schelling, and Milton Friedman informed by formal theory, but not bound by it. 
According to the appreciative approach, since the competitive market economy is the best known method of allocating resources, departures from it through either public policy or private behaviour are regarded as prima facie undesirable, unless justified by well-reasoned arguments and persuasive evidence. ... What is needed is a good appreciative understanding of how the price system works, as well as understanding the cautionary warning from second best theory that any policy may have unexpected and undesirable consequences in apparently unrelated parts of the economy that need to be watched for and mitigated where necessary. Useful piecemeal policy advising is not impossible; neither can it be determined purely scientifically; instead it is an art, assisted by good economics, both theoretical and empirical.
To say that we live in a second-best world is just to say we live in the real world, not a blackboard model. Good policy advice in the real world is at least as much applied moral philosophy, psychology, and anthropology as it is applied economics. And if piecemeal policy advising is an art, then a useful wonk is a sort of artist, but in the way a good surgeon is an artist, not the way a novelist is. The theorists are novelists, illuminating the real world by inventing false ones. The best policy-oriented economists, both left and right, are second best economists in the sense that they grasp the lesson of their fictions, but aim at truly feasible ideals, not blackboard utopias.
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