State interventions and the theory of the second best

Eclipse_aviationWhen should governments intervene in the economy? A fairly mainstream view is that interventions should aim to correct market failures when they arise, to move the economy towards greater efficiency or welfare. Many governments around the world engage in forms of industrial policy, which generally involves the promotion of particular firms and sectors which are thought to have large positive spillovers or linkages to the rest of the economy. In a developing country, the usual aim is to encourage firms to absorb and learn how to use already existing technologies, and ‘catch up’ with more advanced countries in terms of levels of productivity and output per head.

In advanced countries closer to the technological frontier, policy should be more focussed on encouraging innovation and moving the frontier itself forward. This might involve promoting links between research and development (R & D) bodies and firms, or providing infrastructure which supports clusters of firms which can learn from as well as compete with each other in the growth process.

A number of economies, including the US and UK in recent decades, have seen dramatic declines in the share of manufacturing output and employment in their economies. Part of this may be part of the normal process of structural change in the development process, as services grow at a faster rate than industry, driven by changing consumer tastes as well as faster price inflation in the service sector due to its relatively lower productivity growth. Some economists have argued that this process of deindustrialization has gone too far, leading to persistent imbalances in the current account of the balance of payments which over the long-term may reduce growth and employment. So there may be a strong case for policy to in some way encourage greater investment and output growth in industries which export or compete with foreign exporters.

A dramatic change in the world economy since the 1980s has been the rise of the Chinese economy and its more recent emergence as the largest manufacturing nation in the world. China is unusually open to trade for a large economy, when compared with the US, and its exporting prowess has had a huge impact on global trade flows and other countries’ manufacturing sectors. China has made the transition from a communist to a capitalist economy, but it has attempted to manage the process carefully, and arguably to date, this has been a success. It has grown at on average 10% per year for about thirty years, which is unprecedented. Hundred of millions of people have been brought out of poverty. As part of its strategy, China has used an industrial policy which promotes foreign direct investment (FDI), but in special zones, and has tried to encourage the transfer of foreign technological know-how to domestic producers. It is now a middle-income country, in terms of income and output per capita, and still has scope to encourage the aforementioned ‘learning’ of current technologies, at the same time as promoting innovation.

It is clear that China’s growing competitiveness in manufacturing in recent decades has played a role in the deindustrialization in more advanced countries. Given that China has intervened to encourage high levels of investment and exports, should the rich countries have responded passively and simply accommodated industrial decline, or should they have supported industry more directly, in order to allow their domestic producers and exporters to compete on a level playing field with Chinese firms? In economics, ‘the theory of the second best’ provides one answer.

The theory of the second best suggests that when one market distortion cannot be removed, then a policy which creates another distortion in the same market may produce greater overall efficiency than doing nothing. The case is therefore made for intervention in some markets which creates distortions, when one or more distortions are already present.

Given the industrial policies carried out by governments in many emerging and developing economies, including China, the theory of the second best may support industrial policies in countries whose manufacturing sectors are in competition with them. Successful industrial policies will alter trade flows internationally, including in a hypothetical country without state industrial intervention. One could argue that economic welfare would be greater without any intervention at all, but given that this is a poor reflection of the interrelations between states and markets, which in my view are inevitable, it may improve national and global welfare if governments intervened to prevent industrialization to some degree by encouraging innovation in industrial production which allows the relevant trading firms and sectors to compete with sectors in countries such as China. Of course, a rich nation would not be wise to try to compete in textiles, as it simply would not have low enough wages to do so, but in more advanced sectors, industrial policies in two trading countries may well create greater welfare for both economies, rather than reducing it. The theory of the second best provides one argument for this.

Economists and policy-makers arguing for a no-intervention state are simply ignoring the lessons of history, in which all currently rich nations engaged in forms of industrial policy by protecting infant industries and encouraging growth in particular sectors so as to raise their overall growth rates. Political economy rather than pure economics comes into play here, and the debate should not be ‘intervention versus no intervention’ but ‘what kind of intervention is most effective at improving economic performance’. Behind all the political rhetoric, few governments once in power simply avoid any interventions at all. They may engage in ones which fail, cost resources and reduce welfare, but the point remains: states should try to engage in carefully targeted interventions rather than dream of a free market utopia.

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