Training “Second Best” Thinking….

By Cindy Ivanac-Lillig

The theory of “second best” basically states that if one condition cannot be met in a model, meeting the remaining conditions may not necessarily give you the next most efficient outcome. In other words, one condition not being met fully sometimes requires other conditions to be abandoned to get a “second best” result. Here is a more precise definition for those interested.

I recently read an article about the Fed by Paul McCulley entitled, “Because I said so….” I didn’t necessarily agree with all his arguments, but he did make me think differently about the subject matter and how it could be used effectively to teach macroeconomics. McCulley paraphrases a Deputy Governor of the Bank of England, Charles Bean, who says that in the absence of a powerful global macro-prudential regulatory regime, central bankers will have to seriously consider the “second best” option of incorporating asset prices more explicitly into their Taylor-like rules –if that is what is necessary to enhance prospects for systemic stability.

Many economists believe monetary policy decision-making does not need to take into account asset prices because aggregate demand data will essentially point in the same direction policy-wise. Because of that, they conclude, there are not many benefits and, in fact, many potential pitfalls in trying to incorporate asset prices and more specifically asset bubbles (which are notoriously hard to predict) into decision-making models. However, here we are at the end of 2009 and the question of asset bubbles haunts central bankers and economists all over the world. Did the well accepted central banking “condition” or assumption fail in terms of asset prices reflecting aggregate demand data? If, as McCulley states, the Fed’s “reaction function” is flawed in this way, what is the “second best” option?

Perhaps questions like — what will be the likely outcome if asset prices are not incorporated into decision-making processes in the future and what other options are available to central banks to deal with this issue — need to be answered before accepting the simple explanation that there isn’t a good theoretical way to incorporate asset prices into existing monetary policy thinking.

Regardless of your opinion on McCulley’s article, learning how to think about what is “second best” is important. The article reminds us that “second best” thinking divorces the perfect from the near perfect. They are not always just one tweak away from one another. In fact, they can be somewhat distant from one another. I think what Governor Bean is saying is that you may actually have to distort something else to deal with existing issues in the next best way.

I think a really interesting assignment would be to ask students to find examples of “second best” decisions being made. What markets and/or policies illustrate how further distortion was necessary in order to get a “second best” solution? What were the other alternatives?

Please share your thoughts on either the article or an assignment idea….

4 thoughts on “Training “Second Best” Thinking….”

  1. Hi Cindy,

    I had never thought about the theory of second best and given our current financial predicament I think it is worthy of valid consideration. Thanks for giving me something new to think about as 2010 approaches.

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