THE THEORY OF SECOND BEST AND U.S. TRADE POLICY D. B. Timmins, PhD Summary Politicians have learned that the perfect in often the enemy of the good . We economists, being proprietors of a more exact science, seem unwilling to merely satisfice , always wishing to go for the brass ring, even though this is rarely obtainable in the real world. Lipsey and Steiner in their General Theory of the Second Best tell us, "Despite the theoretical promise that true free markets will be perfectly efficient, the real world is not a textbook. It is full of . . . distortions, and piecemeal attempts to move closer to a pure market may make matters worse. Therefore we are not infrequently better off finding the best available 'second best' rather than looking for an unobtainable first best. The 1980s, alas, are replete with proofs of this theorem." (Emphasis supplied -- and the precise two points of my own PhD dissertation written well before Lipsey and Steiner, and the insights which earned my doctoral degree at Harvard). Another astute commentator has observed that if practice followed theory, producers would be immediately thrown out of business as soon as a product with better design or lower price came on the market, even before they had time to react and readjust. This is pretty well what happened to the U.S. TV and VCR industries -- and came close to happening with car makers when the Japanese entered the American market. In such circumstances we can even experience the perverse situation in which an industry in one country which under Free Trade would enjoy most comparative advantage, can be displaced by one in a protected environment having less comparative advantage. Fortunately, the U.S. government assisted the American car companies by insisting the Japanese adopt quotas (and by extending financial help to Chrysler) in time to save the US automobile industry -- which has recently shown how a threatened industry can restructure and recover, given time to recognize its mistakes and react. The Economist magazine printed an article in its School Briefs some time ago called Protectionism Gets Clever , in which it listed ways countries have been reacting to the Japanese challenge. Among these were implementation of Optimum Tariff policies and expanding lists of Strategic Exceptions. I wrote to suggest that a better solution would be adoption of Second Best measures to provide some reaction time. But the Economist -- like most liberal journals and pundits who haven't taken time to study the matter au fond, misunderstood the point and attacked this as outright protectionism. Not so. Under Infant Industry, Optimum Tariff, and Strategic Exceptions, the world is clearly worse off. And likely to remain so, because once adopted, nations never seems to give these up. Under Second Best, which simply acknowledges that a playing field is not always even (as for example in Japan where the system is dominated by inter-locking ownership structures [known as keiretsu ] in which banks own large blocks of manufacturing companies, which in turn share ownership with both wholesalers and retail outlets, so that no one not a member of the league can find shelf space in any significant shop or store), steps can be taken to give a truly marginal competitor reasonable, but limited time to react, saving the world from having to be supplied forever afterwards by a non-competitive firm. Paul Krugman has calculated that the cost of a 100 per cent tariff on each of the three giant trading blocs, reducing imports by a high side estimate of 50 per cent, would reduce world trade by less than 2.5 per cent -- less than 0.75 per cent of world income. A carefully calculated, second best departure from the Free Trade norm would make the entire world better off than a protectionist solution -- admittedly not to the extent of ideal Free Trade, but better than the Third Best conditions under which it would otherwise be suffering, and with very limited downside risk if it didn't achieve its full objectives. And such Second Best measures might well even induce the offending trading partner to clean up its act, enabling us to proceed towards an ideal First Best free market world. Presidents Reagan and Bush negotiated vigorously with the past five Prime Ministers of Japan. Their Structural Disparities Initiative seemed to add up to nothing more than asking the Japanese to be less competitive, not addressing at all the real problem of Japanese monopsonistic market structure. Congress finally appears to have gotten the message, even if it hasn't yet got the theory right about what is happening and why. But, then, even Keynes had it wrong: it is not politicians blindly following the scribblings of a previous generation of economic thinkers which create the problems: it is the delay awaiting a succeeding generation of economic thinkers to get around to explaining to the politicians the theory behind what real world businessmen have long discovered by trial and error, so that timely political remedies can be enacted. It will be interesting to see what Mickey Kantor, President Clinton's Trade Czar, does with the Second Best Super 301 ammunition the Congress has given him.