In economics there is a theory that can help a policy maker determine the most efficient, or most effective, policy to solve a particular problem. The theory is known as the theory of the second-best. Without going into the details (you can read more about the theory here) it says that the best way to correct for an economic problem is to choose a policy that will attack the problem in the most direct way possible, one that really goes to the heart of the matter. Such a policy choice is called a first-best policy, while all other policies, which may correct the problem somewhat but less effectively, are called second-best policies.

For example, in a trading context, if the problem is rising unemployment because of surging imports, some policymakers might suggest a tariff to remove the competitive pressure caused by imports and thus save jobs. However, this policy would be a second-best policy since the source of the problem isn’t really the imports. Instead the real economic problem is the unemployment that is caused because workers cannot easily find new jobs once released from the import-competing firms. Given the changed trade circumstances, shifting workers quickly to the next most effective industry is the best way to realize the full potential of the country’s comparative advantage. Thus, a more effective policy, i.e., a first-best policy, would be one that targets worker mobility in the labor market and assists workers to find new jobs as quickly as possible.

In light of our current macroeconomic crisis, we can evaluate proposed policies in a similar way. For example, to decide whether the $775 billion fiscal spending package proposed by President-elect Obama yesterday, is the right policy for us to implement, we might ask to what extent it gets at the heart of the problem. In other words is a massive fiscal stimulus package a first-best or second-best policy option?

To answer this we need to first identify what the heart of the problem is. Although I’m sure some would disagree, it seems to me that the underlying cause of our current predicament is relatively simple. First, the crisis was surely set off because of the large number of mortgage foreclosures last year, which caused falling housing prices and a drop in construction activity. This in turn led to the crisis in confidence in the financial industry in September when financial institutions could not easily value their mortgage backed securities, forced several financial giants into bankruptcy or buyouts, and led to the curtailment of lending. The drop in confidence in the financial sector and the future economy led businesses and households to sell off stocks causing the plummeting market values and a loss of over $1 trillion in wealth – this on top of the losses everyone was experiencing in the real estate market. Faced with an impending and severe recession most households have become frugal, first because they all feel poorer, (despite the fact that many have no plans to spend their retirement funds or use the equity in their houses soon), and second because they fear a near-term job loss.

So next we can ask how well the proposed fiscal stimulus program will do to solve the underlying problems … but all that will have to wait for another post. Stay tuned.