Second-Best Institutions

Reader Ali Sohail has pointed us to a paper (Second-Best Institutions) by Dani Rodrik of Harvard University that asks why “best practices” are an unhelpful way to think about institutional reform. 

The paper is about economic institutions but it complements very nicely the theme we explored in the last post regarding governance and pure democracy in developing countries—that the best can be the enemy of the good and that the best is often dangerously innocent of contextual realities. 

Here are some relevant excerpts from Dani Rodrik’s paper: 

The focus of reforms in the developing world has moved from getting prices right to getting institutions right… “Governance reforms” have become the buzzword for bilateral donors and multilateral institutions, in much the same way that liberalization, privatization and stabilization were the mantras of the 1980s. 

But what kind of institutions should reformers strive to build? 

Developing nations are different from advanced countries in that they face both greater challenges and more constraints.  That this may require “appropriate” institutions differing from those that prevail in rich countries is an old theme that goes back at least to Alexander Gerschenkron (1962).

The type of institutional reform promoted by multilateral organizations… is heavily biased towards a best-practice model. It presumes it is possible to determine a unique set of appropriate institutional arrangements ex ante and views convergence towards those arrangements as inherently desirable…. This approach is grounded in a first-best mindset which presumes the primary role of institutional arrangements is to minimize transaction costs in the immediately relevant domain–without paying attention to potential interactions with institutional features elsewhere in the system.

I shall argue that dealing with the institutional landscape in developing economies requires a second-best mindset.  In such settings, a focus on best-practice institutions not only creates blind spots, leading us to overlook reforms that might achieve the desired ends at lower cost, it can also backfire. 

Real-world reformers operate in a second-best environment of their own, which means they need to keep an eye on how proposed solutions affect multiple distortions. Sometimes binding constraints will lie elsewhere and they need to guard against adverse interactions with other distorted margins. At other times, there will be multiple ways of removing a constraint, some of which may be politically much more feasible than others. Finally, the nature of the binding constraint will change over time, requiring a change in focus as well.  Best-practice institutions are, almost by definition, non-contextual and do not take account of these complications. Insofar as they narrow rather than expand the menu of institutional choices available to reformers, they serve the cause badly.

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