Finding binding constraints in the Pacific

Hausmann et al. (2004, 2005 and 2006) provide an important reminder of the implications of the theory of the ‘second best’. In the economist’s world of ‘first best’, an economic distortion is analysed as if it were the only distortion, and its removal can be assumed to increase community welfare (barring adverse equity effects). In the world of the second best, however, there are many distortions and the removal of one distortion can reduce economic welfare because of its interactions with other distortions. Hausmann et al. (2005) present a second-best portrayal of development, including recognition that politicians might have limited ‘political capital’ with which to implement reform. It is the policy implications that Hausmann et al . attached to their ‘diagnostics’ framework that has attracted the most attention. Their key point is the importance of targeting economic reform on the binding constraints. Because across-the-board reforms are politically difficult and have often failed to achieve growth, we have offered an approach that targets the most binding constraint... different circumstances send different diagnostic signals. An approach to development based on these signals is likely to be much more effective than one based on a long list of institutional and governance reforms that may or may not be targeted at the most binding constraints on growth (Hausmann et al. 2006). Hausmann et al. reject a laundry-list approach based on ‘whatever reforms seem to be feasible, practical, politically doable, or enforceable through conditionality’ (2005:5). They argue against the notions that (i) any reform is good; (ii) the more areas reformed, the better; and (iii) the deeper the reform in any area, the better. This paper seeks to provide a practical discussion of how binding constraints on economic growth in the Pacific islands could be identified as a basis for targeted economic reform.