Sunday, December 05, 2021

The transcendental economist

The stunning theoretical contributions of Kenneth Arrow, who died last week, both built and undermined all of politics and all of market economics

Written by Arvind Subramanian |
February 28, 2017 12:15:30 am
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Almost everything that has to be said about the recently deceased Professor Kenneth Arrow has been: Gifted economist, the youngest recipient of the Nobel Prize for economics, extraordinarily generous human being, mentor of several subsequent Nobel laureates, and polymath. So what is left to say, apart from the overlooked facial resemblance to another Nobelist, the author Saul Bellow?

At the risk of over-claiming and over-simplifying, it is probably fair to say that amongst 20th century economists there were (with apologies to Sir John Hicks) John Maynard Keynes, Paul Samuelson, Kenneth Arrow, and then everyone else. These were the three gods of the economics pantheon, all theorists, each dazzling in his own way, each creating and/or shaping a whole discipline or disciplines both in content but also in basic framework and methodology.

Keynes created the discipline of short-run macroeconomics with profound implications for the conduct of macro-economic policy. And unlike the other two, who confined themselves to the academy (mostly), Keynes flitted between the ivory tower and the corridors of power frequently and formidably to show that economists could shape and influence economic policy and economic institutions directly. He was the exemplar of economist-as-policy-practitioner.

When Samuelson, also a Nobelist, died, Paul Krugman famously wrote (drawing upon Isaiah Berlin) that there are foxes (who know many things), hedgehogs (who know one big thing), and then there is Paul Samuelson; meaning that he knew many things and many big things, a true intellectual colossus. Krugman then went on to list Samuelson’s eight seminal contributions to economics.

Comparisons are, of course, silly and dicey, but one can hazard that Arrow’s achievements were in some ways arguably greater than Samuelson’s. Samuelson’s many contributions helped us think through the first principles of many issues in economics — public goods, taxation, savings, trade, consumer preference, pensions, and finance. Arrow’s two stunning contributions (both theoretical) in some ways both built and undermined all of politics and all of (market) economics. Samuelson made mega-contributions, Arrow made meta-contributions. Samuleson’s related to one discipline, Arrow’s transcended two.

Arrow’s Impossibility Theorem — the first contribution — questioned whether democratic politics itself was possible in any meaningful sense. If you start with individual preferences, it is very difficult (or impossible) to come up with a rule (say majority voting) that aggregates these preferences and produces a societal preference that can satisfy some basic conditions. The only rule that satisfies these conditions, it turns out, is a dictatorship, or rule by one person which would be abhorrent to all, Arrow included.

His work (along with Gerard Debreu’s) on General Competitive Equilibrium established the possibility of the market economy as a coherent, inter-connected system. Adam Smith famously said, “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.” The work of Arrow and many others showed how such self-interested individual behaviour could produce outcomes that had broadly desirable social virtues; prices and the information that they conveyed were at the heart of the mechanism for the transmission from individual selfishness to social good.

But this work showed how demanding were the conditions for the market system: For the price mechanism to work, undistorted markets needed to exist for all goods and services, for all future times, and for all contingencies (“state-of-nature”) with full information available to all agents in the economy. And one of the major implications of his work, was followed up by Arrow himself. He showed how asymmetric information between the provider and consumer of health services made the market for health fragile, requiring extensive government intervention to fix. Obamacare, coming several decades later, could be seen as inspired by Arrow’s work.

Stepping back one might say that Arrow’s two contributions showed the inherent limits to, even the existential difficulties of, all politics and economics which starts from atomistic decision-makers — voters in politics, and firms and consumers in economics. So, when Francis Fukuyama proclaimed the triumph of democratic politics and market economics as an empirical matter in 1989, Arrow — affirming the famous joke about the economist — could well have said, “Sorry Frank, they may work in practice but I showed 40 years ago that they do not work in theory.” Post-Brexit and Trump, we are now discovering that perhaps they don’t work in practice either.

Another contribution of Arrow’s is worth mentioning. In the early 1960s, the two Cambridges (the one on the River Charles in the US and the other on the River Cam in England) were bickering viciously over the definition, description and measurement of capital as an input in production (the famous “Capital Controversy”). Arrow (then very much in Cambridge, US) chose to stay above the fray, and in the very issue of the Review of Economic Studies (1962) that featured the controversy, wrote a piece on learning-by-doing which influenced the theory of endogenous growth developed decades later by Paul Romer, now the chief economist at the World Bank. The key insight of Arrow’s being that average costs of production decline with scale so that increasing returns was more likely to characterise most production technologies, leading to uncompetitive markets dominated by a few large firms rather than the competitive world of many small firms.

The Arrow-Samuelson comparison is interesting for another reason: Family connections. Arrow’s sister, Anita Summers, a well-known academic herself, was married to Robert Summers, an economist, whose brother was Samuelson. Larry Summers is thus the nephew of both Arrow and Samuelson, and the lineage shows. The world needs reminding that in this stellar family, Robert Summers himself was deserving of the Nobel Prize. He, along with Larry Heston and Irving Kravis, created the famous Penn World Tables (PWT), which allowed incomes and consumption — and hence standards of living — to be compared across countries using the concept of purchasing power parities. Without these PWT data, what is now the rich and exciting field of empirical development economics may have not bloomed at all. Robert Summers, alas, is no more, but the Nobel committee — which does not grant the award posthumously — can still honour his work by awarding the Nobel to Heston.

It is surprising that Sylvia Nasar has not already mined this rich material for a family biography that might be titled, “Two Brothers and A Brother-in-Law”. And, that brother-in-law, Kenneth Joseph Arrow, may possibly have been the best and most impactful of them all.

The writer is chief economic advisor to the government of India

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