Business World, 6 March 2017


Barely noticed in our part of the world, Kenneth Arrow, probably the greatest economist in the second half of the last century, passed away at age 95 two weeks ago, on Feb. 21.

His death makes for poor headlines: his name is not a household word; it rings no bells for the wealthy and mighty. Instead he was the economists’ economist. His work — mostly formal and abstract and therefore inaccessible to the lay person — was nonetheless completely fundamental to many fields, including the economics of welfare, general equilibrium, social choice, uncertainty, insurance, incentives, employment, and the many sub-subfields derived from these. One is hard put to name a field in economics that has not benefited somehow from some primordial concept or comment due to Arrow. Even the practical analysis of health insurance and health care, for example, would be unthinkable without Arrow’s insights, from basic concepts of risk aversion to moral hazard and adverse selection.

His typically popularized epitaph however is that he — alongside the French-born Gerard Debreu — laid down the formal (mathematical) conditions under which Adam Smith’s “invisible hand” conjecture is valid. The “Arrow-Debreu model” of general equilibrium is the canonical description of a competitive market economy running on pure private interest that yields socially optimal (i.e. efficient) results. Students who first confront this work however are inevitably struck by the unrealism or restrictiveness of the assumptions needed to obtain the desired efficiency results, among them the assumed existence of markets for all goods (even potential future ones); no economies of scale, fixed and regular consumer preferences, and so on. One is allowed to wonder: how can this possibly be of any use?

As it turns out, however, unrealistic assumptions themselves are the necessary gaps that let the light in. The fact that some markets are missing in real life, for example, helps one understand why entrepreneurs exist, why employment contracts make sense, why the law defines property rights, why governments impose taxes and provide public goods, and even why traditional communities and ethnic groups have a raison d’etre. All these are social mechanisms or institutions that precede or replace markets because there are costs to organizing and operating the latter. The genius of Arrow’s model of frictionless markets is not that it asserts that ideal conditions exist (although we can and might strive for them, as in the development of markets for financial futures and derivatives). But perhaps more importantly for a developing country, it also shines a light on the valuable functions fulfilled by nonmarket institutions in a non-ideal, friction-laden world.

As for the epitaph, it’s not quite true either that Arrow completely nailed down Smith’s invisible hand. Arrow did show how a decentralized price-system under ideal conditions could perform well in allocating known resources. But that only did part of the job. For Smith’s larger problem was not how to allocate resources to known uses but rather how to find new uses for resources, uncover new technologies and sources of productivity that often involved economies of scale. In short, the unfinished canvas painted by Smith’s invisible hand was not that of efficient allocation but rather the larger one of technical progress and development. That even Arrow’s prodigious mind could only push the matter so far is a measure of the enormity of the intellectual task — as well as of the continuing challenges of real-world development, where high theory is less of a sure guide.

Curiously enough, the part of Arrow’s work of more current interest to the Philippines may not be his work on markets but that on social choice, which touches on politics. Using methods of mathematical logic, Arrow showed that majority rule in the midst of great diversity of individual preferences inevitably ran the danger of being inefficient or even perverse, such as when voting leads to A being preferred over B, and B over C, but C being preferred to A. The real-world implications of what is called “Arrow’s impossibility theorem” remain a contentious issue among political theorists. For while the predicament obviously happens frequently enough on a small scale (e.g., fractious committees and university councils), its larger challenge to the possibility and desirability of democratic rule is disturbing to some. Indeed it may be interpreted as giving intellectual comfort to those (Rodrigo Duterte and Bongbong Marcos?) who favor the imposition of dictatorship for consistency and efficiency.

As in Arrow’s work on general equilibrium, however, the real issues lie with examining what is assumed. Various ways around Arrow’s dictatorship conclusion have centered on relaxing one or more of the axioms he used (among them, consistency, accommodation of all kinds of individual preferences, and Pareto optimality). On a practical plane, one obvious takeaway is that societies whose citizens have very heterogeneous preferences (e.g., because of wide social inequalities, differing racial or ethnic origins or experiences) may have a harder time with democracy. Conversely, if people’s preferences and political opinions are more convergent, or at least mappable along fewer dimensions, e.g., Left or Right, or aggregable in larger political programs, then Arrow’s impossibility may be mitigated. At the very least, the indirect caveat is that would-be democracies cannot neglect their citizens’ education, particularly civic and political education.

More recently A.K. Sen has suggested that complete optimality (an Arrovian axiom) may itself be too restrictive a requirement that is incompatible with liberty: within a minimal personal sphere, without hurting others, I should be able to do as I please, regardless of how others feel about it. The converse, of course, is the regime of the intrusive tokhang, EJKs, and the quasi-police state.

The weighty and far-reaching implications of his work notwithstanding, Arrow always left it to others to draw their own conclusions, preferring to remain in the role of the self-effacing academic. Nowhere in his writing can one detect a hint of self-pride, nor even a taste for controversy or for scoring debating points; only ever a measured, ethical, and serious tone. Those of us who read him were impressed not only by his formidable intellect but also his humane, magnanimous character, which shone through the page. His nephew Lawrence Summers called him a “gentle genius.”

Arrow was not a “public intellectual.” He rarely spoke out on current topics, but he would on a few occasions lend his name to petitions on issues about which he felt strongly. For what it’s worth, one of these was a 2014 statement on drugs that said: “It is time to end the ‘war on drugs’ and massively redirect resources toward effective evidence-based policies underpinned by rigorous economic analysis. … Continuing to spend vast resources on punitive enforcement-led policies, generally at the expense of proven public health policies, can no longer be justified.”

Just saying…