An Interview with Kenneth Arrow, Part One

[UPDATE: part two is here and part three is here.]

I spoke with Kenneth Arrow, Stanford Professor and Nobel Prize-winning economist, for about an hour last week. Dr. Arrow is perhaps most famous for the eponymous Arrow's Impossibility Theorem, one of the cooler ideas in public choice economics. But his work is wide ranging and we talked mostly about other topics. (I also couldn't think of anything to ask about the Impossibility Theorem.)

I have divided this interview into three parts. The first, published below, is mostly about the state of modern economics, the concept of general equilibrium analysis, and behavioral economics. The second part, which I will publish tomorrow morning, is about health-care economics. (In 1963 Dr. Arrow wrote what is probably the seminal paper in modern health economics, and very relevant to the current debate.) The third part, which I will publish as soon as I finish the editing, is about climate change. (Dr. Arrow was also a lead author on several of the Intergovernmental Panel on Climate Change reports.) My questions are in bold.

Conor Clarke: I'm interested in big, vague questions about what economics has learned or should learn from the current situation. I know you've done a lot of work on general equilibrium analysis...

Kenneth Arrow: Well, that's the intellectual issue. The major driver of economics is the equilibrium approach, which has taken various forms over the years. General equilibrium is the statement that all the different parts of the economy influence each other, even if it's remote, like mortgage-backed securities and their demands on automobiles. Repercussions can go on for a very long time and in different routes. That's where the world of general equilibrium comes from -- and it's also the idea that the things tend to balance out. The central picture we have is that prices will adjust so that balancing occurs.

Markets clear. People want to buy what is offered and prices will reflect that. When the price of one thing goes up others will too -- like the price of gasoline and automobiles. When prices go down that affects the number of workers and when workers are out of jobs that affects the amount of houses. The general equilibrium picture -- which goes back to Adam Smith the late 18th century -- is that the prices will reflect all of this. Basic things, like productivity. A new product comes on the market. A hurricane calls for repairs.

All these things change the economy and the economy changes itself. More capital changes how you supply goods, and this feeds back on investment. It's a complicated set of reactions and the equilibrium picture creates a favorable and smooth picture and, seemingly, more or less in balance. The trouble is that -- while it is a very important that things do balance and respond to fundamental changes -- we also are accustomed to the fact that things don't balance and that things will go array. In the medieval ages, things fluctuated -- but that was due to war. Our market cycles were due to the weather or wars or clinical circumstances, diseases and so forth. People got impoverished if soldiers were fighting in their territory. But things that happen under capitalism -- which was observed fairly early, maybe in the late 18th century -- well, those fluctuations are not because of outside influences but due to the market itself.

The business cycle.

The business cycle. We saw it after the Napoleonic Wars and we saw it in the Depression. We don't understand why and how we have recurrent business cycles but there's always a lot of talk about how to understand them.

Like sticky prices and so forth.

Dr: Right, wages and prices -- and wages especially -- tend not to change as quickly as the theory says -- you know, demand drops and the prices will drop. You do see this with the securities markets, which are the best organized. Everywhere else you have little complications. Especially with wages, because of the human relations involved, the social relations, the interactive relations.

And on top of all of this there is another question about what we now call a financial crisis. Not every business cycle has a financial crisis. Frequently they do. A whole apparatus is needed to oil the economy: you need a flow of money and a flow of credit. That's the essential thing. You need credit. As people lay out money, as businesses lay out money, they hire workers, buy goods -- you don't get paid for some time and you need some credit to bridge this. Someone needs to finance that. You don't use your own money, you borrow money from other people who don't need the money right now.

And then somehow, sometimes the credit mechanisms go awry. Not every business cycle has this financial crisis. At least the sticky prices precipitate a business cycle, but not all business cycles are ripe for a financial crisis.

This time around it seems like you hear a lot of dissatisfaction with the rational expectations model. What do you think of behavioral economics?

Yes, there is a tendency to go to these psychological arguments. But my problem with these arguments is not that they are wrong -- though sometimes there are wrong -- but that they are not helpful.

Why?

They don't predict anything! I don't know which way human psychology will go wrong. We have a world in which there is uncertainty. There are new technologies. And one of the problems is that we do things today with a thought to the future. Any purchase is one for the future. If you buy a refrigerator you are making a commitment to the future, so that you have food to eat for the next ten years. That's a simple theory, one of many simple theories -- theories that people agree on and that don't, in a fundamental way, change. But every once in a while there is unemployment, and wages will drop, and there will be several different interpretations.