Thursday, July 06, 2006

An Arrow in the Heart of Capitalism

Is Capitalism Characterized By Growing Externalities?

Back in 1979, when I was an eager student in my first year at the University of British Columbia, I obtained a small book called The Viability and Equity of Capitalism. It was a copy of the Woodward Memorial Lecture given at UBC 3 years earlier by the Nobel Prize-winning economist Kenneth J. Arrow. In it, Professor Arrow explained why he was not confident about the long-run stability of capitalism, even though it had proven to be enormously productive and resilient in the twentieth century. A key feature of his argument was that capitalism was characterized by growing externalities--the technical term that economists use to describe the side-effects that an economic activity can have for people not engaged in it and that are not reflected fully in prices. Since these costs and benefits do not form part of the calculations of people, they can constitute a market failure--i.e. markets under-supplying beneficial activities (public goods) and over-supplying harmful activities (pollution and social ills).

Since that time, I have often wondered: was Professor Arrow simply reflecting the prevailing doom and gloom that was fashionable in the mid-seventies, with its economic instability and stagflation, and fears expressed by outfits like the Trilateral Commission about the crisis of governability afflicting advanced capitalist democracies? I have not had the opportunity to verify whether Arrow's pessimism has been modified in light of the fall of communism, the achievement of relative price stability, or the reduction of international trade barriers. Yet something tells me that he has probably not fundamentally altered his view, regardless of intellectual fashion or political developments, because it was based on deep reflection about the underlying nature of the economic system, and not on current events.

Professor Arrow is regarded by many of his peers as being, along with Paul Samuelson, (and with all due respect to Milton Friedman) the greatest of all living economic theorists. His doctoral dissertation, published in 1951 as Social Choice and Individual Values, is rivalled only by Samuelson's Foundations of Economic Analysis for its precocious rigour. Its conclusion--referred to ever since as the "Arrow Impossibility Theorem"--was that there was no democratic voting system that could be relied upon to aggregate individual preferences in such a way as to arrive at an unambiguous social preference. While such an analysis might appear to frown on government intervention, Arrow's subsequent work in general equilibrium theory and welfare economics took aim at that Achilles heal of "free market" economics, uncertainty and asymmetry of information. His classic 1963 article "Uncertainty and the Welfare Economics of Medical Care" launched modern health economics. He concluded that failures of information ("uncertainty") render health care and health insurance largely unmarketable, and that professional self-regulation and direct government regulation may therefore be necessary . Arrow's analysis is the starting point for all sensible discussions of market-based health care reform to this day.

When an economist as famously rigorous and scrupulously non-ideological (or at least even-handed) as Kenneth Arrow worries about the long-term viability of capitalism, we should take heed. Evidence of growing externalities is easy to find in the early twenty-first century: genetic diversity is being extinguished at a rapid rate, with one vertebrate (back-boned) species going extinct approximately every nine months instead of the natural rate of one such extinction every 1,ooo years; deforestation and over-fishing are examples of environmental externality problems wich arise largely because the costs of internalization exceed the benefits; and of course global warming is probably the ultimate example of a cost that tends not to be "counted' by users of fossil fuels. Environmentalists are surely right to question the narrow definition of "cost" as a foregone economic benefit, when that fails to fully include the damage incurred by people and nature in the process of production. Social critics are surely right to worry about the growing power of transnational corporations, given their built-in tendency to generate externalities for the sake of maximizing profit. As surely as the transition from industrial economies of "extensive" growth to post-industrial economies of technologically driven "intensive" growth proved to be pivotal in the demise of communism, so too will the experience of pervasive natural and social constraint likely force us to revise some of the fundamental assumptions of liberal capitalist societies.

In particular, a deep understanding of the effciency advantages of a market-price system must not be allowed to be the light that blinds us to the public interest. Professor Arrow's message is as relevant today as it was three decades ago.

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