Book: THE ROAD TO FREEDOM, ECONOMICS AND THE GOOD SOCIETY
Author: Joseph E. Stiglitz
Published by: Allen Lane
Price: Rs 899
The two fundamental theorems of welfare economics are deceptively simple and enticingly elegant. The first states every perfectly competitive equilibrium is Pareto optimal. The second states for some set of initial endowments, every Pareto optimal allocation will emerge as a perfectly competitive equilibrium. Intuitively understood since the ‘invisible hand’ days of Adam Smith, formal proof had to wait till the 1950s and for Kenneth Arrow and Gérard Debreu (independently). These two theorems provide the intellectual buttress for the belief in the superiority of market-based decision-making. Every economist knows these theorems require fairly stringent assumptions — agents as price-takers, complete and perfect information, rational behaviour, absence of externalities and constant returns to scale. The assumptions
are unlikely to be satisfied in any real context.
The non-economist may not know that in 1986, Bruce Greenwald and Joseph Stiglitz authored a seminal paper. This showed that the two fundamental theorems do not hold if markets are incomplete, or if there is imperfect information. Indeed, the Greenwald-Stiglitz paper went further. It found that with asymmetric information, a competitive equilibrium need not be Pareto optimal. However, the State can find Pareto-improving interventions. Thus, Stiglitz’s work has a solid ground in theory. This is what Stiglitz has to say in this book on Arrow-Debreu. “Putting aside the unreality of the assumptions, the beauty of the proof of the result and its far-reaching implications are breath-taking… The result was interpreted in three different ways by different groups of economists. A small group, of which Debreu was the leader, took the result for what it was: a mathematical theorem to be analysed and generalized, but that was it…. Conservatives, on the other hand, thought of it as a vindication of what they had long believed. It reinforced their conviction in ‘market fundamentalism’… The third group — to which Arrow largely belonged — held that what had been proven was that the market was not efficient. The fact that the assumptions under which the economy was efficient were so distant from the real world meant that Arrow and Debreu (together with later economists who investigated each of the assumptions in more detail) had proved that markets were, in fact, not efficient; that is, when those unrealistic conditions are not satisfied, in general the economy is inefficient.”
Stiglitz isn’t only a theoretical economist. He is a policy economist too. In addition, he is the popular author of Globalization and Its Discontents; The Price of Inequality; The Great Divide; Power, People and Profits; Rewriting the Rules of the American Economy. These titles indicate his economic position. This book builds on what he has called the “third group”, particularly building on externalities and behavioural economics. In fourteen chapters, divided into three heads (the book could have done with an index), there is a critique of neoliberal capitalism, with Milton Friedman and Friedrich Hayek being singled out for some special stick. The critique is fine, so far as it goes. However, the costs of State failure can also be significant. Understandably, Stiglitz’s popular work (as opposed to academic papers) is based on US economic experiences, with Stiglitz identifying himself with the Democratic Party. This means some arguments in this book have specialised, rather than generalised, appeal.
Extrapolating the argument, there is no perfect market-based system anywhere in the world. The position one adopts on market failure versus State failure is often context-determined. In an economy where the State is less obtrusive (read the United States of America), concerns about market failure might be relatively more. In an economy where the State is more obtrusive (read India), concerns about State failure might be relatively more. This though is a book worth reading.
