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Nobel Prize Laureate Kenneth J. Arrow in Vienna

Economics and meteorology have a lot in common. At least that is what economist and Nobel Prize laureate Kenneth J. Arrow explained during his lecture on "Knowledge, Belief and the Economic System" in Vienna. However, weather forecasts are a less risky business: While the basics of weather, a physical system, have been explored and understood, in economics there are disagreements even about fundamental questions. The unpredictability of economic development is also dependent on the fact that economic agents base their decisions on their expectations of the behaviour of others, which in turn is based on the expected behaviour of yet other parties. This necessitates forming expectations about expectations. Decision makers and economists, who predict the former’s decisions about for example investments or consumption, need to ultimately predict all these interlaced expectations correctly.

Prices, according to one of the fundamental economic assumptions, contain all the information needed by market participants to make decisions. But this hypothesis does not withstand a reality check – a lot of very necessary information is not passed on in the price system. The prices of stocks immediately before the crash of a stock market bubble say very little about their true worth. For a perfect market system, according to Arrow, markets for all products and for all points in time are needed. These markets do not always exist and sometimes cannot exist – for example markets for products not yet in existence.

The deficiencies of markets have been illustrated starkly during the financial crisis. Everyone knew that real estate prices in the USA rose too quickly – all the same, well-informed bankers invested huge sums in the real estate market. Here expectations come into play again: As long as everybody expects that the others expect that prices will continue to rise, it makes sense to invest, because profits continue to be made. The risk of incurring losses also rises, but banks which are "too big to fail" do not need to care about the risks – since in case of huge losses tax payers will come to their rescue. Only when bank shareholders and maybe the financial backers of banks are made to bear the risk of such losses, we can hope that such extremely risky behaviour will decline.

The full text of the lecture has been published in WIFO-Monatsberichte 12/2013.

In a second lecture, Karl Aiginger, director of the Austrian Institute of Economic Research (WIFO), talked of Kenneth J. Arrow’s economic agenda for the 21st century, which Arrow had presented ten years ago and which still serves as an inspiration for the WWWforEurope project today. This European research project, coordinated by WIFO, is developing a strategy for a more dynamic, socially inclusive and economically sustainable European future. Arrow’s main points in 2002 already were climate change, the widening income gap and the risk of deregulating the financial sector.

Why do governments regularly fail to make progress in such important areas and generally in reaching their goals? And why do the majority of the people in democratic systems vote against their financial interests? Unfortunately, according to Karl Aiginger, everything the neoliberal economists of the Chicago School said about the self-regulation of the market was wrong, but their predictions on the failure of government were correct.

How can the most pressing problems of our times be approached? Karl Aiginger stressed the importance of determining long-term goals and developing strategies to reach them. Such strategies should be worked out by politicians, experts and social groups together and implemented consistently, since continual changes of topics and unclear long-term goals make interventions by the state inefficient. In this respect we can also learn from Kenneth J. Arrow: Even at over 80, Arrow, who is now 93, took a daily bicycle ride around Hoover Tower, the bastion of conservative and neoliberal powers at Stanford University, to discuss a social and ecological agenda for the future with students, professors, and politicians from around the world, just like he has done now at WIFO in Vienna.

Kenneth J. Arrow’s lecture "Knowledge, Belief and the Economic System" took place within the framework of the "WWWforEurope – Welfare, Wealth and Work for Europe" project, which is coordinated by WIFO and funded by the European Union within the 7th Framework Programme. In this project, WIFO and 32 European partners are working together on the analytical foundations for a new European growth strategy to bring about a socio-ecological transition to high levels of employment, social inclusion, gender equity and environmental sustainability.

Kenneth J. Arrow is a member of the WWWforEurope scientific board.