If you have recently upgraded to iLife 11 or moved your iPhoto pictures folder to another place and there is no arrow besides the 'iPhoto' line in the desktop & screensaver preferences pane, all you have to do is to remove a file from your home folder. First, QUIT system preferences if you have it running, then open terminal.app and type
rm Library/Preferences/com.apple.desktop.plist
That's it! Now when you run desktop & screensaver preferences, iPhoto will be available again with all your photos !!
Does not work. iPhoto shows up but no arrow.
If you have a lot of photos, you have to wait, and wait for long the first time, until the library fully loads and shows into desktop background change. Leave preferences running, after time you will see that the arrow will appear.
IMPORTANT : The iPhoto application MUST be running, in order for the arrow to appear, first RUN iphoto, and THEN run desktop background change preferences!!!!!!!!