Economists and Reality

When I submitted my doctoral dissertation for a Ph.D. degree at Columbia University forty-three years ago, the university ranked it as one of its top doctoral dissertations and, jointly with The Free Press, published it as a book, (Industrial Democracy Yugoslav Style).As you might imagine, I was extremely proud.It was years later, after I had given up my tenured professorship at UCLA and migrated into consulting, that I realized the whole dissertation was faulty. My conclusions were all wrong.How come?My dissertation was about the Yugoslav practice of self-management, also called “industrial democracy.” I compared it to the American management theory that I had studied at school (At that time, I had zero experience with actual practice). My conclusion, as presented in the dissertation and subsequently in the book, was that the self-management system was deficient compared to the American system.What was wrong with my conclusion?I was comparing a should (a theory) with an is (a reality), instead of comparing a should with another should, or, as I did later, an is with another is.I compared apples to tomatoes––not even oranges. I compared the theory of one system to the practice of a totally different system, and obviously, practice turned out to be messier. But when I started consulting to American companies and saw how those organizations actually work, I realized that my conclusions would have been very different had I compared practice to practice.Why am I telling you this embarrassing story?I’m getting to that:In the Financial Times of Aug. 19th, Nobel Prize laureate in economics Joseph Stiglitz argued that economists don’t live in the real world. Because they don’t, their models and theories are based on assumptions that––though they might display elegant reasoning and precise mathematical formulations––do not reflect reality (“Needed: a new economic paradigm,” p. 7).For instance, economic theory assumes rational behavior, but in reality that just ain’t so. Economic theory assumes that all actors in the market are identical, which anyone with real-life experience knows is false. It assumes perfect market functioning, in which supply and demand will balance out over time––in other words, a “hidden hand” that regulates markets. Great, Stiglitz says––except there is no hidden hand.This reminds me of a joke:A physics professor, an engineer, and an economist are stranded in the desert with only one can of food and no can opener. The physics professor suggests they make a fire and place the can in it. As it expands from the heat, he explains, it will open.“That is stupid,” the engineer objects. “The can will explode, and the food will scatter. What we need is a sharp object, for leverage …”“You are both wrong,” interrupts the economist. “Let’s assume we have a can opener …”(By the way I was initially trained as an economist)This lack of connection to reality, Stiglitz claims, is responsible for the astounding fact that not a single economic theory or model predicted the worldwide financial credit crisis. Stiglitz suggests that it is time for a new, reality-based economic theory.My insight is that, when economists start looking at what is really happening, as Stiglitz suggests, they are going to find out (as I did ) that economic theories have insufficient tools to accurately understand reality.We live in an environment where problems are holistic and systemic, requiring more than knowledge of economics to understand and solve them. We must also know sociology, political science, and psychology and must free ourselves of attachment to any single theory that might interfere with objective observation––and must use lots and lots of common sense.If I am right, one conclusion from this insight might be that, the President’s Economic Council, currently composed only of economists, should be a cross-disciplinary team––including some generalists (top executives), who know from experience how things really are, not only how they should be.In general, it is prudent to beware of clean, elegant formulas based on a single theoretical discipline that limits ones capability to understand world’s messy reality.Sincerely,Dr. Ichak Kalderon Adizes