Knut Wicksell and the origins of Modern Monetary Theory

30 June, 2012 at 14:33 | Posted in Economics | 11 Comments

Many mainstream economists seem to think the idea behind Modern Monetary Theory is new and originates from economic cranks.

New? Cranks? How about reading one of the great founders of neoclassical economics – Knut Wicksell. This is what Wicksell wrote in 1898 on “pure credit systems” in Interest and Prices (Geldzins und Güterpreise), 1936 (1898), p. 68f:

It is possible to go even further. There is no real need for any money at all if a payment between two customers can be accomplished by simply transferring the appropriate sum of money in the books of the bank 

A pure credit system has not yet … been completely developed in this form. But here and there it is to be found in the somewhat different guise of the banknote system

We intend therefor, as a basis for the following discussion, to imagine a state of affairs in which money does not actually circulate at all, neither in the form of coin … nor in the form of notes, but where all domestic payments are effected by means of the Giro system and bookkeeping transfers. A  thorough analysis of this purely imaginary case seems to me to be worth while, for it provides a precise antithesis to the equally imaginay case of a pure cash system, in which credit plays no part whatever [the exact equivalent of the often used neoclassical model assumption of “cash in advance” – LPS] …

For the sake of simplicity, let us then assume that the whole monetary system of a country is in the hands of a single credit institution, provided with an adequate number of branches, at which each independent economic individual keeps an account on which he can draw cheques.

What Modern Monetary Theory (MMT) basically does is exactly what Wicksell tried to do more than a hundred years ago. The difference is that today the “pure credit economy”  is a reality and not just a theoretical curiosity – MMT describes a fiat currency system that almost every country in the world is operating under.

In modern times legal currencies are totally based on fiat. Currencies no longer have intrinsic value (as gold and silver). What gives them value is basically the simple fact that you have to pay your taxes with them. That also enables governments to run a kind of monopoly business where it never can run out of money. A fortiori, spending becomes the prime mover and taxing and borrowing is degraded to following acts. If we have a depression, the solution, then, is not austerity. It is spending. Budget deficits are not the major problem, since fiat money means that governments can always make more of them.

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The Flaw of Averages

30 June, 2012 at 14:16 | Posted in Statistics & Econometrics | Comments Off on The Flaw of Averages

Germany is the biggest threat to Europe

30 June, 2012 at 13:00 | Posted in Economics | Comments Off on Germany is the biggest threat to Europe

As financial markets slide toward disaster, scarcely pausing to celebrate the “success” of the Greek election or the deal to recapitalize Spanish banks, the euro project is finally revealing its fatal flaw. One country poses an existential threat to Europe – and it is not Greece, Italy or Spain. Every serious proposal to resolve the euro crisis since 2009 – haircuts for bank bondholders, more realistic fiscal consolidation targets, jointly guaranteed eurobonds, a pan-European bailout fund, quantitative easing by the European Central Bank – has been vetoed by Germany, and this pattern looks likely to be repeated next week.

Nobody should be surprised that Germany has become the greatest threat to Europe. After all, this has happened twice before since 1914. To state this unmentionable fact is not to impugn Germans with original sin, but merely to note Germany’s unusual geopolitical situation. Germany is too big and powerful to coexist comfortably with its European neighbors in any political structure ruled purely by national interests. Yet it isn’t big and powerful enough to dominate its neighbors decisively, as the U.S. dominates North America or China will dominate the Far East.

Wise German politicians recognized this inherent instability after 1945 and abandoned the realpolitik of national interest in favor of the idealism of European unification. Instead of trying to create a “German Europe” the new national goal was to build a “European Germany.” Unfortunately, this lesson seems to have been forgotten by Angela Merkel. Whatever the intellectual arguments for or against German-imposed austerity or the German-designed fiscal compact, there can be no dispute about their political import. Merkel’s stated goal is now to create a “German Europe,” with every nation living, working and running its government according to German rules.
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Why Wren-Lewis can’t get it right on macroeconomics

30 June, 2012 at 00:13 | Posted in Economics, Statistics & Econometrics | Comments Off on Why Wren-Lewis can’t get it right on macroeconomics

In a new piece on the ongoing discussion of macroeconomics, professor Wren-Lewis yesterday wrote:

What I want to say in summary is this. Microeconomists are right in many of their criticisms, but what they often fail to see is the root cause of the problem. This is that macroeconomic policy is highly political, with strong ideological implications. Ideology and politics distort macroeconomics as a science. Yet despite this, there is – and for many years has been – a substantial body of analysis that most macroeconomics would sign up to, and which has sound empirical backing.
   What is this substantial body of analysis? It is what used to be called the new neoclassical synthesis … For a closed economy, its details are well represented in Romer’s graduate textbook, for example. This body of analysis has important gaps and omissions, of course, such as a naive and simplistic view of the financial sector. However … the financial crisis itself showed up this incompleteness, but did not invalidate most of what was in the synthesis. Indeed, events since the crisis have provided significant empirical support for the Keynesian elements of that synthesis.

“[T]he financial crisis itself showed up this incompleteness, but did not invalidate most of what was in the synthesis.” Really?

The financial crisis of 2007-08 hit most laymen and economists with surprise. What was it that went wrong with our macroeconomic models, since they obviously did not foresee the collapse or even make it conceivable?

The root of our problem ultimately goes back to how we look upon the data we are handling. In modern neoclassical macroeconomics – dynamic stochastic general equilibrium, new synthesis, new-classical and new-Keynesian – variables are treated as if drawn from a known “data-generating process” that unfolds over time and on which we therefore have access to heaps of historical time-series. If we do not assume that we know the “data-generating process” – if we do not have the “true” model – the whole edifice collapses.

Modern macroeconomics obviously did not anticipate the enormity of the problems that unregulated “efficient” financial markets created. Why? Because it builds on the myth of us knowing the “data-generating process” and that we can describe the variables of our evolving economies as drawn from an urn containing stochastic probability functions with known means and variances.

After thoroughly neglecting anything resembling a real-world finance system, one can’t just go on as if nothing has happened and simply append financial considerations to  neoclassical macromodels where finance more or less is equated to the neoclassical thought-construction of a “market for loanable funds.”

Both ontologically and epistemologically founded uncertainty makes any hopes of being able to consistently integrate financial crises into neoclassical macroeconomic models totally unfounded, since those models are based on assumptions of rational expectations, representative actors and dynamically stochastic general equilibrium – assumptions that convey the view that markets – give or take a few rigidities – are efficient!

Finance has its own dimension, and if taken seriously, its effect on an analysis must modify the whole theoretical system and not just be added as an unsystematic appendage. Finance is fundamental to our understanding of modern economies, and – as Johan Åkerman used to say – acting like the baker’s apprentice who, having forgotten to add yeast to the dough, throws it into the oven afterwards, just isn’t enough.

Feministen Lars P Syll

29 June, 2012 at 12:12 | Posted in Varia | Comments Off on Feministen Lars P Syll

Efter att ha uppdaterat min medvetet sparsmakade bloggrulle idag slog det mig att de enda svenska bloggar på listan är två kvinnor – Helena von Schantz och Lena Sommestad.

LPS feminist? Ja visst!

Financial psychology

29 June, 2012 at 11:54 | Posted in Economics | Comments Off on Financial psychology

To-day, in many parts of the world, it is the serious embarrassment of the banks which is the cause of our gravest concern …

[The banks] stand between the real borrower and the real lender. They have given their guarantee to the real lender; and this guarantee is only good if the money value of the asset belonging to the real borrower is worth the money which has been advanced on it.
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Game Theory

29 June, 2012 at 10:41 | Posted in Economics | Comments Off on Game Theory

En av de främsta spelteoretikerna i världen – Ariel Rubinstein vid Tel Aviv University och New York University – tar i ett samtal med Russ Roberts (EconTalk) upp en intressant diskussion om vad spelteorin, så här nästan sextio år efter von Neumann och Morgenstern publicerade Theory of Games and Economic Behavior, egentligen har åstadkommit. Enligt Rubinstein egentligen inte speciellt mycket.

För yours truly kommer detta som en sentida bekräftelse på något jag hävdade redan för tjugo år sedan, i min första doktorsavhandling – Samhälleliga val, värde och exploatering. Där gjorde jag ungefär samma värdering som Rubinstein, vilket då i etablerade neoklassiska ekonomkretsar – milt uttryckt – inte var speciellt uppskattat:

Vid upprepade tillfällen har det funnits anledning att kritisera de uppställda axiomen (transitivitet, fullständighet, konsistens, neutralitet, oberoende, monotonicitet m m) och problemlösningsförslagen (Nashlösning, harsanyis baysianska lösning, Rubinsteins förhandlingslösning, maximinkriteriet m m). Även själva analysförfarandet (fixeringen vid Paretovillkoret, den bakåtvända induktionen, osäkerhetsmomentets behandling m m) har ifrågasatts. Många gånger verkar matematisk elegans ha varit viktigare som utgångspunkt för de gjorda beteendeantagandena, än realism och relevans.

Det lär nog bli svårare att vifta bort samma tankar när de nu, tjugo år senare, formuleras av en av spelteorins egna giganter

Macroeconomics – barely a science at all

29 June, 2012 at 09:53 | Posted in Economics, Theory of Science & Methodology | Comments Off on Macroeconomics – barely a science at all

In a post the other day I was complaining – after having read a piece by Simon Wren-Lewis – about macroeconomists that go on teaching macroeconomics after the crisis as if nothing really happened in the Great Recession 2008-9.

Noah Smith now also has reacted on Wren-Lewis gobsmacking picture of the state of macroeconomics:

I’m pretty sure that Wren-Lewis’ statement that “nothing has really been thrown away” applies to the journals too. Four years after a huge deflationary shock with no apparent shock to technology, asset-pricing papers and labor search papers and international finance papers and even some business-cycle papers continue to use models in which business cycles are driven by technology shocks. No theory seems to have been thrown out. And these are young economists writing these papers, so it’s not a generational effect …

If smart people don’t agree, it may because they are waiting for new evidence or because they don’t understand each other’s math. But if enough time passes and people are still having the same arguments they had a hundred years ago – as is exactly the case in macro today – then we have to conclude that very little is being accomplished in the field. The creation of new theories does not represent scientific progress until it is matched by the rejection of failed alternative theories.

The root problem here is that macroeconomics seems to have no commonly agreed-upon criteria for falsification of hypotheses. Time-series data – in other words, watching history go by and trying to pick out recurring patterns – does not seem to be persuasive enough to kill any existing theory. Nobody seems to believe in cross-country regressions. And there are basically no macro experiments …

So as things stand, macro is mostly a “science” without falsification. In other words, it is barely a science at all. Microeconomists know this. The educated public knows this. And that is why the prestige of the macro field is falling. The solution is for macroeconomists to A) admit their ignorance more often … and B) search for better ways to falsify macro theories in a convincing way.

“So as things stand, macro is mostly a “science” without falsification. In other words, it is barely a science at all.” That almost sounds as an answer to my post from yesterday – Is economics really a science?

Is economics really a science?

28 June, 2012 at 20:55 | Posted in Varia | Comments Off on Is economics really a science?

In cycle after cycle the same script is acted out. An asset bubble begins inflating, together with its associated credit bubble. The lead singers of the free market school strike up their familiar song: markets know best, markets are efficient, there are no bubbles, let the markets run. While asset prices rise and credit expands, the doctrine of market efficiency reigns supreme. But immediately as asset prices begin falling and the credit bubble begins contracting, the singers swiftly change tune. The free-marketeers cast aside their message and, without even the decency to blush, strike up a new song: central banks must cut rates, governments must stimulate, credit must not contract, asset prices must not be allowed to fall. While the lead singers flip from song to song, apparently unaware of their discordant lyrics, the backing singers maintain a constant comical chant: markets are stable, markets are stable, markets are stable.

For a field of study aspiring to the status of a science today’s economic consensus is in a risible state, both internally inconsistent and entirely in conflict with the experimental evidence. Had Isaac Newton subjected himself to these standards he would have given us three laws of gravity: one telling us how an apple behaves when thrown up into the air; another quite different law telling us how it then falls back to earth; and a third law telling us the apple never moves at all.

Historiens dom över euron kommer att bli hård

28 June, 2012 at 19:35 | Posted in Economics, Politics & Society | Comments Off on Historiens dom över euron kommer att bli hård

Lena Sommestad  – ordförande för (s)-kvinnor – om euron:

Europeiska politikers missgrepp är förödande för världsekonomin, men framförallt är de förödande för Europas egen befolkning.

Sorgligast av allt, som jag ser det, är att Europa idag borde vara en kontinent på topp – inte en kontintent i kris.

Europa hör nämligen till de regioner i världen som just nu har den minsta försörjningsbördan i form av barn och gamla. Potentialen för ekonomisk tillväxt är därmed utomordentligt god. Inte minst i det krisdrabbade Sydeuropa är befolkningsstrukturen fördelaktig.

Problemet är bara att en betydande del av den stora, arbetsföra befolkningen i södra Europa går arbetslös – på grund av en fullständigt misslyckad och felriktad monetär politik.

Historiens dom över dagens europeiska politiker kommer att bli hård. Det var ett stort missgrepp att införa euron, men det är ett lika stort missgrepp att idag envist hålla fast vid en valutaunion som driver in Europa i en allt djupare politisk, ekonomisk och social kris.

Ekonomins dyrbaraste resurs är människor. Europa har idag  tidernas största generation välutbildade, kunniga medborgare – men deras kunskaper tas inte till vara. Det borde vara dags för Europas socialdemokrater att samlas för en ny ekonomisk politik; en politik som tar vara på Europas dyrbara mänskliga resurser, innan det är för sent.

Why some economists got it completely wrong

28 June, 2012 at 12:08 | Posted in Economics | Comments Off on Why some economists got it completely wrong

In a post the other day I was complaining about macroeconomists that go on teaching macroeconomics after the crisis as if nothing really happened in the Great Recession 2008-9.

To be honest, it really gets me rather gobsmacked. I find this rather self-congratulatory and complacent attitude both unwarranted and intellectually dishonest. The line of repentant mainstream neoclassical economists ought to be long, and  it’s abolutely outrageous that we haven’t seen even one single prominent economist who has had the courage and integrity to admit that he or she got things completely wrong.

As an appendage to that post – and having a Ph. D. in both economics and economic history – I therefore can’t restrain myself from citing Brad DeLong’s complaint about economists obviously not being able – or wanting – to learn from history:

We economists who are steeped in economic and financial history – and aware of the history of economic thought concerning financial crises and their effects – have reason to be proud of our analyses over the past five years. We understood where we were heading, because we knew where we had been.

In particular, we understood that the rapid run-up of house prices, coupled with the extension of leverage, posed macroeconomic dangers. We recognized that large bubble-driven losses in assets held by leveraged financial institutions would cause a panicked flight to safety, and that preventing a deep depression required active official intervention as a lender of last resort.

Indeed, we understood that monetarist cures were likely to prove insufficient; that sovereigns need to guarantee each others’ solvency; and that withdrawing support too soon implied enormous dangers. We knew that premature attempts to achieve long-term fiscal balance would worsen the short-term crisis – and thus be counterproductive in the long-run. And we understood that we faced the threat of a jobless recovery, owing to cyclical factors, rather than to structural changes.

On all of these issues, historically-minded economists were right. Those who said that there would be no downturn, or that recovery would be rapid, or that the economy’s real problems were structural, or that supporting the economy would produce inflation (or high short-term interest rates), or that immediate fiscal austerity would be expansionary were wrong. Not just a little wrong. Completely wrong.

Of course, we historically-minded economists are not surprised that they were wrong. We are, however, surprised at how few of them have marked their beliefs to market in any sense. On the contrary, many of them, their reputations under water, have doubled down on those beliefs, apparently in the hope that events will, for once, break their way, and that people might thus be induced to forget their abysmal forecasting track record.

Brad DeLong

A Manifesto for Economic Sense

28 June, 2012 at 11:37 | Posted in Economics | 3 Comments

It is not every day that yours truly signs a manifesto. But today I have – together with Paul Krugman, Richard Layard and lots of other economists.

A Manifesto for Economic Sense

More than four years after the financial crisis began, the world’s major advanced economies remain deeply depressed, in a scene all too reminiscent of the 1930s. And the reason is simple: we are relying on the same ideas that governed policy in the 1930s. These ideas, long since disproved, involve profound errors both about the causes of the crisis, its nature, and the appropriate response.
These errors have taken deep root in public consciousness and provide the public support for the excessive austerity of current fiscal policies in many countries. So the time is ripe for a Manifesto in which mainstream economists offer the public a more evidence-based analysis of our problems.
The causes. Many policy makers insist that the crisis was caused by irresponsible public borrowing. With very few exceptions – other than Greece – this is false. Instead, the conditions for crisis were created by excessive private sector borrowing and lending, including by over-leveraged banks. The collapse of this bubble led to massive falls in output and thus in tax revenue. So the large government deficits we see today are a consequence of the crisis, not its cause.
The nature of the crisis. When real estate bubbles on both sides of the Atlantic burst, many parts of the private sector slashed spending in an attempt to pay down past debts. This was a rational response on the part of individuals, but – just like the similar response of debtors in the 1930s – it has proved collectively self-defeating, because one person’s spending is another person’s income. The result of the spending collapse has been an economic depression that has worsened the public debt.
The appropriate response. At a time when the private sector is engaged in a collective effort to spend less, public policy should act as a stabilizing force, attempting to sustain spending. At the very least we should not be making things worse by big cuts in government spending or big increases in tax rates on ordinary people. Unfortunately, that’s exactly what many governments are now doing.
The big mistake. After responding well in the first, acute phase of the economic crisis, conventional policy wisdom took a wrong turn – focusing on government deficits, which are mainly the result of a crisis-induced plunge in revenue, and arguing that the public sector should attempt to reduce its debts in tandem with the private sector. As a result, instead of playing a stabilizing role, fiscal policy has ended up reinforcing the dampening effects of private-sector spending cuts.
In the face of a less severe shock, monetary policy could take up the slack. But with interest rates close to zero, monetary policy – while it should do all it can – cannot do the whole job. There must of course be a medium-term plan for reducing the government deficit. But if this is too front-loaded it can easily be self-defeating by aborting the recovery. A key priority now is to reduce unemployment, before it becomes endemic, making recovery and future deficit reduction even more difficult.
How do those who support present policies answer the argument we have just made? They use two quite different arguments in support of their case.
The confidence argument. Their first argument is that government deficits will raise interest rates and thus prevent recovery. By contrast, they argue, austerity will increase confidence and thus encourage recovery.
But there is no evidence at all in favour of this argument. First, despite exceptionally high deficits, interest rates today are unprecedentedly low in all major countries where there is a normally functioning central bank. This is true even in Japan where the government debt now exceeds 200% of annual GDP; and past downgrades by the rating agencies here have had no effect on Japanese interest rates. Interest rates are only high in some Euro countries, because the ECB is not allowed to act as lender of last resort to the government. Elsewhere the central bank can always, if needed, fund the deficit, leaving the bond market unaffected.
Moreover past experience includes no relevant case where budget cuts have actually generated increased economic activity. The IMF has studied 173 cases of budget cuts in individual countries and found that the consistent result is economic contraction. In the handful of cases in which fiscal consolidation was followed by growth, the main channels were a currency depreciation against a strong world market, not a current possibility. The lesson of the IMF’s study is clear – budget cuts retard recovery. And that is what is happening now – the countries with the biggest budget cuts have experienced the biggest falls in output.
For the truth is, as we can now see, that budget cuts do not inspire business confidence. Companies will only invest when they can foresee enough customers with enough income to spend. Austerity discourages investment.
So there is massive evidence against the confidence argument; all the alleged evidence in favor of the doctrine has evaporated on closer examination.
The structural argument. A second argument against expanding demand is that output is in fact constrained on the supply side – by structural imbalances. If this theory were right, however, at least some parts of our economies ought to be at full stretch, and so should some occupations. But in most countries that is just not the case. Every major sector of our economies is struggling, and every occupation has higher unemployment than usual. So the problem must be a general lack of spending and demand.
In the 1930s the same structural argument was used against proactive spending policies in the U.S. But as spending rose between 1940 and 1942, output rose by 20%. So the problem in the 1930s, as now, was a shortage of demand not of supply.
As a result of their mistaken ideas, many Western policy-makers are inflicting massive suffering on their peoples. But the ideas they espouse about how to handle recessions were rejected by nearly all economists after the disasters of the 1930s, and for the following forty years or so the West enjoyed an unparalleled period of economic stability and low unemployment. It is tragic that in recent years the old ideas have again taken root. But we can no longer accept a situation where mistaken fears of higher interest rates weigh more highly with policy-makers than the horrors of mass unemployment.
Better policies will differ between countries and need detailed debate. But they must be based on a correct analysis of the problem. We therefore urge all economists and others who agree with the broad thrust of this Manifesto to register their agreement at http://www.manifestoforeconomicsense.org, and to publically argue the case for a sounder approach. The whole world suffers when men and women are silent about what they know is wrong.

How to sign the manifesto

Added 29/6: Happy to see that other Swedish economists also consider signing the manifesto.

What saves the euro will kill the union

27 June, 2012 at 23:14 | Posted in Economics | Comments Off on What saves the euro will kill the union

A better, bolder and, until now, almost inconceivable solution is for Germany to reintroduce the mark, which would cause the euro to immediately decline in value. Such a devaluation would give troubled economies, especially those of Greece, Italy and Spain, the financial flexibility they need to stabilize themselves.

Although repeated currency devaluations are not the path to prosperity, a weaker euro would give a boost in competitiveness to all members of the monetary union, including France and the Netherlands, which is why they might very well choose to remain in it even if Germany were to gradually leave. A resurgence of manufacturing would also allow the vast unemployment rolls of Spain, Portugal, Greece and other countries to begin to decline. The tremendous loss of human capital and human dignity we are witnessing would ease.

Reintroducing the mark would not solve the debt burdens of southern European countries, but it would give them needed breathing room to restructure their economies, reform labor markets, collect more taxes and reassure investors. The ability of the southern European countries to service their sovereign debt would immediately improve, helping to end the slow-burning debt and banking crises that have engulfed the Continent since 2008.
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Greed, greed, greed

27 June, 2012 at 22:55 | Posted in Varia | 1 Comment

 

The euro system – a comedy of errors

27 June, 2012 at 18:01 | Posted in Economics | 1 Comment

 

On debt and effective demand in the eurozone

27 June, 2012 at 17:52 | Posted in Economics | Comments Off on On debt and effective demand in the eurozone

 

Socialdemokratin bäddade för dagens massarbetslöshet

27 June, 2012 at 15:23 | Posted in Politics & Society | Comments Off on Socialdemokratin bäddade för dagens massarbetslöshet

Att förstå drivkrafterna för den politiska och ideologiska utvecklingen de senaste 25 åren tillhör samtidshistoriens mest utmanande uppgifter.
För några dagar sedan gästades ABF-huset i Stockholm av LO:s förre chefsekonom P-O Edin och tidigare ordföranden Bertil Jonsson som tillsammans med Leif Hägg skrivit boken Så tänkte vi på LO – och så tänker vi i dag.
Edin inledde med att ställa frågan vem som hade trott på någon som 1985 givit följande framtidsscenario:

Att man i dag skrivit in i den svenska grundlagen att låg inflation går före full sysselsättning
Att samhället bekostar friskolor för Livets Ord
Att samma fastighetsskatt gäller för villor i Djursholm och Hultsfred
Att de finansiella marknaderna avreglerats
Att Televerket är börsnoterat – och marknaderna för post, el och apotek är avreglerade
Att vård och omsorg kan bedrivas av vinstmaximerande företag, vars vinster hamnar i skatteparadis
Att stora delar av det kommunala bostadsbeståndet har sålts ut till privata ägare
Och – dessutom – att det socialdemokratiska partiet i slutändan inte haft några allvarliga invändningar på någon av punkterna

Svar: Ingen.

Ingen kunde nånsin förutspå den här utvecklingen.
Så hur kunde det då bli så här?
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Why more debt can be the solution to the debt crisis

27 June, 2012 at 11:51 | Posted in Economics | Comments Off on Why more debt can be the solution to the debt crisis

One of the common arguments against fiscal policy in the current situation – one that sounds sensible – is that debt is the problem, so how can debt be the solution? Households borrowed too much; now you want the government to borrow even more?

What’s wrong with that argument? It assumes, implicitly, that debt is debt – that it doesn’t matter who owes the money. Yet that can’t be right; if it were, we wouldn’t have a problem in the first place. After all, to a first approximation debt is money we owe to ourselves … Ignoring the foreign component, or looking at the world as a whole, the overall level of debt makes no difference to aggregate net worth – one person’s liability is another person’s asset.

It follows that the level of debt matters only if the distribution of net worth matters, if highly indebted players face different constraints from players with low debt. And this means that all debt isn’t created equal – which is why borrowing by some actors now can help cure problems created by excess borrowing by other actors in the past.

To see my point, imagine first a world in which there are only two kinds of people:
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Prayer Of The Heart

27 June, 2012 at 10:09 | Posted in Varia | Comments Off on Prayer Of The Heart

 

Put null hypothesis significance testing where it belongs – in the garbage can!

26 June, 2012 at 17:40 | Posted in Statistics & Econometrics | 2 Comments

A couple of weeks ago I had a very interesting luncheon discussion with professor Deirdre McCloskey on her controversy with Kevin Hoover on significance testing. It got me thinking about where the fetish status of significance testing comes from and why we are still teaching and practising it, despite its obvious inadequacies.

A non-trivial part of teaching statistics is made up of learning students to perform significance testing. A problem I have noticed repeatedly over the years, however, is that no matter how careful you try to be in explicating what the probabilities generated by these statistical tests – p values – really are, still most students misinterpret them.

A couple of years ago I gave a statistics course for the Swedish National Research School in History, and at the exam I asked the students to explain how one should correctly interpret p-values. Although the correct definition is p(data|null hypothesis), a majority of the students either misinterpreted the p value as being the likelihood of a sampling error (which of course is wrong, since the very computation of the p value is based on the assumption that sampling errors are what causes the sample statistics not coinciding with the null hypothesis) or that the p value is the probability of the null hypothesis being true, given the data (which of course also is wrong, since it is p(null hypothesis|data) rather than the correct p(data|null hypothesis)).

This is not to blame on students’ ignorance, but rather on significance testing not being particularly transparent (conditional probability inference is difficult even to those of us who teach and practice it). A lot of researchers fall pray to the same mistakes. So – given that it anyway is very unlikely than any population parameter is exactly zero, and that contrary to assumption most samples in social science and economics are not random or having the right distributional shape – why continue to press students and researchers to do null hypothesis significance testing, testing that relies on weird backward logic that students and researchers usually don’t understand?

Statistical significance doesn’t say that something is important or true. And since there already are far better and more relevant testing that can be done (see e. g. here and  here), it is high time to give up on this statistical fetish. 

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