Naked Capitalism has the article Philip Pilkington: Thinking Makes It So – The IMF Bailout of the UK in 1976 and the Rise of Monetarism.

This was a classic example of a rather unimportant variable becoming important merely because people began to think it important. In 1977 Treasury Minister Denzil Davies summed the situation up perfectly when he said,

[W]e should do all we can do to keep M3 within the announced target during this financial year. It matters not, it seems to me, that the definition of M3 is arbitrary; that the commitment to the IMF is in terms of Domestic Credit Expansion (although everyone knows that DCE is irrelevant when a country is in a balance of payments surplus); and that an increase in the money supply caused by “printing money” may be of a different nature to an increase caused by inflows. All this, no doubt, is good stuff for a seminar. Unfortunately, those people who have the power to move large sums of money across the international exchanges believe, on the whole, that “money counts”. The fact that it may not count as much as they think it does, seems to me to be somewhat irrelevant. (p25)

I wonder about the implication of this on proponents of Modern Monetary Theory.  I presume that Philip Pilkington is one.  Rather than proving that MMT is correct  and the monetarism discussed in this article is incorrect, perhaps it proves that whatever the people with the money believe in most strongly is what is correct.  At least it, not surprisingly, shows that what people believe in most strongly is what dictates their behavior.

I’ll have to read the stories at the links in the article to see the more detailed description.

I think I have figured out what the lesson is here.

There is a natural tendency to look at how people use the rules to take advantage of others. From this analysis people propose new rules to stop this bad behavior under the old rules.  What they fail to account for is that the behavior of the people taking advantage is not a constant.  The behavior is a function of the rules that are there to be used to one’s advantage.

The one behavior that is constant in some people is to think, “Well, if your going to be so stupid as to make an easily subverted  rule like this, then I might as well use it to my advantage.”  I have that philosophy myself when considering how to survive in the current economic system while at the same time decrying some of its rules.  This is how Enron took advantage of the energy market rules in California that were lobbied for by Enron.

The lesson is that when you set up new rules, you must be aware of and constantly guarding against this human behavior.  Just because something will work if people continue to behave the way they do now, there is no reason to believe they won’t change their behavior when the rules change.  In fact, what I am saying is that when you change the rules, you can almost be guaranteed that people will change their behavior accordingly.

This was beautifully demonstrated in the recent financial collapse due to the mortgage bubble debacle.  People were creating and were investing in financial derivatives based on mortgages.  The inventors of these derivatives made calculations on their safety based on historical records of the levels of mortgage default.  What they failed to take into account is that the historical behavior was based on a real estate market that did not have the derivatives they were inventing. The historical market had incentives that forced the purveyors of these mortgages to strictly enforce rules about the creditworthiness of the people getting the mortgages.   The incentive was that the issuers of these mortgages could go bankrupt if there were too many bad loans given out.

The ability to sell mortgages in packages of financial derivatives did away with the incentive to try to make only good loans.  In the new system, the banks could easily get rid of any risk from making bad loans.  In fact, the best way to make money in the derivatives market was to make as many bad loans as possible and sell them off before they went bad.

The buyers of these derivatives felt comfortable because they figured that if people defaulted, the banks would take possession of the valuable real estate and sell it at a profit.  The trouble is that this tactic only worked in the real estate market that existed before the creation of derivatives.  With a real estate market collapse which could be best brought on by massive investments in the same type of poorly thought out financial “asset”, the saving strategy would be made inoperative by the very tool that depended on the tactic to assure that it was a safe investment.

As with most sure-fire investment systems that are validated by back testing against  the historical record, they work until everyone tries it.  Then they don’t work.  They only work when not everyone is trying to do it.  It’s the same paradox that Keynes’ explained about the economy.  Some people can put more money into savings if they just resolve to do it, unless of course everybody makes the same resolution at about the same time.  Keynes pointed out that when everybody tries to do it, the economy collapses and there is not enough income for people to increase their savings when savings are totaled up over the entire economy.  When everyone tries to save, the total net savings actually declines.

This also touches on what George Soros explains is the difference between social systems and systems based solely on physics.  For the most part, you can study physical systems, derive laws of behavior, and then predict future behavior from those laws.  Social systems don’t behave this way because the subjects being studied can learn about the conclusions of the  study,  and change their behavior based on what they read.  Soros called this property of social systems “reflexivity”.