We the People

an Austrian defense of short selling against invasive government regulation

Short sellers beware! Not only is the Securities and Exchange Commission after you, but so is The New York Times. In the article “S.E.C. Temporarily Blocks Short Sales of Financial Stocks,” Vikas Bajaj and Graham Bowley adopt a moralizing tone in their reporting – admonishing short sellers and siding with the feds.

In the wake of the government’s bailout of the banks in September of 2008, the S.E.C. “issued a temporary ban on short sales of 799 financial stocks” (Bajaj & Bowley, para. 1). What the reporters do not explicitly illustrate until the end of the article is that these protected stocks comprised the interests of 19 banking firms and the federal government that bailed them out. This kind of regulation – aimed at protecting the interests of the government – hurts ordinary market participants by forbidding short selling.

Short selling is often criticized as a form of speculation. In order to short sell, one borrows stock in a company he expects is overpriced, sells the stock, and repays his loan when the price drops – making a profit if his prediction is correct.

Justifying the short sale ban, New York State’s comptroller Thomas P. DiNapoli said, “This speculative selling has put downward pressure on the entire stock market and threatens to drive our national economy deeper into decline” (Bajaj & Bowley, para. 29). The conclusion that the economy suffers through the practice of short selling is incorrect, because speculation facilitates a healthy market economy.

Speculation helps a market by driving prices towards their equilibrium point, neutralizing the volatility of booms and busts, and spreading information. In Man, Economy, and State, Murray Rothbard writes, “The general effect of speculation is to make both the supply and demand curves more elastic… The more people engage in such (correct) speculation, the more elastic will be the curves, and, by  implication, the more rapidly will the equilibrium price be reached” (p. 251). Relating this knowledge to short selling, one discovers how critical a technique it is for a healthy market economy.

Sort selling acts as speculation, and helps determine supply and demand schedules. Specifically, short selling affects the reservation demand of a stock. If one expects a stock price to increase in the future, he will take a long position: choosing to hold the stock over holding money. This increases the reservation demand of the stock, therefore increasing the price of the stock – all else remaining equal. Short selling works in reverse, and is useful if one expects a stock price to decrease in the future.

In MES, Rothbard writes, “In so far as the equilibrium price is anticipated correctly by speculators, the demand and supply schedules will reflect the fact: above the equilibrium price, demanders will buy less than they otherwise would because of their anticipation of a later drop in the money price; below that price, they will buy more because of an anticipation of a rise in the money price” (p. 250-251). This quote reinforces the importance of action on each side of the equilibrium price.

Short selling is the downward force bringing inflated prices towards equilibrium. When government bans short selling, it cripples the market’s ability to drive prices downwards – creating volatility. This volatility manifests itself in inflated prices, or bubbles. The burst of the housing market bubble led to the banking crisis and the subsequent bailout. By banning short selling, even temporarily, the government runs the risk of creating more bubbles in the market.

Fortunately, attempts to ban short selling cannot entirely halt the market forces in their drive towards equilibrium. This is due to the signals that the S.E.C. sends to investors when it temporarily bans short selling – especially in regards to specific stocks. An observant investor interprets the S.E.C.’s action as negative information, avoids purchasing the protected stocks, and therefore drives down the reservation demand for those stocks – inevitably lowering their price.

Short selling spreads information throughout a market. In his article “Don’t Sell Short Selling Short” Gary Galles writes, “Short selling is part of the information-revealing process that Mises, Hayek, and others emphasized as the central aspect and advantage of the market process. In a world of uncertainty and change, information is the scarcest good, and short selling is an important source of additional information that would otherwise be lost” (para. 4). In this light, the S.E.C.’s actions can be seen as censorship. Indeed, the entire market is harmed by the destruction of the negative information revealed by short selling.

Opponents of short selling justify regulation by raising concerns about abuse. New York State attorney general Andrew Cuomo said of short sellers, “They are like looters after a hurricane” (Bajaj & Bowley, para. 11) Cuomo is accusing short sellers of profiteering after the collapse of the banking industry. However, short sellers predict catastrophe, and get that information out onto the market, stabilizing the prices and avoiding volatility. Cuomo’s accusation could apply to a shareholder who wants to offload his banking firm stocks after the crisis. This nuance is not always clear to government bureaucrats however.

The feds frequently regulate against short selling “abuse” as well. The S.E.C. classifies naked short selling as abusive. Naked shorting takes advantage of the time between agreement to sell and delivery of the stocks in order for the seller to never own or borrow the stock. Naked short selling is not fraud if the transaction goes through. Naked Shorting is fraudulent when the deal does not go through and the buyer suffers a loss while the seller suffers none.

The government attempts to halt all forms of naked short selling, but cannot effectively do so for two reasons. First, how can you know someone is manipulating short selling? Second, how can you tell a manipulator from a legitimate short seller? Regulators can’t tell, and often argue for a permanent ban on short selling. However, any argument against taking a short position is also an argument against taking a long position! Each position is just a reflection of individuals’ reservation demands. Therefore government opposition is an argument against all ownership! This is clearly in violation of man’s property rights, and another approach must be taken.

How do Austrian economists suggest protecting against fraud? In his article, “Short-Sale Restrictions are an Exercise in Naked Power,” Robert P. Murphy writes, “Traders aren’t stupid. They understand the possibility of manipulative schemes, and can take defensive actions accordingly. For example, if a trader believes someone else is engaging in a ‘short and distort’ operation, he can buy the stocks on the cheap, preventing them from falling significantly in price” (para. 18). In this situation, a defensive investor in a long position increases his holdings in hopes that the ‘short and distort’ operation is proven fallacious. His portfolio might suffer for a short period of time, but if he is correct he will be handsomely rewarded!

Austrian analysis shows that government bans on short selling only hurts the market economy. Taking a short position is the converse action of taking a long position and is no less important in determining market prices. Short selling drives prices towards their equilibrium point, neutralizes volatility, and spreads helpful information to investors. By banning short selling, the government destroys information, creates bubbles, and contributes to the crises they set out to stop. The market must be allowed to operate freely, even when it involves the shorting of influential banking firms.