Bubbles, Fraud, Government and Short Sellers

by Chidem Kurdas

The new issue of the Freeman contains an excellent article on short selling by Warren C. Gibson.  This investment method – selling borrowed stocks in the expectation of  buying them later at lower prices – is always controversial. Regulators temporarily banned it for financial stocks during the credit crisis of 2008 and now look to place other restrictions, about which Mr. Gibson provides a lucid discussion.

Short sellers seek to identify companies that are over-valued. Studies indicate that they tend to be correct in their analysis of businesses and the stocks they pick tend to go down. Many corporate frauds were first uncovered by these traders. James Chanos, probably the best known short-seller, figured out Enron a long time before any regulator did.

Short selling can limit bubbles in asset prices. In the past 15 years, we’ve had a stock bubble, real estate bubble and credit bubble. Given this dangerous bubble-proneness, short selling is a particularly valuable market mechanism. Regulators pay lip service to its benefits, but have proposed rules to inhibit this type of trading.

Why they do so says a lot about how the government operates. It also says a lot about how political action skews markets.

As Mr. Gibson observes, “Executives of companies whose stock is being shorted can be particularly vocal about blaming speculators for beating up their company shares when in fact their own management blunders are at fault.”

Those companies have immense resources and political influence compared to short sellers.  Kynikos Associates, the hedge fund managed by Mr. Chanos, is probably the largest such business, but it is tiny compared to the companies he short sells. Even Mr. Chanos is a small player, not only in the market but more significantly in the political arena.

As Sheldon Richman reminds us in the Freeman, “Corporate power and privilege derive from political power and can’t exist without it.” Big corporations have strong political backing. Hence when corporate executives complain that short sellers are manipulating stock prices and ask that they be stopped, politicians and regulators listen and take action.

This has two effects. One, it delays the recognition of incompetent and dishonest company managements. The government did not do anything about Enron until the company was in a state of collapse—Mr. Chanos found out the truth while Enron executives were still successfully spinning their tale of a great business.

Two, government intervention skews price trends. Naturally, executives do not complain about the buyers of their company’s stock—and regulators focus on short sellers driving stock prices down, not so much on buyers pushing prices up. Hence interference creates an upward bias. Regulators swing into rigorous action when prices decline, as in 2008, but not when they rise, as in 1999.

Mr. Chanos quotes Edward Chancellor, a historian of finance, who wrote in 2001, “we need more, not less, shorting activity if, in the future, we are to avoid wasteful bubbles, such as the recent technology, media and telecoms boom…”

By seeking to obstruct short sellers, the government in effect fosters bubbles. But that’s probably not a problem for the political class. It can play the savior after bubbles collapse and use the excuse to expand its own powers, as we see happening now.  Sabotage the short selling correction mechanism; substitute state controls—sounds like a plan.

9 thoughts on “Bubbles, Fraud, Government and Short Sellers

  1. The ban on short-selling, like anonymous access to Fed money or regulatory forbearance or countercyclical shifts between mark-to-market and historical value accounting, are countercyclical policies. They aim of conning the markets up during the boom and avoiding that market forces bring prices down during the bust.

    Monetary policy has been used for more than a decade to remove downside risks from entreupreneurs’ valuations, and now that monetary policy proper is ineffective nonstandard interventions are being put in practice to further socialize risks.

    The only hope for market stability is that the recent ineffectiveness of monetary policy has scared entrepreneurs and reduced the ineffectiveness of monetary interventions and the trust in this marketwide insurance. However, everything is being tried to avoid the recognition of the ultimate folly of insuring entrepreneurs’ risks.

    Middle-of-the-road policies impedes the proper functioning of markets, and lead to socialism. Institutional tools to put a straighjacket on democratic decisionmaking are badly needed.

  2. Intriguing analysis, Pietro. I like your expression, “conning the markets”. But is this pattern confined to entrepreneurs? It involves corporate executives, who are not necessarily entrepreneurs, at least in the usual sense of that term.

  3. Not sure that the “the recent ineffectiveness of monetary policy has scared entrepreneurs.” So far,2008-2009 policies are seen as generally successful!

  4. I agree that they’re trying everything to shape markets to their liking. Last week there was an announcement that “The Securities and Exchange Commission today moved forward with a broad review of the equity market structure…”

  5. Yes, I was using entrepreneurs in a functional (or idiosyncratic?) way as those who make decisions. Also consumers have been conned, in a certain sense, to the extent that they have equity extracted their fictitious wealth to consume more.

    For what concerns effectiveness, I use the term “monetary policy” in the strict sense, i.e., standard monetary operations such as Open market operations: monetizing short term t-bills and affecting the rest of the market indirectly.

    The Newkeynesian literature on the Zero Interest Rate Policy expands the policy tools also to long term treasuries monetization and direct monetization of private assets (the term quantitative easing has different meaning depending on the author: sometimes it is the former policy, other times the latter, sometimes it is also the expansion of the monetary base).

    Despite this, I hold that these policies may have been ineffective, without complementary policies such as accounting forbearance (to avoid deleveraging out of capital adequacy ratios), short selling bans (to mantain a positive bias in valuations) and of course the recapitalization of banks and the clearing up of their balance sheets (the main goal of the expansion of the monetary base). These policies couldn’t be considered monetary even latu sensu, but they have played a key role in postponing (so far) the crisis.

    I don’t think that monetary policy (also latu sensu) would have sufficed.

    The way I look at ineffectiveness is, to state it hydraulically, that firms thrives on price differentials, banks thrive on interest rate differentials (they are the same thing) and excessive monetary expansion in the long run wipes out these differentials.

    In these conditions firms cannot gain profits out of interest rate cuts and banks cannot intermediate, and monetary policy comes to a halt, at least at constant prices. Considering that prices cannot grow when banks cannot keep on inflating money, the result can be ineffectiveness.

    By helping the banking sector a stagflation can always be created. But a healthy recovery, of course, requires a real recession.

    When I said that I hope markets agents have been scared by the crisis I was also thinking that some restructuring may have been already performed. Last year PPI has fallen very much with respect to CPI, and if this is a proxy of price differentials, there can be some breathing space created through the recession. But CPI is on the rise again, and PPI increasing even faster. If prices move before output, I guess they are capital structure bottlenecks at work. Deflation or stagnation? Hardly a beatiful choice.

    I think it’ll be the a jobless recovery much more than in 2000 (more structural problems accumulated in the meanwhile), with a nonnegligible probability of some other crash. At the end, banks can sell their losses to tax payers, but they cannot create price differentials where there are not.

  6. So, your point is that conventional monetary tools were ineffective. Unconventional methods, in particular various versions of quantitative easing, were used. Of course, there was the $700 billion-plus fiscal stimulus and the various other interventions. The combination appeared to contain the crisis and may have prevented the recession from becoming worse. Your long-term view is that these measures are not conducive to robust recovery.

  7. I agree that the ban on short selling and the change in accounting rules by political fiat camouflaged the financial problem rather than solving it.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s