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.