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This week, troubles in Europe may have played as much of a role in the U.S. stock market carnage and volatility as the downgrade of U.S debt. A just-announced decision by European authorities will likely damage markets there and in the U.S. even further by trying to "fix" them.
The European Securities and Markets Authority, which coordinates financial market policies for the European Union, declared a ban (PDF)  Thursday evening on short-selling certain stocks in France, Belgium, Italy and Spain. For an amount of time not specified in the release, no negative bet will be allowed on the prospects of these stocks.
As with proposals to jail executives at Standard & Poor's , the EU's action in this case is properly called "killing the messenger." And if a temporary American ban on short-selling in the panic of 2008 is any guide, it will like make market volatility worse by suppressing vitally needed market signals. Most economists -- both liberal and conservative -- see shorts as a valuable counterweight to the market euphoria that creates bubbles and to the market panic that results in busts.
The main form of short-selling is borrowing shares from a broker and buying them back at a later date. If the stock price drops, short-sellers pocket the profits. But if the price keeps going up, shorts eventually have to "cover" and pay the difference.
As noted in Michael Lewis's best-seller The Big Short, which chronicled the stories of those who bet against housing before the mortgage bubble burst, short-sellers can reap great rewards if they're right. They can also be at great risk if they're wrong. But win or lose, they send very important market signals about both individual companies and the economy as a whole.
As liberal New Yorker writer James Surowiecki observed in his book The Wisdom of Crowds, if the price of a stock "represents a weighted average of investors' judgments, it's more likely to be accurate if those investors aren't all cut from the same cloth." A market with few shorts, he argued, increases vastly the chances that if a price "gets out of whack, it will really get out of whack."
And as John Tamny, free-market economist and editor of RealClearMarkets.com, has written  in Forbes, "Short-sellers provide information, or what some call 'feedback,' to investors, (and) when their activities are made illegal, information that is necessary to correctly price securities is lost."
We know all that, say the European officials as did the American regulators in 2008, but this an emergency! In a panic, they argue, short-sellers add fuel to the inferno.
But in fact, during panic selling, short-sellers are about the only ones carrying an extinguisher. Because they have to buy stock to take their profits, they are the ones who call a bottom in the market as well as a top. As Tamny observed, "while short-sellers bristle as their sales take stock prices down, they're the ultimate savior of those same firms later on in the game." In a panic, without bears, there are only neutered bulls stampeding for the exits.
A consensus is emerging that the U.S. short-selling ban of 2008 actually made the stock market fall further than it otherwise would have. As the New York Times noted  Thursday in reporting on the European ban, "the ban on short-selling in 2008 has been widely criticized and blamed for driving investors out of the market altogether, further hurting stock prices."
Going back further, short-selling bans worsened the Great Depression in the early 1930s. As free-market economist Benjamin Anderson wrote in his classic Economics and the Public Welfare, the series of bans in 1931 and 1932 resulted in share price declines that "were more extreme," followed by "rallies [that] were far feebler than would otherwise have been the case." Since today markets are more interconnected than ever and many American investors have European stock -- indeed many European firms trade on our stock exchanges -- the fact that a shorting ban may make prices eventually fall further would hurt American portfolios as well.
The real question policy makers should ask about shorts is why aren't there more of them. If more investors had been like the heroes of The Big Short, the mortgage bubble would not likely have accelerated as fast as it did, because of the check shorts provide on irrational exuberance. Rules for mutual funds and exchange-traded funds should be liberalized so that retail investors can enjoy the same opportunities for shorting in their portfolios as the wealthy investors served by hedge funds now enjoy.
In examining the balance sheets of companies and of countries, suppressing the messenger doesn't work. If Europe says its corporations are so fragile that they need to be protected from any negative feedback, why should anyone invest in them or loan them money in the first place?