I noted, a few days back, that Alistair Darling had suggested it would be desirable to curtail short selling, and provided links to a technical piece I had done on this a while back, in which I explained what short selling contributes to market functioning, why it is important that it not be curtailed, and why much proposed regulation concerning short selling fails to address the (very limited) set of negative issues to which, in principle, it can give rise.
Since then, Vince Cable has stepped up the pressure, incoherently suggesting that short sellers have a one-way bet because of the likelihood of government support for a failing institution (presumably a moment of madness on Cable's part - he can't really be that ignorant about how short selling works and yet choose to recommend its restriction, can he?). Short sellers have been widely blamed for the quasi-demise of HBOS, and Osborne has been pressed on Newsnight to condemn short selling.
Let me say this overly frankly: curtailing short selling would be a really really stupid idea, pandering to the most incoherent rantings of incoherent, nay ignorant anti-capitalists.
Perhaps for Vince Cable's benefit, and perhaps for the benefit of some other readers, let's remember what short selling is. In its so-called "naked" form, it means selling shares you don't own, and then, before the time at which you would have to surrender the relevant share certificates, buying the number of shares you need. When done at scale, the more usual practice is not "naked" shorting (which is actually illegal in many jurisdictions), but, instead, paying someone that holds shares in a company on a longer-term basis (e.g. a pension fund) so that you can borrow their certificates (as it were), sell those shares to someone, then buy an equivalent set of shares later so as to return them to the original owners.
Short selling is a kind of bet on the price of shares falling - what you want is to have sold short (let's say, at £10 per share) then have the price fall (let's say to £1 per share) before you buy back and you then make a profit out of the difference (in this case £10 - £1 = £9 per share). (This is, of course, why Cable has it completely wrong - for government bailouts provide a floor on share prices, preventing them from falling, and thus limit the short sellers' gains. The short seller's best scenario is for the company to go bankrupt, so he could buy the shares he needs for £0.01.)
Short selling is thus the exact opposite of speculative purchasing. Few people complain if speculators buy large volumes of shares in businesses on speculation that the price of those shares will rise. Well, going short is just the form of speculation that functions in a falling market. If short selling is bad, then so must be buying shares speculatively ("going long", as the jargon terms it).
So, perhaps we ought to object to all speculation? But speculation greatly promotes market efficiency, in at least two key ways. Firstly, because speculation provides an incentive for speculators to do analysis of prices to see whether some companies are over- or under-valued. Without such analysis, fewer problems and opportunities would be discovered. Secondly, once it becomes understood that a company is over- or under-valued, the price needs to change to reflect that, so that prices can thereafter give efficient signals (the basis of a well-functioning market economy). Speculative money assists in achieving more rapid price correction.
Now of course, when "more rapid price correction" means that a company's shares halve in value over a couple of days rather than over several months, it is easy to understand the temptation to blame the speculators - it almost seems as if it is the speculators' fault that the price has fallen. But that is an error. The speculators are just the messangers here. It isn't the speculators that make the company worth only £1bn instead of £2bn - the company's value is determined by the nature of its business. What happens is that the speculators have realised that the company is worth only £1bn instead of £2bn, so if other market players are daft enough still to pay £2bn for the company's shares (to pay more for the shares than they are really worth), that gives the speculators an opportunity to profit from the mistakes of the misguided.
The main consequences of curtailing short selling would thus be twofold:
- First, there would be less research done into whether companies were over-priced. That would mean that more often, company failures or losses would come as a surprise to the market, and hence that action to correct failures would come later when damage caused had been greater.
- Next, when it had been revealed that companies were over-priced, falls in their prices would be more drawn out. Thus it would be later before alternative buyers for companies, that might have improved management techniques or other business ideas that would help ailing companies, would feel that prices had fallen sufficiently to justify their taking over. Consequently, badly run companies would stay badly run for longer, and superior business ideas and practices would have to wait longer before being introduced.
Now, if Vince Cable and Alistair Darling think that introducing these kind of inefficiencies into markets would be a Good Thing, then one can only grit one's teeth. In the meantime, I am very glad that George Osborne resisted the pressure to condemn selling short, and I urge him to stay the course.
