Cargo Cult Regulation

Someone noticed that just before certain stocks crash in value, there is a lot of short-selling.  So the US government has banned short-selling, at least temporarily.  Classic cargo-cult logic. 

Boy this sure makes perfect sense in a time when we are concerned about speculative bubbles -- let's ban one of the most important tools that exist for bubbles to be shortened and made less, uh, bubbly.  Here is why (very briefly and non-technically) short-selling takes the edge off speculative excesses.

At the start of the bubble, a particular asset (be it an equity or a commodity like oil) is owned by a mix of people who have different expectations about future price movements.  For whatever reasons, in a bubble, a subset of the market develops rapidly rising expectations about the value of the asset.  They start buying the asset, and the price starts rising.  As the price rises, and these bulls buy in, folks who owned the asset previously and are less bullish about the future will sell to the new buyers.  The very fact of the rising price of the asset from this buying reinforces the bulls' feeling that the sky is the limit for prices, and bulls buy in even more. 

Let's fast forward to a point where the price has risen to some stratospheric levels vs. the previous pricing as well as historical norms or ratios.  The ownership base for the asset is now disproportionately
made up of those sky-is-the-limit bulls, while everyone who thought
these guys were overly optimistic and a bit wonky have sold out. 99.9% of the world now thinks the asset is grossly overvalued.  But how does it come to earth?  After all, the only way the price can drop is if some owners sell, and all the owners are super-bulls who are unlikely to do so.  As a result, the bubble might continue and grow long after most of the world has seen the insanity of it.

Thus, we have short-selling.  Short-selling allows the other 99.9% who are not owners to sell part of the asset anyway, casting their financial vote for the value of the company.  Short-selling shortens bubbles, hastens the reckoning, and in the process generally reduces the wreckage on the back end.

Update:  From Don Boudreaux:

To ban short-selling of stocks is to short-circuit an important
mechanism through which people share their knowledge and expectations
with others.  Banning a mechanism that better allows share prices to
reflect the expectation that the underlying assets are not worth as
much as current market prices suggest does nothing to change the
underlying reality.  Such a ban merely distorts knowledge of this
reality

  • ErikTheRed

    I think that calling this "cargo cult regulation" is unfair to Cargo Cultists. It's a deliberate and cynical attempt to scapegoat a certain class of investors who had the foresight and temerity to profit off of bad news. Damn those investors for being smarter and ballsier than us politicians!

  • morganovich

    the peoples republic of down jones has once more trounced the reactionary running dog short sellers! rejoice comrades!

    for an excellent object lesson in how little such curbs accomplish, take a look at pakistan. they banned short selling, caused a 3 day market spike, and then watched the market drop another 25% from pre-restriction levels over the next couple of months.

    not only are short selling bans horrible re distributors of wealth, but they are also almost certainly ineffective.

    nice work.

  • Richard

    Interesting that irrationally exuberant "animal spirits" in the real estate market were just fine with Morgan Stanley and Goldman Sachs when they were increasing leverage and spinning off billions in annual bonuses, but now that they claim market emotion is pessimistic the government must intervene to put an end to it! Regulatory bias?

  • Methinks

    You didn't finish the story, Morganovich. After the Pakistani market fell another 25% from post restriction levels, the stock exchange was attacked and vandalized by an angry mob. At this point, I wouldn't be at all surprised if that happened here - and I expect Johnny Mack to be the ringleader. Incidentally, Bess is a big hit. Everyone I sent her rant to instantly fell in love and are eagerly awaiting another one. I'm hoping you will hook us up if she strikes again.

    Two entirely unsurprising things happened today. First, companies got in line to whine and beg to be added to the short ban list. In response, the SEC announced that we are to expect the list to grow over the weekend. Second, the restrictions on the options market makers and stock market makers were removed today because the predictable happened - spreads got so wide, you could drive a truck through them. Liquidity was sucked out of the market and transactions costs increased while transparency decreased. Apparently, the answer to solving a financial crisis born of an illiquid, opaque market is to find a liquid, transparent financial market and kill it.

  • Mesa Econoguy

    Die liquidity, die!!!!!

    [I’m short liquidity, long shame]

  • Mesa Econoguy

    Die liquidity, die!!!!!

    [I’m short liquidity, long shame]

  • Mesa Econoguy

    I did not post that twice.

    Liquidity still needs to die.

  • Methinks

    SEC to responds to Mesa's demands.

    Done!

  • http://hertzlinger.blogspot.com Joseph Hertzlinger

    Banning short selling is like dealing with a fire alarm by putting your fingers in your ears.

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