Apparently, the Obama administration may soon put limits on short-selling. If so, this is cargo-cult thinking at its worst. Prices fell really fast, so it must be the sellers' fault! If we could just stop all this selling, then prices would never go down!
Here is my previous explanation of why short selling is in fact a critical tool to moderate bubbles, adding to the irony that we should be considering limits on this tool while suffering a bubble-induced recession.
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.
Megan McArdle hilariously commented:
I don't understand why the Commission doesn't focus on something more effective, like installing lavish statues of Mammon on trading floors so that traders can better propitiate him.
Update: By the way, this could be argued to be just another piece of corporate welfare. CEO's hate short sales of their stocks, and would love Congress to ban the practice altogether. The fact that the practice enforces accountability on them, I am sure, has nothing to do with it. The reality is that if buying and selling are thought of as voting for or against a company's or asset's value and prospects, then banning short selling is a way of disenfranchising most of the world from this process.
By the way, not that I think it should matter from a policy perspective, but have you noticed that the shorts seem to be right an awful lot? In retrospect, more shorting of bank and insurance stocks 3 years ago would have been a good thing.