It’s uncontroversial to say that people like good things to happen to them. Good things only please, no bad ones. But sometimes there can be too much of a good thing.
Take short-selling. Free market acolytes and their captive professors will aver that short-selling is good because it promotes perfect markets, improves market efficiency and enables price discovery. There are gigabytes of academic papers to convince us so. Intellectually, I can appreciate the fine argument. A security is “overpriced”. The short-seller borrows the security from someone who has it and then sells it in the belief that the price will (soon) drop and he can buy the same security back at a lower price and return it to the lender. His profit is the difference between the high price at which he sold less the lower price at which he bought the security back less any charges. But wait a minute.
Wait a minute! Who said the security was “overpriced”? Where is the “fundamental value” of a security recorded so we can compare it to the market price and “know” that the security is “over” or “under” priced? Secondly, when the short-seller short sells, is he doing it for market efficiency and society or to make a profit? That’s easy, he wants to make a profit and this is where he and his professors quote Adam Smith. By making a profit he is contributing something good to society, like the baker who doesn’t care about feeding you, really, only about making a profit while he sells you bread. Fair enough. Where I get lost is the automatic jump from baker to short-seller. The baker produces things. The short-seller is a speculator.
The act of short-selling increases the ratio of sellers to buyers thus arresting the price of the security. If there are enough short-sellers selling the stock, then short-selling becomes self-fulfilling as the price of the security plunges. This only encourages more people to dive in to line their pockets and keep up with their peers (or else you get sacked for “underperformance”). Even people who want to buy the stock (i.e. go long) will take a breather and wait for the price fall to stop before dipping in. Afterall, why buy now if you can pick it up cheaper later.
Here’s the thing though. Even the company might panic into buying its stock to support prices, that is, instead of using cash to invest. Employees panic too as they see their delayed stock compensation plummet. Talk about aligning employee and stockholder interests. One may even question what sort of a shareholder owner will lend his stock to be shorted and potentially send the price to zero. These are not true owners, they are rascals. What sort of baker sets fire to his bakery except he’s trying to collect on the insurance.
At some point all short-sellers have to buy the security back (to cover their shorts) which can send the price sharply up particularly if the security can’t be found because a few wise souls have cornered the market (i.e bought mass-loads of the security and then removed it from the market only to drip feed it back to the hungry short-sellers caught short). That’s illegal or at least frowned upon. More likely the price of the security see-saws back and forth and there’s no telling where it goes. You see it here, you see it there and you see pictures of traders glued to their monitors doing nothing productive. Or it becomes a game the market plays, indifferent to the impact on people’s lives. A fine way to run an economy!.
Is there any good in short-selling? Perhaps, in small measures there is a case for having a mechanism for preventing prices reaching for the stars because when they come back down, a lot of simpleminded investors will be hurt. Yes, I know a fool and his money are soon parted and maybe that’s natural justice but a government shouldn’t just sit by. On the other hand, short-selling should be regulated to prevent it sending security prices, at least theoretically, to zero. It distracts the economy and if companies falter then, again, the ordinary people suffer but this time through no fault of theirs. Governments should not just sit idly by.
I hope some day it won’t be controversial to have policies that control security prices so they are not bid through the roof in speculative madness or bid to the floor by the collusive action of short-sellers. Which ever way security prices go, perfect and efficient markets should guide them towards the Aristotelian mean. Allowing security prices of companies (not in distress) to go to extremes is too much of a good thing.