Short selling: panicked pols ban proof of failure
- Ivo Vegter
- 16 Aug 2011 06:49 (South Africa)
Blame anyone. Blame bankers. Blame derivatives traders. Blame short sellers. No, blame “naked” short sellers!
The one thing politicians will never do from their bully pulpit is blame themselves.
Which is why you should never, ever, believe a politician when they're explaining to you why the global economy is in such a colossal mess, despite all the science and technology the market has brought to bear on the productivity of hard-working individuals.
Politicians claim the right to be in charge of the economy, mostly as a consequence of the fact that companies and investors who made bad decisions were getting hurt.
They claim the authority to set the price of credit and to determine the value of money. They claim to be able to write the regulations by which the economic effort of ordinary people is restricted and redirected to serve the government's public policy ends. They claim the power to tax and spend if those policy ends are not met, and to print money when even those taxes are not enough to satisfy their favourite corporate interests.
Once again, politicians find themselves embarrassed, because the real world proved how arrogant they were to believe their own press about how cleverly they can manipulate vast economies and pump them full of the elixir of eternal growth.
Magic potions don't exist, of course. Politicians can no more spend beyond their means than you and I can. And when they buy up boatloads of toxic debt in the hope that doing so will save crony capitalists who are “too big to fail”, they can no more detoxify that debt than had you or I bought it.
Now they're in trouble. And they can't afford to let on, because then everyone would head for the exits.
So first they blame bankers, for responding to their laws and monetary policy exactly as the textbooks said they would. They call them “reckless” for doing exactly what the politicians said they wanted: increase risky lending to marginal businesses and consumers. Then they blame the insurance companies and hedge funds and derivatives traders who bought the risk from mortgage banks, secure in the knowledge that they could offload it onto government-sponsored financial giants. If all else failed, they could intimidate the government's lender-of-last-resort (the central bank) to bail them out.
All this duly happened as scripted. Trillions were spent on demand stimulus and bailing out bankrupt banks. All this failed. Your mother could have told you that retail therapy is probably not the smartest solution to a debt problem, but the government's finest economists didn't see this coming.
So they need people to blame, and it's easy to blame the financiers. They move billions using complex financial instruments. They have been caricatured over the centuries in ominous and often racist terms. They're easy to hate. Most of us don't understand the arcane concepts of high finance.
Even better for the politicians: it is the business of financiers to move capital to where it can best be used for production, so their profits depend on whether they choose correctly, not on whether markets go up or down. They can make money on the swings and on the roundabouts.
It's easy to claim, for example, that short selling is evil when those are the traders who profit when shares go down. And while CNBC's Janet Whitman notes an extraordinary admission by Christopher Cox, the former chairman of the US Securities and Exchange Commission – who said the biggest mistake of his term was to issue a three-week ban on short-selling bank stocks at the height of the financial crisis in 2008 – half of Europe has now done exactly the same, for exactly the same misguided reasons.
Let's establish a matter of principle, first. If it is not illegal in the normal course of events, short selling is clearly not held to be wrong. It is just as legitimate to sell cash for shares (buying shares) as it is to sell shares for cash (selling shares). If you don't have the cash on hand, it is perfectly legitimate to borrow it. Likewise, borrowing shares to trade is simply a private credit contract.
It is no more wrong or puzzling than a farmer who obtains a loan for working capital, on the strength of a futures contract for maize that he hasn't yet grown, but promises to deliver at harvest-time.
Now consider the real problem: major currencies – including the world's reserve currency – are collapsing, because the issuing governments are drowning in debt.
Because of deliberate easy money policies, nobody had an incentive to save to build up capital, and everyone had a reason to spend, spend, and spend. Consumers loaded credit cards, homeowners refinanced homes to pay for holidays, businesses loaded their balance sheets to finance expansions and takeovers, and governments issued cheap bonds to fund bread and circuses.
When the house of cards came crashing down, the bureaucrats played their trump card. They simply had the governments print money to buy up all the toxic debt that was floating about. This stuff was worthless to start with, of course, which is why banks were foreclosing non-paying debtors as fast as investors were fleeing from banks.
Now national governments are sitting with this junk, and account for it all at face value. Worse, central banks bought this debt at face value from national treasuries, plonked it under “assets” on their balance sheets, and happily issued more credit to flood the market – a process known as “printing money”. If anyone in private business had done that, they could expect to spend a decade or two in prison for fraud.
Needless to say, owners of government bonds are not entirely convinced that the politicians just magicked all the garbage away. They don't believe that the assets column of the central banks justify the amount of currency in the liabilities column.
This crisis – and it is a crisis, of which the dot com and housing crashes were mere preludes – has been a very long time brewing. It is not a short-term problem that can be papered over just by tweaking a few of the controls the economic czars have at their disposal. Just lowering the interest rate or pumping some fiscal stimulus into the market will not repay the debt. In fact, as we can all see, it makes it worse.
But worse is yet to come. Waiting in the wings is inflation. If you believe the government's official inflation numbers, you clearly haven't kept track of the price of food, industrial materials, fuel, and most of what ordinary people and companies spend their money on.
Which raises the question: why are they lying? Politicians are brazenly claiming not to be worried about inflation, but in reality they're in a flat spin, pressing every button they can think of, before the awful truth hits home: citizens will be paying off the government's debt with plummeting currency values and declining standards of living. They sneer when you mention the Weimar Republic, or Yugoslavia, or Zimbabwe, because it couldn't possibly happen to the United States of America or the European Union, could it?
Perhaps they'd care to explain why they're immune to the laws of economics. And if they think they're “too big to fail”, perhaps they'd care to explain who they expect will be bailing them out. China? It also doesn't particularly like dollars any more, if its international hard asset buying spree is any indication.
So politicians have painted themselves into a very tight corner. And they won't blame themselves, because that would mean voters have to throw the bums out. They can't even blame the opposition, because in most countries, including the US, this crisis has been building no matter who was at the helm. It is state-control of the financial system itself that is at fault, not the partisan slogans of any particular politician.
So they blame everyone else. Bankers. Foreigners. Merchants. The wealthy. Speculators. Money-changers. Short-sellers. All the usual suspects vilified by demagogues from time immemorial, to deflect the mob's anger at their own larceny.
Take the recently-banned short sellers, for example. They are merely market-watchers who notice when companies are overpriced. They believe that the capital these companies have been given by investors can be more profitably employed elsewhere. By acting quickly on their opinion, they alert the rest of the market. If they're wrong, and the market disagrees, they stand to lose real money. If the market agrees, they've done the economy a service by more rapidly correcting the price of the mispriced shares.
Much like the crowd-sourced content of Wikipedia, or the customer ratings on Amazon.com, all traders, long and short, determine the appropriate price for a stock or a bond. In this way, the allocation of available investment capital depends on the combination of all their knowledge, experience and expectations. There is no single trader who cannot be challenged by other traders betting against him.
Without short sellers, a share would still reach its true value, but it would take far longer. Instead of shorting a stock, they might have to buy something else they believe will be inversely correlated with that stock's performance, such as the shares of a competitor, or a position in commodities. This will ultimately have the same effect – correcting the price of the overvalued share – but it will just take longer.
A market with short sellers is more transparent and efficient, because it permits expert analysts to circle the market looking not only for shares that are too cheap, but also shares that are too expensive. These dispassionate observers can assess whether shareholders are making the right decisions, simply by taking a bet with them.
Without short sellers, holders of shares tend to be deceived by positive spin from company directors, the optimism of other shareholders, and their own inertia and confirmation bias. That's how bubbles form. In the same way that brave bargain-hunters do the market a service when the market crashes and shares are oversold, short sellers do the market a service by trying to spot and prick bubbles sooner rather than later. Bargain-hunters and short sellers both thrive in volatile markets, but far from causing the price to rise or fall, in tandem they react to reduce volatility. They protect other investors from mispriced assets and protect the economy from misallocated capital.
The only difference with the even more-maligned “naked” short sellers is that they short a stock without even borrowing the shares first. They trade on the strength of a contract that says they have to buy them if they lose the bet. They survive entirely on their credit reputation.
Think of them as “naked” because their brass balls are exposed and vulnerable. If short sellers are wrong, the naked ones get hurt the most.
That kind of risk-taking increases the amount of information in the market, making sure unjustified valuations are corrected more quickly, and capital gets more efficiently deployed. That information benefits the entire market.
Why would anyone want to ban information, except a politician whose money-printing failures are being exposed? DM