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The Securities and Exchange Commission took the very drastic step of outlawing the essential financial practice of short selling in an attempt to galvanize financial markets. (The SEC recently extended at least some portions of its initial ban through October 17.) But short selling provides essential information to market participants and helps us update our expectations accordingly. By outlawing short selling, the SEC has eliminated a crucial element of what makes markets work.

To understand why someone would "go short" on a stock, it's easiest to first consider the opposite case. When an investor thinks that a stock is an attractive buy, he "goes long" by buying the stock at its current (undervalued) price. If his hunch is correct and the price rises, the investor can sell the stock at the higher price, pocketing the difference.

But if an investor is pessimistic about a stock, and thinks that it is overvalued at its current price, then he can "short" the stock. Specifically what happens is that the investor instructs his broker to borrow shares from an existing owner and sell them at the current (overvalued) price. (With the practice of "naked" short selling, the sale is booked before the shares are actually located and borrowed from a current owner.) If the investor's hunch is correct and the stock price falls, then he can instruct his broker to "cover the short" by buying the same number of shares in the open market to return to the original owner. The successful short seller pockets the difference between the original (overvalued) price at which he shorted the stock, and the lower price at which he covered the short. (We are of course ignoring transaction costs.) Naturally there is risk involved: if the price of the asset rises, the short seller loses.

Short selling plays a crucial role in the market. If many investors are selling a stock short, it means that they think the asset is overvalued. The more people risk their wealth by shorting a stock, the more pressure is brought to bear on the stock price.

However, there are two sides to the contract. Every share that is sold short has to be bought long. At first, this seems like a zero-sum transaction, but it plays a crucial role by providing information. Profits tell entrepreneurs and speculators that they are realigning the structure of production more closely with the desires of consumers. Over time, those who speculate incorrectly (and who would misalign the structure of production) will be weeded out. On his blog, Arnold Kling notes that short selling cannot drive down an asset's price per se; the only way short selling could reduce the price would be if other market participants don't take up the other side of the contract and defend the value of the shares. In this case, the short selling itself doesn't reduce the price of the asset: it is the fact that the short sellers overwhelm those going long that reduces the price of the asset.

"The SEC will have to invent ever more rules in a vain effort to prevent people from putting their money where their views are."

There is a role for psychology, to be sure, but this is unlikely to be significant at the margin. People earning nine-figure compensation packages to make ten-figure decisions every day have an incentive to avoid acting rashly. The SEC's ban eliminates important elements of the market's feedback mechanism and will compound these problems of psychology rather than solve them. In particular, if there is a "herd mentality" that is pushing up a certain stock's price, it takes disinterested short sellers to come in and restore sanity more quickly to the market. Without this "damper," such herds will stampede the price higher, and it will fall all the harder when the bubble finally bursts, which it always does.

Ironically, the ban on short selling only a particular group of stocks will make investors less likely to deal with those firms. There are at least two reasons for this. First, shorting is a way for firms to hedge themselves when they offer "credit-default swaps," which are basically insurance policies covering a bond default. For example, an insuring company might offer credit-default swaps to lenders who have bought bonds issued by Goldman Sachs. Now if the insuring company starts getting nervous about all of the Goldman coverage that it has sold, it can short shares of Goldman to hedge itself. This way, if bad news comes out and Goldman goes bankrupt, the insuring firm has to pay out on its credit-default swaps (because Goldman defaulted on some of its bonds) but at least the insuring firm makes money from the fall in Goldman's share price.

But now, because of the SEC ban, insuring firms can't hedge themselves against sudden collapses of financial firms. This makes it riskier for insuring firms to offer protection on the bonds issued by these same "protected" financial firms, meaning that they will charge more to insure their bonds. Ironically, the SEC's ban thus makes it more expensive for lenders to loan money to firms in the financial industry, and so these "protected" firms will be even further starved for injections of private capital. Note that this inability to raise private funds is the very problem the government is trying to cure.

Second, the SEC ban will make investors less willing to buy shares of the financial firms in question. Before, average investors knew that an army of speculators were circling the markets, looking for vulnerable firms loaded up with toxic mortgage-backed assets. Therefore, if a big bank wasn't getting hit by a wave of "attacks" from short sellers, this meant it was probably a relatively sound institution. The SEC ban has taken that source of information away from the average investor, who now may shun the financial sector altogether because there is no longer any money for expert analysts to make in digging up accounting irregularities or other troubles with particular firms.

Even though the practice of short selling has been made illegal, the potential gains from trade have not been eliminated. Speculators with billions of dollars on the line have incentives to find a way to short sell under a different name, and the unintended consequences of the new regulatory environment are undesirable. For example, pessimistic investors might buy put options, which are another way to profit from an expected price fall, or they might buy assets that typically move in the opposite direction from the stock they wanted to short. The SEC will have to invent ever more rules in a vain effort to prevent people from putting their money where their views are. But the market will continually adapt to the new rules of the game. Over the long run, the creation of a new regulatory infrastructure will create a new political constituency with a financial and ideological stake in the new institutions, and they will resist reversion to the preintervention status quo.

Government intervention lends ideological or institutional legitimacy to further intervention.

The second unintended consequence is the ideological and institutional legacies that interventions leave. In his book Crisis and Leviathan, economic historian Robert Higgs argues that one of the more subtle long-run effects of government intervention is that it lends ideological or institutional legitimacy to further intervention. As he has pointed out , some of the government's attempts to fix the current financial crisis have their roots in the institutional and ideological legacy of the New Deal.

Loosely speaking, the price of an asset reflects market participants' best estimate of the (market) value that can be created using that asset. If the price of a share of stock is $100, this means that the market's best guess as to the value that can be created with the underlying property is $100. People make mistakes in such estimations all the time. Most people might think that a share of the company can produce $100 worth of value, but someone else might think that the share can produce only $90 but that the rest of the market doesn't know it yet. If he is certain enough to act on his convictions, he can short sell the stock and earn a profit if the price falls. To short sell, an investor borrows shares from someone and agrees to return the shares sometime in the future. Suppose an investor writes a contract to sell 100 shares of stock at $100 each. He can borrow the shares from his broker or from someone else, but he will need to go into the spot market at some point in order to purchase the assets and cover his position. If he was correct, the price will be $90 and he will earn a profit of $10 per share. If he was incorrect and the price increases to $110, he will lose $10 per share.[1]

Short selling is risky because it is trading with borrowed money. If you are short selling, you are entering into contracts to borrow, sell, and restore someone else's assets. Short selling is not possible unless there are other investors who are willing to defend an asset — in other words, you cannot short sell based on your belief that an asset is overvalued unless someone else is willing to meet your price for the shares on the belief that the asset is either valued properly or undervalued.

Short selling is vital to a well-functioning market economy because it transmits valuable information about investors' beliefs about the quality of an asset. By outlawing short selling, the Securities and Exchange Commission outlawed a practice that produces information necessary for financial markets to function smoothly.

And who are the winners from the SEC's ban? It isn't everyday investors, who are denied crucial information about the quality of the assets in their portfolios. No, the winners are the managers of the protected (poorly performing) firms, who are able to keep the market capitalizations of their firms above water by denying the rest of us useful information. Ironically, the SEC's ban has lumped all financial firms into one big category with a "WARNING" stamped on it by the government. This is bad for the industry itself, but it actually dilutes the bad news for those financial firms most heavily loaded with dubious mortgage-backed assets.