What Is Wrong With Short-Selling?

That is what reporters should be asking the Securities and Exchange Commission (SEC) and the Bush administration as they impose restrictions on naked short-selling, the practice of betting that a stock's price will fall. Whatever happened to free market fundamentalism? Why shouldn't individuals be allowed to bet that a stock's price will fall if they believe it is over-valued? And aren't these the same folks that were completely opposed to any restrictions on speculation in oil and other commodities?

This is more than just a gotcha. Short-selling can play a very important role in the market. If informed investors recognize that a stock is over-valued they perform a valuable service by selling it short and pushing down its stock price. This can both deprive the company of capital and be a signal to other actors in the market that the company might not be as healthy as is generally believed.

The economy would have benefited enormously if large numbers of traders had shorted Fannie and Freddie 4 years ago when they were buying up hundreds of billions of mortgages issued to buyers who bought homes at bubble-inflated prices. This would have stopped the bubble years ago. Similarly, we could have prevented the financial chaos at Merrill Lynch, Citigroup, Bear Stearns and the rest, if traders had recognized their financial shenanigans and aggressively shorted their stock. In the same vein, heavy shorting by informed investors could have prevented the boom and bust of the tech bubble.

The decision to intervene against short-selling is completely inconsistent with the belief in the wisdom of the markets. Of course short-sellers can be wrong and depress stock prices more than is justified by fundamentals, but so what? The government doesn't intervene when it thinks investors have exaggerated the true value of a stock. The public has no more reason to fear under-valued stock prices than over-valued stock prices. This one-sided intervention by SEC is hard to justify on any grounds. Reporters should be asking about it.

--Dean Baker

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