The SEC banned shorting in the financial sector last Friday as part of its response to the latest toppling dominoes in the subprime mortgage meltdown. I’m not convinced this is a great idea. Hoover tried this in 1929, as Amity Shlaes discusses in The Forgotten Man (2007):
Without short contracts, he reckoned, the stock market would not experience such violence ructions. The shorts, to his mind, put downward pressure on a market that might in some instances otherwise do fine. Now he wanted new rules to limit shorting. But the argument against shorting had a flaw. For every short seller — the man who was exerting downward pressure — there was always a long buyer — the man who bet he could get the stock for cheap under the arrangement, and then sell it himself, for more. [Emphasis mine.]
And the point of the SEC’s action, really, is not to remove downward pressure on otherwise good stocks — it’s to discourage people from jumping ship on their bad stocks, ostensibly temporarily, until Congress can get around to passing Paulson’s $700 billion bailout package. Larry Kudlow is as skeptical as I am:
In extreme, the absence of short sellers would inflate stock market upturns, probably into bubbles. Short sellers keep the market honest. I know many in the short-selling community and most of them really do their homework. They are skeptical about puff pieces on companies and they are properly cynical about corporate press releases.
The wisdom of the bailout package is an entirely other matter about which I am equally skeptical. It’s time once again to see what our congressional representatives are made of, but I would bet money on them selling us out again.
