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“Rizzo, what do you think about regulating short-selling?”

I get questions like this all the time. Readers can imagine my answer. But the reason for the post is an obvious contradiction here. Government lovers the world around like to use economic theory to justify their market interventions. With the financial crisis raging, and the health care sector causing such “problems” a new favorite theoretical justification for technocratic planning of our lives is “an information problem.”

The crux of such arguments are that private markets suffer from terrible information asymmetries, and government intervention is required to overcome them. For example, many insurance markets are thought to break down because those being insured know more about their propensity to need to file a claim than do the insurance companies themselves. Such a distinction leads to the unraveling of insurance markets, with only the high risk folks getting insured and at a very high cost. One “solution” is to FORCE everyone to stay insured.

What does this have to do with short-selling? Well, if it does anything, the presence of short-sellers in a market provides much needed information about markets and expectations. And now, government lovers the world around are saying that TOO MUCH INFORMATION is also problematic – they wish to prohibit or severely restrict short-selling. You can’t have it both ways folks.

What’s next? Should we restrict long-buying too? After all, if lots of people get into the long-buying business, expectations of future price increasesmight stimulate irrational “fear” that the market will continue to go up, and allowing people to purchase stocks fuels speculative bubbles. Let’s ban that activity? Heck, shouldn’t we ban the short-selling and long-buying of everything else too?

Seriously, think of what else resembles “short-selling” … individuals sell an asset now that they do not own, and agree to buy it in the future for delivery. Do businesses not manage inventories this way? Do farmers not hedge risks in this way? Sounds a little like surrogate mothering too!

One Response to “Question from a Student”

  1. Harry says:

    To answer your student, not much, for my own account.

    Many people told me the tale of Bernard Baruch, who heard his shoeshine boy tell him to get into the market, upon which Bernard Baruch sold short. This story is not important because it should encourage others to get into that game, but rather to help us all about what investing means.

    I have known many people who have gone long on cocoa beans, short on pork bellies, and have straddled both. Some of them are alive and poor, and the rest died poor. The same thing goes for at least three lawyers I know who margined their accounts in the expectation that their stock would rise.

    I was a farmer, too, though not a grain farmer from Iowa. Such farmers might hedge their bets on fertilizer and the cost of custom combining by selling their future crops at a predictable price. Southwest Airlines also bought fuel in the futures market, at the expense of a short seller. These calculations were similar to Bernard Baruch’s.

    Similarly, Chris Dodd and Barney Frank engineered a system to have thousands of people to go long in real estate, leaving someone else go short on the other end. The someone else holding the short straw is me, Wintercow, and eventually you, the student.

    All of this financial engineering creates no wealth, with the exception of the farmer who planted his wheat, harvested it, and fed his family and the rest of us.

    If we are free, we should be allowed to make contracts, including going short on a ton of wheat, as long as there is a willing buyer on the other side of the trade, assuming they both are willing to pay a trader for the privelege of the friction.

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