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Tuesday, September 23, 2008

Gnome-o-gram: Economic Dictatorship and Short Selling

I'm still digesting the details of the US$700 billion bailout plan floated over the week-end. Perhaps 700 billion may actually be a lot less than the ultimate damage were the credit markets allowed to collapse (which may, of course, happen sooner or later anyway, and may not have happened this time, but nobody knows—the fact that nobody knows being a direct result of the lack of transparency which contributed to this unfolding calamity).

But what really bothers me is that in less than a week the U.S. appears to have adopted, without any public or congressional debate or a single vote in congress, a system amounting to absolute economic dictatorship not seen since the age in which the treasury of the realm was the personal piggy bank of the king. Now Gosplan was a bureaucratic nightmare, but at least decisions were made on a collective basis and accountable to the Politburo, not at the whim of a single unelected official with sovereign power across the economy.

But now, the chairman of the Fed and the Secretary of the Treasury need but speak:

According to the bailout plan, the Wirtschaftsführer—excuse me—Secretary of the Treasury, is to be granted absolute discretion over the disposition of US$700 billion with:

Sec. 8. Review.
Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.
What monarch or dictator since the Renaissance had such power? This is 50% larger than the Pentagon budget for 2009! Imagine the reaction were it proposed to place that entire budget at the sole discretion of the Secretary of Defense.

The short selling decree is just insane—sometimes you want to just sigh. Now, I don't want to take the time here to explain short selling in detail, but basically it's a way to speculate on a fall in the value of a security by borrowing shares from another investor and selling them. (In the case of a naked short you sell without even borrowing them, but this is a family publication and we'll avoid such risqué transactions here.) If the speculator's prediction is correct and the price of the security falls, then he or she can buy it back at the lower price, return the borrowed shares, and pocket the difference between the higher sale and lower purchase price. It's just the flip side of “buy low; sell high”—in the mirror universe of short selling, “sell high, buy low” works just as well.

And if the stock goes up? Well, then the short seller has to either put up more and more margin to cover the trade or give up, buying the stock back at the higher market price and delivering it against the borrowed shares. Unlike an investor who is “long”: an outright owner of the stock, who can, in the absolute worst case lose the entire investment if the stock goes to zero but has an unlimited upside if the stock climbs to the sky, the investor who's short has the inverse prospects. The profit potential is limited to the price at which the stock was shorted, but the losses are unlimited, as the stock may climb arbitrarily high from the level at which it was so unwisely shorted. While the investor who is long can hang onto the stock for an arbitrarily long time, the short seller, when things go sour, must keep in mind that:

He who sells
what isn't his'n,
must buy it back
or go to prison.

Now consider: who is the one guy, the only guy, who you know is going to buy a stock in the future? The guy who's short. If the stock goes down, he buys to cash out, supporting the price when it's under pressure, and if it goes up, he's squeezed and buys to limit the damage, furthering the ongoing rally. One can argue for the “uptick rule” to avoid positive feedback (although now that we have penny-precise pricing instead of ticks it doesn't make much difference), but banning shorts is just pulling one of the feedback plugs in the market and that's usually a bad idea.

But short sellers are perceived as vultures who profit from stocks falling, and hence they're a perennial target of politicians when markets encounter turbulence. And, like most things politicians uninformed about markets and basic economics do, banning short selling has precisely the opposite outcome of that intended—it removes a moderating influence from the market and accentuates volatility.

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