Short-Sale Restrictions Are an Exercise in Naked Power

by Bob Murphy
by Bob Murphy

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On July 29, the SEC announced that it would extend its original 10-day restriction on "naked" short sales of 19 major financial companies through August 12. Analysts across the board agree that this particular SEC rule, by itself, will have little effect except to raise transaction costs for those wishing to short Fannie Mae, Freddie Mac, Goldman Sachs, JP Morgan, and other powerhouses.

However, in conjunction with the Fed's recent lending operations to investment banks and Fannie and Freddie, the restriction on naked short sales makes perfect sense as part of a process of getting the public used to federal/private partnerships that would have been unthinkable before the credit crisis — especially from a "laissez-faire" administration.

In this article, I'll explain short selling (and the "naked" variant), its benefits to the market economy, and the harm from arbitrary government restrictions on the activity. I'll close by speculating on the possible motivation for the government to engage in an apparently pointless gesture.

Short Selling

I explained in a previous article how (successful) stock speculators provide a "social" service by steering asset prices to their correct levels. If investors believe a particular stock is underpriced, they can buy shares of it and then unload them once the stock has met or surpassed what they view as its "proper" level. In this way, they quickly push up underpriced stocks. Notice that it doesn't matter whether the investors who notice the initial underpricing own any of the stock at the outset.

However, things are different when an investor believes a stock is overpriced. If the investor happens to own shares of the stock in question, the obvious move is to sell some or all of the position, which both earns a relative gain for the investor and also speeds the downward move in price.

If this were the end of the story, there would be an obvious asymmetry in the market's ability to rely on the dispersed knowledge of experts in diverse fields. The only people who could act on their belief that a stock was overpriced would be those who already owned the stock. Such a restriction would be even worse than a small random sampling of the population, because the people who purchase a stock are more likely than the average person to have overrated it.

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September 23, 2008

Bob Murphy [send him mail] runs the blog Free Advice.

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