Dispatches from District 48
Someone noticed that just before certain stocks crash in value, there is a lot of short-selling. So the US government , at least temporarily. Classic cargo-cult logic.
Boy this sure makes perfect sense in a time when we are concerned about speculative bubbles -- let's ban one of the most important tools that exist for bubbles to be shortened and made less, uh, bubbly. Here is why (very briefly and non-technically) short-selling takes the edge off speculative excesses.
At the start of the bubble, a particular asset (be it an equity or a commodity like oil) is owned by a mix of people who have different expectations about future price movements. For whatever reasons, in a bubble, a subset of the market develops rapidly rising expectations about the value of the asset. They start buying the asset, and the price starts rising. As the price rises, and these bulls buy in, folks who owned the asset previously and are less bullish about the future will sell to the new buyers. The very fact of the rising price of the asset from this buying reinforces the bulls' feeling that the sky is the limit for prices, and bulls buy in even more.
Let's fast forward to a point where the price has risen to some stratospheric levels vs. the previous pricing as well as historical norms or ratios. The ownership base for the asset is now disproportionately
made up of those sky-is-the-limit bulls, while everyone who thought
these guys were overly optimistic and a bit wonky have sold out. 99.9% of the world now thinks the asset is grossly overvalued. But how does it come to earth? After all, the only way the price can drop is if some owners sell, and all the owners are super-bulls who are unlikely to do so. As a result, the bubble might continue and grow long after most of the world has seen the insanity of it.
Thus, we have short-selling. Short-selling allows the other 99.9% who are not owners to sell part of the asset anyway, casting their financial vote for the value of the company. Short-selling shortens bubbles, hastens the reckoning, and in the process generally reduces the wreckage on the back end.
Update: From :
To ban short-selling of stocks is to short-circuit an important
mechanism through which people share their knowledge and expectations
with others. Banning a mechanism that better allows share prices to
reflect the expectation that the underlying assets are not worth as
much as current market prices suggest does nothing to change the
underlying reality. Such a ban merely distorts knowledge of this