The Free Market 23, no. 9 (September 2003)
It happens in every bear market and in every crash. Investors get it wrong. Then regulators get it wrong. They look for scapegoats and find the wrong ones.
They whoop up a holy war in the popular press as markets are embraced by a persistent bear. They indict the wrong people. They’re like the Christians in the Bard’s The Merchant of Venice. They hate Shylock for charging interest on loans, instead of blaming themselves for their spendthrift ways.
In this case, once again, the notorious Shylock is the short seller. He is branded "unpatriotic," a very dangerous charge in wartime. That’s because he bets that markets, or parts of them, are overvalued.
Ah, yes, the infamous short seller. He’s the person so many people despise when markets crash. He reminds me of the smartest kid in my class whom I hated when I was a kid. He was disliked not because he was obnoxious, but because he worked harder than most other students. Therefore, I, along with most of my fellow students, felt obliged to hate him or her, as idiotic and irrational as I later realized that sentiment was.
Yet short sellers, I believe, provide a vital service to our markets. By their risky bets, they often expose the overpriced companies, companies whose value hasn’t gone up because of strong earnings. Rather, these fraudulent companies have been puffed up by investors who have been misled—misled by cheap money policies that distort markets—into thinking bad companies actually have some inherent value.
Short sellers are often the Totos of the marketplace, barking up a storm, pulling back the curtains to expose the frauds of our own market wizards and the failed system of regulation that enables them. It is, after all, those unpleasant folk who won’t shut up when the nude emperor waltzes by—short sellers—who insisted that Enron, Worldcom and other "New Age" stocks of the late 1990s were overvalued.
The short seller is the classic picture of the man who does the most public good because he is pursuing private profit. Short sellers not only warn that a stock is in trouble, they bet money backing up that insight. Short selling, which has been around since at least the late fifteenth century, disturbs many investors because it is a contrarian play. It is the investment for those who don’t want to goose-step with the crowd. It is for those who are automatically suspicious of the great authorities in our lives—the regulators, the central bankers and the companies that we are told are sure things. But this public criticism of those who don’t want to go along with popular sentiment has been going on for many years.
Go back to the early 1970s and remember the bankruptcy of Penn Central, an enterprise that many investors felt sure was going to be a survivor. The regulators of that time were shocked by the railroad’s sudden demise. But many suspicious investors—who saw what generations of ICC over-regulation had been doing to railroads—weren’t.
Was it their fault that the government ran a great industry into the ground? Were they unpatriotic because they used their noodles and made money short selling railroads in the 1960s? And is it the short seller’s fault that we are now all paying for the Fed’s disastrous easy money policies of the 1990s?
Go back to the booming markets of the mid-1920s. There were investors who warned that the crash was coming. Those who took their advice and shorted the market made a lot of money. Some who shorted the market became the scapegoats of their time. Yet criticizing people who did so is mindless. It is the same as complaining about someone who moved out of a region because he knew there was a considerable chance of an earthquake or a flood.
Over the past three years, as the Fed’s disastrous policies have imploded, many short sellers have prospered while most of the rest of us have seen our investment balances plummet. We have to blame somebody. Let’s see who can we nab?
It couldn’t be the fault of investors who thought that at least 20 percent gains a year were their birthright, even though this flew in the face of historical patterns. It couldn’t be the fault of media elites in the last decade. Remember these journalistic hucksters? They eulogized Alan Greenspan to such an extent that anyone who didn’t approve of Greenspan’s nomination for the first opening in the Blessed Trinity was considered, at best, a rude fellow, and, at worst, a traitor. Since the above options had to be dismissed, it was time to take a loan from our modern Shylock, then blame him because he charges interest.
And, once again, there’s a call for regulators to "do something" about "unpatriotic" short sellers. Indeed, the Securities and Exchange Commission has been stepping up its enforcement of short selling violations. The regulators are targeting hedge funds, which use short selling techniques to give their clients a chance to make money at times when markets are down.
The SEC staffers are no different than regulators everywhere—they have a good ear for politics and power, which is another reason why the system of regulation is, has been and will always be flawed. (Those who want to know about the birth of our destructive system of American regulation are advised to read a masterful book called The Triumph of Conservatism by Gabriel Kolko.)
For me—ever skeptical of the efforts of regulators and our egregious central bank, the Fed—the history of the attempts to regulate short selling is a chronicle of failed efforts. It is the same sorry story as our Federal Reserve Board. The latter’s founding in 1913 was supposed to ensure that there would be no more crashes, recessions and speculative parts of the business cycle. Of course, those things are exactly what we have gotten over the past 90 years.
Under the Fed, within just a decade of its birth, the nation was engaged in a frenzy of speculation caused by cheap money. This was followed by a crash and then the greatest depression the nation had ever known, a depression that was certainly not cured by the New Deal’s flawed fiscal policies or by FDR’s favorite Fed chairman Marriner Eccles.
After the crash, the Fed’s defenders conveniently passed the blame to "speculators." However, most monetary historians today agree that the Fed, before and after the crash, botched things.
Congress didn’t get it. By 1934, they were on a bogeyman hunt. One of its conclusions was that the SEC should be set up and that it should be given considerable authority to regulate short selling. (By the way, the SEC’s first head, Joseph Kennedy, had used short selling to help build his fortune.)
The most conspicuous effort to regulate short selling is the uptick rule. In the spirit of finding a scapegoat, this rule was adopted by the government in the midst of the Great Depression, which the government caused with its dreadful monetary policies. The rule holds that short selling is only allowed when done on an uptick or zero plus tick. An uptick is when the last reported stock price was an increase. The rule was designed to prevent crashes and volatile markets. By that standard, obviously the rule and the SEC have been gross failures.
Unfortunately, the SEC and its myriad rules have had the same deleterious effects on our economy as the Federal Reserve. For example, a 1963 SEC study looked at the relationship between short selling and price patterns.
"It showed that short selling volume increased as markets declined and that the uptick rule did not prevent the ill effects on stock prices that Congress intended." (From Tom Taulli’s Streetsmart Guide to Short Selling, New York:McGraw-Hill, 2002, p. 8.)
More investors shorted stocks as they declined. That, to me, is a good thing. It signals that markets, if left alone, will correct themselves. So why let governments dither with markets? Governments have shown, throughout history, that the greater the interventions, especially with the money supply, the more damage that is done.
Upset about your shell-shocked portfolio? Need a scapegoat? Then find the right one. He’s on the Potomac.
Gregory Bresiger, a business writer living in Kew Gardens, New York, holds a graduate degree in history from New York University (gbresiger@hotmail.com).
