Tuesday, 12 May 2009

IEA, the crisis and shorting

The Institute of Economic Affairs is the latest organisation to put forward its thoughts on the financial crisis, which can be downloaded here. I've not read the report, which looks interesting even if I'm not likely to be in tune with its thinking, but you won't be surprised to see their headline points, like
The prevailing view amongst the commentariat (reflected in the recent deliberations of the G20) that the financial crash of 2008 was caused by market failure is both wrong and dangerous. Government failure had a leading role in creating the conditions that led to the crash.
no significant changes are needed to the regulatory environment surrounding hedge funds, short-selling, offshore banks, private equity or tax havens.
Their bullet points aren't really directed at banks, from what I can see, though they do call for more disclosure from banks to shareholders (who have done a great job of the oversight role, eh?).

I did have a quick flick through the report though, and was drawn to the paper on shorting. This is a decent enough standard liberal defence of shorting, but, as usual, I have problems with some of the assertions. Here's a particularly grating example:
Not surprisingly, a ban on short sales is popular in the boardrooms of many UK quoted companies, where the idea of markets as elections in which short sellers are free to vote against the management is anathema – far better in their view to restrict the electorate to a Yes (purchase) or an abstention (no purchase).
This is a spin on the old line about markets being a voting machine (in the short-term), but I actually think he extends the argument incorrectly and in a misleading way. Markets are likened to an election/voting machine in the sense that prices reflect opinions (votes cast). It's an illuminating idea, but not the way he applies it here.

For example, he suggests that markets without shorting only allow you to vote for or abstain. But that's exactly the same as your typical political election. I can either vote for the party of my choice, or abstain. I don't get to vote against anyone, let alone get to borrow someone else's vote to use against a party I don't like.

But I don't actually think the comparison works well anyway. For one, in an election, the action (the vote) is intended as a signal, and that is its sole purpose. In a market the action (buy/sell) sends a signal as a byproduct. The 'voters' in a market may not care that they have 'voted', and certainly often aren't interested in the 'result' if they 'abstained' by not buying or voted 'against' by selling. And that's another point against - if you want to use the ill-fitting election comparison, then selling is a vote 'no' in terms of the approach the author of this article uses. It's the equivalent of pulling your support for a political party and - unlike in an election - you can exercise that right at any time. Unlike an election the voting is going on constantly.

That the right to 'vote against' - as defined by this article - already exists in markets is actually demonstrated by proponents of shorting each time they (rightly) point out that share prices can plummet even when shorting bans are in place. Just to be crystal clear - shorting is only selling shares, just shares that you have borrowed, if it counts as a 'no' vote then so does any other sale. So if you really want to stick with the election idea, then shorting really means borrowing other people's votes to tilt the result in your favour. It's leveraged voting. Now that might be fair enough, and as I've said before I'm sceptical about the merits of shorting bans (because I'm sceptical about the merits of shorting), but don't pretend that it's comparable to an election.

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