All Commentary
Monday, August 22, 2011

Shoot the Shorts

Europe's problems aren't so far away.

European bank stocks have dropped sharply in recent days, presumably because they hold large amounts of shaky debt issued by the governments of Greece, Portugal, Spain, Ireland and Italy.  Several European governments have found someone to blame for their financial problems, and their target is that perennial favorite, speculators. And not just any old speculators, but the darkest of that shady lot, short sellers. Short sales of major European bank stocks are banned for a period of time so that traders can’t spread false rumors and trigger a downward spiral in these stocks.

(To sell short means to sell borrowed stock in the hope that the price will decline.  If the stock does fall, sellers buy the shares cheaply, return them to their original owner, and pocket the cash difference.  If the shares rise instead, short sellers have to pay a high price and suffer a loss.  When a number of short sellers cover their positions out of  fear of rising prices, it’s called a short-covering rally.)

What a dreary and stupid move the Europeans have made. They might have learned from the ban instituted in 2008 by U.S. authorities, which accomplished nothing.

Real Fears

There is good reason to fear for the European banks – the problems with European sovereign debt are evident.  Rumors are hardly necessary when the banks’ exposure is well known.  And if false negative rumors justify intervention, what about false positive rumors? Why not ban purchases of stocks when the all-knowing regulators determine they were boosted by bullish rumors?

Is it possible for determined short sellers, perhaps in collusion with one another, to start a downward spiral and run a stock into the ground in defiance of the stock’s fundamentals? Yes, theoretically and perhaps occasionally in practice.  But as a downdraft begins, the temptation to take profits by covering one’s short positions, especially among those who may be in cahoots, becomes overwhelming. A violent upswing is possible when short sellers take profits in such  situations.

Short sales are not always speculative (not that there’s anything wrong with speculation).  They are sometimes part of a hedging strategy, in which a short sale is used to offset a closely related long position.  A ban on short selling is a headache for hedgers, perhaps more so than for speculators.

Those who own the stocks in question won’t likely sit still while the ban is in place. They will be tempted to sell, in anticipation of a price drop once the ban is lifted.  When this happens, share prices may decline as much as they would have without the ban. Also, those who were short when the ban took effect may hold those short positions longer than they would have otherwise, also hastening the drop.

Close Substitute

Put options are a close substitute for short sales.  A buyer of a put option pays for the right to sell shares to the counterparty at a fixed price no matter how low the market price might drop. Another alternative may be to short the bank shares in question on foreign stock exchanges.

So the likely upshot is that the ban will accomplish nothing except to introduce some temporary disruptions, inefficiencies, and inequities into the market.

More important, though, is that today’s sophisticated traders and commentators will probably see this crude move as a sign of weakness or even desperation.  This is not what European economies need – just the opposite.  Like the United States, Europe is suffering from a crisis of confidence.  EU leaders have lurched from one bailout to the next without addressing the root causes of the crisis, each time shedding a chunk of their credibility like a piece of lintel crashing down from the Parthenon.

Central Banking

One root cause is the structure of the Euro, which centralized monetary policy-making at the European Central Bank while leaving fiscal policy to the discretion of each national government.  True, there was a toothless requirement that government deficits be limited to 3 percent of GDP, but that soon fell by the boards.  Frugal Germans are now furious about bailing out the lazy Greeks, Italians, and others, but are trapped by the exposure of their own banks.

European welfare states have been in place for decades now, crushing private initiative. The bills have come due and the cupboard is bare. This is the more fundamental cause of the European crisis, and nothing will be solved until Europeans begin to face up to it.  And rather than indulging in Schadenfreude, we in the United States would do well to apply European lessons to our own troubles.

  • Warren Gibson teaches engineering at Santa Clara University and economics at San Jose State University.