Bans on short-selling block information, render the market inefficient and delay the inevitable
Elizabeth Warren, Bernie Sanders and James Corbyn must be fancying their chances in the forthcoming elections in their respective countries. Never mind that former US President Barack Obama cautioned against the Democratic Party turning too far left. Even if they heed his advice, the world's capitalists and regulators seem united in turning voters and candidates leftwards.
I just saw a story (Return Of Short-Selling Bans: Market Protection Or "War Against Truth"?, 19 November 2019) put out by Reuters that Turkey has banned short-selling. Korea might do so, and so could Europe if Brexit creates market turbulence. Europe had resorted to banning short-selling between 2008 and 2012 as it battled the fallout of the global crisis and then the Greek crisis. Global economies, advanced and developing, now ride on asset prices. As leverage ratios have risen relentlessly both in the public and private sectors, the only way governments can prevent the unravelling of balance sheets is to place all policy tools at the service of underpinning asset prices.
The logic is clear. However, the question is whether its costs would exceed the benefits, and whether it would postpone real price discovery to a later date—only for it to manifest itself more uncontrollably than now.
Stock markets around the world have decoupled much more from the happenings in the real world than they did in the run-up to the year 2000 and in the lead-up to 2008. From Hong Kong to Iraq to Lebanon to Italy to Latin America, economies and societies are in turmoil. Real economic activity has slowed considerably. However, neither bond markets nor stock markets betray any fear or concern. As the Financial Times noted, the fear is the absence of fear itself (19 November 2019). When asset prices do not reflect underlying fundamentals, the convergence happens invariably through violent corrections and crashes in the asset markets, rather than through economic fundamentals improving. Hence, short-selling bans could delay but not deny the inevitable. At the micro-level of stocks, too, the Reuters story points out, citing studies by academics and the Federal Reserve Bank of New York, that short-selling bans did not really serve their purpose.
The bedrock of price discovery is the flow of information. Bans on short-selling prevent the flow of information from pessimists (on a stock or index) to the market at large. To that extent, the market is poorer. Just as governments do not gain anything by withholding bad news (extreme circumstances such as wars or major calamities might be exceptions), except to lose credibility, market participants do not gain by the withholding of information. It merely prevents risk from being priced correctly. In doing so, regulators encourage one-way risk-taking. In other words, speculation is not bad per se. Speculation on the long side is welcome. Monetary policy even buttresses it. However, speculation on the short side is frowned upon. The authorities will come after you. This is almost Orwellian. The might of the state supports the asset-rich. It's no surprise, thus, that politicians espousing polices that favour redistribution are finding traction among voters who are not asset-rich but hold their savings in bank accounts that yield almost nothing.
Investment research reports put out by major banks strike a positive tone on stock indices and individual stocks. Objectivity is more the exception than the norm. Credit rating agencies arrive with their downgrades long after investors have lost their shirts, just as the police in Indian films arrive long after the culprit has been apprehended and beaten up by the public. By all accounts, the big audit firms are in need of an audit of their conduct, governance, probity and much more. Many investors have to rely on their own forensic investigations to determine the true value of assets. Having done the hard work, if they are denied a chance to express themselves in the market, the very notion of a market economy is undermined. After all, the exchange of information between buyers and sellers, as reflected through their transactions and prices, is what makes the market. Without that, there is no market economy. Bans on short-selling imply a march of democratic market economies toward autocratic command economies.
In a recent debate on his theory of market efficiency, Eugene Fama, professor at University of Chicago had said that behavioural economists had still not come up with an alternative model to market efficiency. That is silly because it is impossible to model insanity. What bans on short-selling achieve is the entrenchment of financial market behaviour in the realm of insanity. Whatever little claim that financial markets have had to efficiency has rested on the simultaneous and free flow of all information to all participants. The monetary policy framework over the past quarter century, with its implicit asset price target, has crowded out information that challenges asset prices. Short-selling bans complete the process. If this is capitalism and market economics, perhaps Western societies should not fear the policies of Warren, Sanders or Corbyn.
V. Anantha Nageswaran is the dean of IFMR Graduate School of Business, Krea Universit