Don’t Blame the Shorts: Why short sellers are always blamed for market crashes and why history is repeating itself
Reviewed by Alex Pendleton
The current global economic crisis saw a moment in its early stages when regulatory authorities on both sides of the Atlantic chose to suspend short selling of financial stocks. Indeed, Italy went further and suspended short selling on all stocks.
These bans didn’t last. Their advocates were the same Wall Street and London casino banks that had jeopardised the global economy in the first place. Since this book by New York-based hedge-fund administrator Robert Sloan was published, we have heard more yelps of discontent, this time from European politicians, about short sellers seeking to undermine Greece. In fact, you could argue that the shorts are doing the Greeks a favour, seeking to restore economic discipline to a country that connived with Goldman Sachs to conceal the true extent of its indebtedness.
In Britain, Anglican bishops have condemned short sellers, yet the C of E uses currency hedging as part of its investment strategy. Whatever you may think of bankers, Sloan wishes to persuade you that short sellers have been consistently scapegoated through recent history and that they are socially useful.
The conflict between the shorts and the rest of us goes back to the foundation of Wall Street, when one founding father, Thomas Jefferson, advocated a vision that eschewed financial speculation and another, Alexander Hamilton, a vision that embraced it as a spur to growth. It was a conflict between ‘a class that lived off its land and a risk-taking class intoxicated by the paper wealth of a concentrated banking system’. Which is the more un-American approach: to inhabit an agrarian idyll or to encourage material and social progress through speculation? This question has haunted America over the ensuing 230 years.
Washington has made various attempts to come down heavily on the speculators, but the most sustained campaign was in the 1930s. In the aftermath of the 1929 stock market crash it was a Republican president, Herbert Hoover, who first claimed that bear raids and short selling had caused the crisis.
Richard Whitney, the head of the New York Stock Exchange, appeared before a congressional committee and proved a cogent defender of short selling as a vital element in ensuring the liquidity and smooth functioning of the stock market. Far from causing a liquidity crisis, short selling kept the market open. The fact that Whitney was subsequently exposed as a thief — he embezzled money from his partners and the New York Yacht Club so as to make margin calls — should not detract from the intellectual validity of his arguments.
‘Since the depression began,’ he told the committee, ‘short selling accounted for less than five per cent of exchange transactions.’ A ban on short selling would render stocks illiquid and threaten $5 billion of bank loans against which stocks were held as collateral. Besides, he said, long-selling ‘was a far more depressive force than short selling’. Short sellers had not caused the asset-price bubble that led to the crash.
Sloan’s key message is that draconian regulatory action against shorts today would be as ill-advised as it was in the 1930s, because short selling is bound up with the convertible bonds market which provides liquidity for businesses: ‘By attacking the shorts and trying to help the equity price [in the 1930s], regulators constricted the actual credit markets and funding sources that these firms needed for short-term liquidity to fund their operations.’
Far from being perceived merely as speculators, short sellers ought to be seen as ‘financial protesters’ or as ‘the 60 Minutes of the capital markets’, holding ill-managed and fraudulent companies, or even national economies, to account.
Temporary restrictions on short selling may be justified in extremis, but for the most part short sellers represent a tiny proportion of the market. Every short presupposes a future buy order, while many shorts have a long against them. Pair trades are more commonplace than naked shorts (a single short position). Shorts not only add to liquidity, they reduce volatility by causing staggered drops, while bans on short selling can create disincentives to buy long, since no hedge positions are available to investors.
Sloan’s book is little more than extended historical essay, but it is welcome nonetheless. Timely, concise, accessible to the lay reader and with a decorously polemical edge, it is both revealing and entertaining. No matter what the politicians do, the markets will find a way to challenge the finaglers and the optimists who sustain them. Like the poor, shorts will always be with us.