Robert Murphy

Although they are just playing the hand that Alan Greenspan dealt them, Fed Chairman Ben Bernanke and Treasury Secretary Henry Paulson have been working overtime to discredit the capitalist economy.  The $700 billion bailout of Wall Street, as well as other measures such as a ban on short-selling financial stocks, are a repudiation of the free market principles which the Bush Administration claims to champion.  Besides forcing taxpayers to fund a massive dose of corporate welfare, the latest measures will make the financial crisis worse.

The SEC’s ban on short-selling is a terrible idea, and will endanger the very financial stocks it is allegedly helping.  For one thing, the ban can’t last forever, and any pent up shorting passion will be unleashed the day it is lifted.  By making speculators unsure about the rules of the game going forward, the whole episode may paradoxically concentrate selling pressure when the ban is first lifted, leaving the attacked firms worse off than they were originally.

The ban on short-selling also cripples an important mechanism through which experts reveal their inside information to other investors.  Before the ban, speculators had an incentive to do their homework, and discover which financial institutions were holding dangerous amounts of mortgage-backed securities.  The “vultures” then attacked these sickly firms, just as in the animal kingdom.

While this practice was obviously bad for the firms being shorted, it was good for the majority of other financial institutions who had behaved more responsibly during the housing boom.  The average investor was more likely to buy the stock or bonds of these other financial companies, because they weren’t being targeted by the speculators.  The fact that their stocks weren’t being shorted was a signal that these firms were relatively healthy.

But now the SEC has taken away an obvious source of profit for those who do the research and pinpoint which institutions are holding the bag on bad mortgages.  Without short sellers attacking the weakest firms, regular investors have less information.  They paradoxically may be more reluctant to invest at all in the financial industry.  Notice that since the imposition of the ban, financial stocks have suffered after the initial euphoria.

Robert Murphy

Robert Murphy has a Ph.D. in economics and is the author of The Politically Incorrect Guide to Capitalism (Regnery 2007).

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