Sir Isaac Newton’s third law of physics states that for every action, there is an equal, opposite reaction. In Washington, D.C., however, it seems that for every action there is a sadly predictable government over-reaction. Last month’s hysteria over GameStop’s stock price and the ability of a group of trolls on Reddit to over-inflate its value has been no exception to this rule. Policymakers in Washington are learning the wrong lessons from this affair and will cause more pain in the economy if these misconceptions turn to action. And, it looks like Sens. Elizabeth Warren (D-MA) and Bernie Sanders (I-VT) and Rep. Alexandria Ocasio-Cortez (D-NY) are taking the wrong message and could end up hurting lower and middle income folks with unnecessary regulation and legislation.
Simply put, traders on the Reddit message board r/WallStreetBets noticed that many in more traditional financial institutions were shorting GameStop’s stock—betting that it would soon fail. To counter this, WallStreetBets collectively agreed to buy up the stock to artificially drive up its price and punish the short selling hedge funds in the process. In roughly a week’s time, the stock’s value went from $39.12/share all the way up to $347.51/share. Hedge funds shorting the stock were feeling the squeeze, and redditors were reaping the benefits.
This led to talks of bailouts and certain trading platforms – most notably Robinhood – halted trading of GameStop stock. This drew the ire of elected officials and regulators across the political spectrum. The populist narrative quickly became that the system was tying itself in knots to protect rich and powerful hedge funds at the expense of the Average Joes on WallStreetBets. Calls for retributive action against hedge funds for this volatility grew louder.
One may think hedge funds are good for the economy, one might think they are irredeemably evil – or likely somewhere in between those two extremes. However, it is near impossible to deny that the volatility in GameStop’s stock came from the folks on WallStreetBets and not the hedge funds themselves. It is also difficult to deny the fact that it is not only rich moguls who rely on hedge funds. Scores of retirees, like teachers, fire fighters, and police officers depend on hedge funds for retirement income, as do many public sector pensions. The reflex to punish hedge funds will cause just as much – if not more—pain on Main Street as it will on Wall Street.
Yet, it is far easier to ride the wave of popular opinion and many Republicans who should know better are succumbing to the progressive sirens of Sens. Warren and Sanders and Rep. Ocasio-Cortez. In fact, some Republicans have called for hearings on the issue and Sens. Warren and Sanders have proposed a financial transactions tax on hedge funds. Taxes, regulations, and needless congressional hearings used to be something conservative Republicans stood against. Yet, Sens. Ted Cruz (R-TX) and Marsha Blackburn (R-TN) climbed aboard the regulatory hype train shortly after their progressive colleagues.
Once again, these proposals might feel good in the moment, almost like a David vs. Goliath type of crusade. However, plenty of Davids will get caught up in the regulatory dragnet. A financial transactions tax would harm the nearly half of all Americans who invest money in the stock market, not just hedge funds. It would also devastate the aforementioned pension funds to the tune of billions of dollars.
Further, regulations of the kind described by policymakers in light of the GameStop affair would hurt American competitiveness. Investment would be deterred away from American companies due to the costs associated with these taxes and regulations. It would become increasingly inefficient to invest in innovation in America at any type of scale. This could drive more and more entities out of our market and damage our financial system for years to come.
However, perhaps the most lasting damage could be done by the looming war against short selling and short sellers themselves. Setting aside the fact that short selling is already a very regulated practice; it is also beneficial for the economy. Investors of all stripes – including hedge funds – short a stock when they believe it is overvalued. In today’s digital age, a brick-and-mortar game store like GameStop was naturally one of these overvalued stocks. Short selling helps mitigate the effects of economic bubbles and crashes by pinpointing inefficiencies early on. The 2008 housing crisis would have been far worse had short sellers not recognized how overheated that market was.
Short sellers also don’t simply short a stock, take their money, and then go home. They re-invest that money into companies that are undervalued or have potential. It’s in this way short sellers help our market allocate resources more efficiently and boost up-and-coming business ventures. It is a useful tool to improve liquidity and reduce volatility in the market.
Mindlessly pursuing short sellers and hedge funds for taxation and regulation will cause immense economic pain. Everyone loves a good underdog story and the perception that a group of internet trolls were taking on powerful Wall Street hedge funds and winning played well in the media. However, the narrative is rarely that simple. The stock market is far more complex and the heroes and villains are not nearly as black and white as politicians would have us believe. That is why it is important they resist the temptation to over-react. The so-called “solution” will be far worse than the supposed “problem” they are trying to solve.
Daniel Savickas is a policy analyst for the Taxpayers Protection Alliance.