GameStop and short selling

As ever, when there’s something interesting happening in the stock markets there are the claims that something must be banned. The GameStop story has certainly been interesting and it’s leading to the call that short selling be banned.

Ourselves, well, one calculation is that short sellers have just lost $20 billion. If short selling should be reduced then we’d consider that a pretty good incentive for short selling to reduce.

However, we are these days told that we must “follow the science”. On this particular point the science being Robert Shiller and his Nobel. His point is that the efficient markets hypothesis works only within certain caveats, one of which is that markets must be complete. If people can buy something then we get the views of those who think it will rise. If people can not buy something then we get the view of those who, perhaps, have no view. Only if people can go short can we gain the views of those who think the thing should or will fall in price.

Thus a market which does that market job of price discovery does so better in the presence of the ability to short sell. This is why his solution to the US housing frenzy of 2003 to 2006 being the creation of futures markets where more speculation can take place. That speculation on lower prices is possible tempers and reduces such frenzies.

The implication there - baldly stated by Shiller at times - is that having to short housing finance (those CDS and CDO things) rather than housing more directly delayed the pricking of that bubble.

A proper and decent financial market is one that deliberately creates the structures in which is it is possible to speculate upon falling prices, to sell short. At which point we’d probably not ban the very thing which creates that proper and decent financial market.

We can take a step further back too, to Galton’s Ox, that foundation of the idea of the wisdom of the crowds. The random mass is asked the weight of the dressed carcass and no individual gets it right. The average of the random mass does with startling accuracy. But, and here’s the essential caveat, it only does so when all views, however objectively silly they are, are included.

This is rather redoubled in a financial market where things are worth exactly and precisely what people think they are worth. Banning short selling excludes views from that price setting therefore the price that is set will be wrong in the absence of short selling. Not because there is some objective price that is correct, but because we’re excluding some of the views as to what that price should be.