Does short-selling make a difference?

Short-selling refers to the practice of selling securities like stocks without owning them in the first place. The seller just borrows the stock eg. from a broker to be able sell it, then tries to buy the stock back cheaper in order to give it back and make money out of the process. In so called "naked shorting" the seller doesn't even make that the security can be borrowed. Needless to say, it is a risky process especially considering the potentially limitless losses a short-seller may have to endure. But it can result in significant profits as well.

The thing that makes this a timely topic is the fact that Italy, France, Spain and Belgium set a ban on short-selling two weeks ago to calm the plummeting stock markets . A couple of days ago, they decided to extend the ban for probably at least till the end of September (see Reuters). Were the bans a good decision? An average person usually finds short selling a crazy, speculative and detrimental practice that should be banned not only for a limited period of time but permanently. Many people working in the field of economics on the other hand think that short-selling makes the market work more efficiently and should never be banned. But does short-selling actually make a difference? And if it does, why, how and when? Let's have a look.

An equal selling offer and a buying bid - this should result in a transaction, right?

Starting with the facts, both the people against shorting and supporting shorting can be seen as having legit points. Firstly, like the layman sees it, trying to make money out of falling stocks is not productive for the society in general. On the other hand neither is regular trading. Secondly, like those who support short-selling assert, shorting does support market efficiency. To have a transactions you need someone who is willing to buy and someone who is willing to sell at that price. Anyone can buy shares even if he or she didn't own any, but to be able to sell, you have to own shares of that certain stock. In other words, without short-selling there is much more potential to make a bet that a stock will rise than to bet that a stock will fall.

This partially unilateral nature of a market without the possibility to sell short has a couple of implications. For one, it means that there will be less people willing to sell. This means that the spread between the buying and selling bids increases, which can be seen as making transactions more expensive - in other words the stocks become less liquid. What's more important is that without short-selling, bubbles could easily become bigger, as many of those who would want to bet on falling prices simply wouldn't be able to do so. On the other hand in the case of falling stocks, selling short can make the prices fall unnecessarily deep. Accordingly selling short can make a difference in terms of how stock prices behave. That on the other hand might affect how tempting it is to start trading on the stock market or how the wealth gets redistributed eg. in times of crises.

But does that matter much to the layman who doesn't have a dime invested in the stock market? It might. Stock market doesn't exist in a vacuum, but rather reflects the confidence in economy in general. The bigger the bubble the stock market experiences the bigger the general downfall may be, and the more dramatic effects it may have on the real economy - thus also affecting the life of the layman. In that sense, short-selling can be good for everyone. On the other hand, in a bearish market it might make the overreactions at the lower end more deep and thus cause unnecessary damage to the real economy, which would make short-selling bad in that situation - even though studies haven't found many signs of this.

Short-selling does make a difference for all of us. Especially thinking about overheated markets (like in 2007), I think it's better to always allow short-selling than have it permanently banned. Still, I'm not sure if bans are always a bad idea either. If imposing a ban on short-selling ever makes sense, it should probably be at times when the stock markets are being hit particularly hard - like it now has been.

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World in turmoil

Just a couple of years ago perhaps the most major subject of global debate at least from a European perspective seemed to be global warming. The reason for this increased interest was probably largely the fact that on the surface economy and life seemed to be developing so smoothly that there was enough mental resources to concentrate on something that's below the surface; something that seemed to call for serious long-term planning. Now, even with some small glimpses on the subject we get especially through the misery and famine caused by the drought in East Africa, several other more acute themes have taken over.

The world is in turmoil. As the death of one man caused the whole Arab street starting from Tunisia to stand up and demand for proper human rights for the average citizen, Europe is also starting to face more riots that are fundamentally stimulated by immigration-related social segregation, latest of which we've now seen in London - riots that were also initiated by the death of one man. On another front, the supply and demand of oil have reached the point where extracting oil from for example the bituminous sands in Canada has become lucrative despite the expensiveness of the process. Utilization of oil is thus reaching its final frontiers, while another form of energy, namely nuclear power is facing serious opposition and even shutdown plans eg. in Germany due to the terrifying aftermath of the tsunami that hit Japan in March this year.

Still, the economy is currently taking the biggest headlines in the western world. Whereas many economies in the East, most notably China are still rapidly developing, the economies in Europe and the United States are facing serious issues with debt and insufficient economic growth. A week ago we got a significant indication of this: one of the three major credit rating agencies Standard & Poor's downgraded the rating of United States from AAA to AA+ for the first time ever. This change, even though perhaps not that big per se, is historical and might be a sign of what's to come.

'World sucks', a statement painted on a stone in Athens during the 2008 Greek riots. (Picture taken on 29.12.2008)

Environment, democracy, culture, energy, finances - they are all important areas of how the human world functions. The politics, economy and social relations around the world are becoming more global year by year, which causes local troubles to span across the globe more easily. The philosopher Hegel once said "periods of happiness are empty pages in history". This doesn't mean that mankind would need wars, but sometimes difficult times can result in something better in the end. Accordingly, the interesting question is, how the world will appear once things settle down.

On a global scale, the economical turmoil might have a favourable outcome in the end: a more equal world, with a wealthier east and hopefully a more balanced financial system everywhere. The disturbance in the Arab world should also finally result in sounder, more democratic societies. The question is just when and how this will exactly happen, but like we've seen, the ease of spreading ideas through modern technology can give a serious boost to potential revolutions.

What's potentially more unsettling in the longer run are the subjects that are not currently hitting the headlines. Global warming (whether caused by mankind or not) might have much more dramatic and seriously detrimental consequences at least in some parts of the world, even though I don't find widespread or large scale problems very likely. But how about what will happen when the global economy is back on track again? The demand for oil will increase, and if we've reached the peak in oil production, the prices might easily skyrocket to levels that are ultimately unaffordable by both individuals and businesses alike. Is the global infrastructure really prepared for that?

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