No Sympathy for Short Sellers

Steve Waldman unleashes a heartfelt cry in the face of uncaring markets – a cry for the short seller, a breed among which he counts himself. He's responding to my blog entry saying that there's no legal case on behalf of short sellers against investment banks and the like, and he's not convinced:

Bears who were right deserve to get paid just as much as bulls who were right, and justice delayed is justice denied for shorts. Similarly, investment banks who knowingly overpay for assets in order to prevent larger losses on derivative positions are market-manipulators, and should face consequences for that. As should central banks and sovereign wealth funds, if their trading in markets other than their own debt is driven by anything other than direct return maximization as ordinary price-takers. There is no theory that lets us give real-world meaning to market prices when price-setters are driven by second-order side effects rather than direct valuation of the assets being traded. We have no reason other than blind faith or ideology to believe that anything resembling efficient allocation of real resources would occur in an economy driven by capital markets with bizarre feedback loops. I think we are watching capital market failure happen all around us, and it will work out badly.

I feel for Steve, but I don't agree with him. For one thing, there's only one species of investor who "deserves to get paid", and that's an investor with a contract which guarantees him money. I think they're called bondholders. If you buy a security in the hope that its price will rise, or sell a security in the hope that its price will fall, you don't "deserve to get paid" anything, whether you're right or whether you're wrong. Markets are not some kind of primary-school sports day where prizes get awarded to the most deserving. In the words of parents worldwide, "life's not fair".

Secondly, no one is accusing invvestment banks of knowingly overpaying for assets. The only real accusation is that they might be knowingly holding onto assets for which they overpaid in the past, rather than selling them and revealing their real market value. The only time an investment bank will knowingly overpay for an asset is when it knows that there's a buyer in the future who will pay even more for it. (Think Nigerian barges, here.) That might well be fraud, but it's not market manipulation.

Thirdly, central banks and sovereign wealth funds and other international institutions such as the IMF have lots of motivations beyond "direct return maximization" in terms of how they invest their money. They always have, and they always will. Traders and investors know this, which is why they can make lots of money buy buying Mexican debt in 1994 on the true grounds that Mexico won't be allowed to default. (They can also, of course, lose lots of money buy buying Russian debt in 1998 on the false grounds that Russia won't be allowed to default. That's markets, that is.) If China or Norway wants to be long Treasuries or short Wal-Mart for non-economic reasons such as supporting exports or punishing union-bashers, that's entirely their prerogative.

Steve is living in cloud cuckoo land if he believes in the "real-world meaning of market prices on the basis of direct valuation of the assets being traded". If that was really the case, then there would never be any price difference between voting shares and non-voting shares, for starters. Capital markets, in this sense, have been failing for as long as they have existed. And a lot of smart, long-term investors have made a lot of money by arbitraging those failures. On the other hand, a lot of smart, long-term investors have also lost a lot of money by attempting to arbitrage those failures. Being smart and right is not enough to make you rich.

If Steve is really punting his life savings on a belief in "efficient allocation of real resources," he's got much bigger problems than market manipulation which may or may not be going on in some dark corner of the CDO world. Yes, Adam Smith's invisible hand has been surprisingly effective over the past couple of hundred years. But the surprising thing is precisely that there is some efficient allocation of real resources – not that there is inefficient allocation of real resources. Real resources have always been allocated inefficiently, and they always will be. Just look at the fashion industry.