On September 24, President George W. Bush—a self-professed devotee of the free market—addressed the nation in an effort to drum up support for an unprecedented intervention in the U.S. economy. The political elite, left and right, were united in their desire to spend other people’s money to purchase depressed financial assets at premium prices. If the federal government did not step in, said the president, a “financial panic” would likely result. But despite reports all last week that a “bailout deal” was imminent and, finally, that a “reformed” version was “sure to pass,” this would-be massive wealth transfer from the middle class to Wall Street’s reckless plutocrats was defeated by Congress on September 29.
For President Bush, this marked yet another failure in the most unpopular presidency in U.S. history. Democratic leaders, who joined Bush in calling for the intervention, were exposed as allies of the same financial interests that are said to dominate the GOP. The successful opposition to the bailout came from both ends of the political spectrum, with conservatives in both parties and principled liberal Democrats uniting to send a message to Wall Street: “Get off America’s back!”
Stock Market Wipes Out Illusory Gains
As a result of the bailout’s failure, the stock market experienced a historic meltdown on Monday. The Dow Jones Industrial Average plummeted a record 777 points, and the S&P 500 and NASDAQ composites fell by even greater amounts, 8.8% and 9.1%, respectively.
This has led some observers to believe the hype: that the failure to pass the bailout bill put the economy in peril. The truth, of course, is the exact opposite: it was government intervention that promulgated this most recent crisis, and only the promise of continued government intervention was keeping stock prices as high as they were. If the bailout had gone through, perhaps the markets would have rallied—but at what cost? The debasement of the dollar that would have accompanied the massive monetary expansion needed to finance the $700 billion bailout would have eaten away as much of your portfolio’s value as Monday’s crash, even if your account showed nominal gains.
The Roots of the Crisis
The roots of the current crisis stretch back to 1913 with the passage of the Federal Reserve Act or certainly to August 15, 1971, when the dollar’s connection to gold was finally severed. But more directly, we can turn back to that fateful day: September 11, 2001.
After the Twin Towers fell and America began its interminable “War on Terror,” we should have had a rather serious recession. We were, after all, recovering from the Fed-caused inflationary bubble that gave us the tech boom and bust. But instead of allowing the economy to return to normalcy, the Federal Reserve—with the blessing of the Bush administration—slashed interest rates to provide “economic stimulus.” Bush, in particular, encouraged homeownership as part of his “ownership society” platform. Thus, hundreds of billions of newly created dollars were pumped into the economy, staving off a recession—for the time being.
Seven years later, the chickens have come home to roost. Greenspan is out of office, and Bush has one foot out the door. The aggressive interest-rate manipulation they orchestrated led to the boom phase of the housing bubble and set up this inevitable bust. Artificially low interest rates sent false signals to consumers and businesses, incentivizing them to take actions they would have never even considered under a regime of real interest rates set by savings and investment. When economic conditions returned to reality, all of Greenspan and Bush’s excess liquidity hit the proverbial fan—and created quite a mess.
Keep an Eye on the Fed
So IndyMac, Lehman Brothers and WaMu all failed, and we were told there would be more bank failures unless the government intervened. To finance the $700 billion bailout, the government would have issued new bonds, for which the Federal Reserve would have created the money to buy. An extra $700 billion would have been added to the money supply, diluting the value of the dollars in your savings account and redistributing wealth from hardworking Americans to Wall Street hotshots who made bad bets.
Thankfully, this travesty has been averted—for now. But even though the bailout bill failed, don’t expect the Federal Reserve to slow down its monetary expansion. When AIG needed its bailout, Congress wasn’t even consulted: the Fed just “monetized” an $85 billion loan to the ailing insurer, and it could “monetize” $700 billion worth of loans to various beneficiaries just as easily.
But the Fed must tread lightly. The long-dormant populist spirit of the American people has been invigorated. The Federal Reserve has operated with impunity for close to 100 years, but if it thwarts the will of the people by proceeding with the bailout—in defiance of Congress—then it will be exposed as the unaccountable instrument of monetary destruction that it is.
Based on a September 18 Times (UK) report regarding the meeting of Middle Eastern finance ministers, the question was asked about the veracity of a plan for a single currency for the Middle East based on oil.
The answer is both true and false and maybe.
Yes, the immediate goal of the meeting last week was to establish a single currency for the Mideast. In that sense, the new currency would be similar to the euro, where various countries have joined under a common umbrella.
No, there were no (public or published) talks of an oil-based currency, which would effectively replace the U.S. dollar as the principal currency of oil trade.
Maybe? The idea of replacing the US dollar with an oil-based currency is not new. The late Saddam Hussein, various Iranian leaders and others have often broached the idea.
As early as 1987, financier George Soros in his book The Alchemy of Finance outlined just such a plan.
A single, oil-based currency would require the agreement of the various Middle Eastern heads of state as well as further agreement by OPEC.
Recent U.S. financial disasters do not rule out such an eventuality. However, the cumbersome and institutional process required should not add fuel to existing speculation.
The single currency issue addressed (without the use of oil) is planned for slightly more than two years hence. However, instability in world financial markets may prompt more rapid agreement to reach the goal.
The Arab oil ministers meeting agreed in principle to establish a single currency. While there was no mention of oil or another commodity backing the potential currency, there is some speculation that the euro, rather than the U.S. dollar, could be designated for oil trades.
Stephan is a former department chair for economics and taught at various colleges and universities at both graduate and undergraduate levels. If you would like Stephan to answer your economics-related questions, read his post “Got an Economics Question?” and submit your questions in the comments area there.
In the late 1970s, the total compensation of chief executives in large American corporations was 35 times that of the average American worker. In 1993, Congress limited the tax deductibility of executive salaries to $1 million unless it could be demonstrated that the extra pay was linked to performance incentives. This contributed to the practice in later years of very generous grants of stock options, which helped drive executive pay to new heights. According to an estimate by the liberal research organization the Economic Policy Institute, in 2007, an executive’s salary was 275 times that of the average worker.
Wall Street executives, with their eight figure earnings, are at the top of the corporate pay range. Wall Street firms have a bonus system which rewards short-term trading profits. It acts as an incentive for executives to expand their highly profitable businesses in exotic securities and ignore the risks. The present financial crisis is a direct result of the compensation practices at these Wall Street firms, which encouraged executives to maximize profits and ignore risks. The salary levels at some Wall Street firms are appalling, given their performance. After news of the bailout plan spread on September 19, experts felt that it was only reasonable to impose limits on the salaries of executives of firms that would participate in the bailout. It was they who made those risky bets on behalf of their firms.
As Congress and the Bush administration (represented by Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke) deliberated the bailout plan before it was rejected by the House on Monday, lawmakers felt that executives should not be allowed to walk away enriched, especially since many have contributed to the present crisis by taking too many risks. There were calls to impose some limits or approval authority on salaries of executives whose firms seek help.
Presidential candidates Barrak Obama and John McCain have both called for limits on the salaries of such executives. There is a fear among many, including lawmakers, that Wall Street’s tarnished titans might walk away with tens of millions of dollars a year while taxpayers pick up the tab.
A Senate draft document calls for a ban on incentive payments that the Treasury deems “inappropriate or excessive” and a “claw-back” provision requiring an executive to give up pay or severance benefits if the firm’s financial results are later shown to be overstated. Other proposals call for a ban on severance payments and allowing large shareholders, with a stake of 3% or more, to propose alternative slates of board directors. This would be an effort to tackle excessive pay practices by opening up and strengthening corporate governance.
Opponents of the proposals say that pay restrictions will discourage hard work and innovation. It would have an overall impact on the financial sector and the economy. Some feel that it would be best to stretch out payments for several years, encouraging executives to pursue the long-term health and stability of the firms they head. However, the salaries are bound to fall. With consolidation, more people would be competing for fewer jobs, leading to lower salaries.
“OK, everyone, stay calm. Hand over the $700 billion right now, and no one gets hurt. Make a wrong move, and the whole economy goes down! Make it quick, or you can all kiss your retirements good-bye!”
Dialog from an old-fashioned “stick-em-up” Western? No, actually, this drama was playing out in real-time Congress last week as Treasury Secretary Hank Paulson, Federal Reserve Chairman Ben Bernanke, and President George W. Bush promoted a $700 billion financial bailout plan to Congress and, I might add, a mob of very angry constituents. The drama ended today with the House of Representatives voting to reject the plan.
Paulson’s bailout plan has forced Main Street and Wall Street into a really ugly confrontation, and if you think I’m overstating this, read the comment sections attached to the New York Times editorials. Those comments are running at around a thousand or more each day. Wading through them, I found not one that said anything remotely resembling, “Thanks Hank! What a great idea! Thank goodness we have a smart guy like you in charge at a terrible scary time like this!”
Before rejecting it, Congress had managed to negotiate some governmental oversight to be added to the plan (the original bailout deal specified no oversight allowed and complete immunity from prosecution) and also negotiated the addition of some provisions for helping homeowners in foreclosure refinance and stay in their homes. Still at issue were CEO salaries and consequences for banks and lending institutions that avail themselves of the Paulson plan to buy up the worst junk on their books: mostly dubious and impossible-to-value mortgage-backed securities, credit default swaps, and other weird, overly creative investment vehicles that threaten to bring the U.S. economy to a catastrophic halt.
What was emerging, as Paulson’s request sunk in, was an incredible amount of public outrage. Initially, the request was for Congress to push the bailout plan through in a day, if not sooner, or suffer dire consequences. It didn’t take long for the American public to start calling their representatives nonstop to let them know that they would, personally, rather suffer dire consequences than hand over $700 billion in taxpayer money to a Wall Street investment banker on the strength of two words: “Trust me.”
Putting dire warnings and assurances of fiduciary responsibility aside, there was no guarantee that this plan (which was literally cobbled together overnight) would work. Comparisons have been made between Paulson’s plan, or, as NYT columnist and Princeton economist Paul Krugman calls it, the “Cash for Trash” plan, and the Resolution Trust Corporation of 1989. The RTC took home mortgages seized during the savings and loan crisis of the late 1980s and sold the homes attached to those mortgages, eventually recouping some of the money lost in the S&L failures. The markets stabilized, and the RTC was widely credited for helping to get the economy back on track.
The original RTC took in $225 billion worth of bad assets and sold them for $140 billion over time, reducing the actual taxpayer cost of that bailout to around $85 billion. But the Paulson plan was widely expected to top $1 trillion for the initial purchases, and there is a big difference between the assets seized then, which were backed by real property, and the assets clogging the books today, which are so complex and poorly constructed that decoding what backs them and where that property might be has become a nightmare in its own right.
No one knows the actual value of these assets, or if they even are assets, and whether they will ever have any resale value. If they are purchased too cheaply, banks will have to declare large losses and may fail anyway. If they are purchased at too great a cost, it amounts to handing over taxpayer money to the very institutions that created the problems in the first place.
Acknowledging the difficulty in valuing and purchasing these junky securities, Paulson’s solution was to hire investment analysts from the private sector to broker the deals and to protect the brokers and the buyers under a cloak of immunity from scrutiny and prosecution. The appeal of such an approach for Wall Street is obvious. On September 19, stocks rebounded insanely, causing even sympathetic investors (the few that remained) to recoil in disgust. But what was the appeal to taxpayers?
The appeal was, “This will stop The Great Depression II from happening.”
Whether it will or won’t, Congress has killed the chance to find out. For now.
One of our readers left an interesting comment regarding the medical profession and its desire to seek profits for its members. I quote from his comment:
The nature of the AMA, a protected and virtually untouchable union, certainly believes in maximizing its members’ profits. It clearly restricts the supply (as all unions do) in face of a steadily growing demand, forcing prices high and higher.
This sheds some interesting light on the medical profession. It is often overlooked by consumers that the medical profession is limited in its numbers and doctors themselves are part of the reason there is a shortage of doctors. In particular, the number of physicians trained in the United States is far less than the need for doctors. As a country full of patients, we are bulging at the seams and in need of more doctors.
However, the number of physicians in this country is limited by the number of U.S.-trained physicians as well as the number of foreign medical graduates coming here to finish training and to practice. The physicians’ lobby in Washington ,D.C., is very strong in limiting the expansion of training programs. In some specialties, there is such a shortage of physicians that you have to wait several months in some communities to see a doctor.
An example of this would be the surgical subspecialty of Ear, Nose, and Throat Surgery, also known as Otolargyngology or Head and Neck Surgery. There are only a few hundred training positions available in the United States each year for this specialty. If these specialists were evenly divided up across the country, that would leave only 3 or 4 per state. However, physicians tend to be concentrated along both coasts and the Midwest, leaving huge gaps in many states across the country. Thus, the demand is very high, and the supply is low. Like many other specialties in medicine, the lobby is strong to limit the expansion of residency positions, keeping the supply low.
Thus, inherent in the system is a type of unionization to prevent competition. The profession protects itself and is profit driven. However, this monopolization and protectionism is not unique to medicine. If you look at almost any other industry, you will find that there is intense national protectionism from offshoring and outsourcing in the form of tariffs, tax credits, and favorable legislation. Similary, in the U.S. the medical profession limits the number of physicians and creates arduous licensing and credentialing requirements to limit supply.
On September 18, the Food and Drug Administration (FDA) issued a press release on a document regulating the use of genetically modified (GM) animals and products in the United States1. This document is open for public comment until November 18 and can be read here. In it, it states that GM animal developers are required to prove such animals are safe to the environment and for human consumption, as in the case of milk, cheese or meat2. Moreover, they must prove that the DNA change that has occurred in the animal as well as any products or repercussions from such a change is safe for the animal itself and the human population. Since this is a relatively new area with unknown implications, and the animals are changed on a genetic level, the FDA is proposing referring to these animals as “animal drugs.” According to Randall Lutter, the FDA’s deputy commissioner for policy, “the technology has evolved to a point where commercialization of these animals is no longer over the horizon3.”
What exactly is a GM animal, and what possible contributions could it make to our society? Achieved in the 1980s, GM animals are similar in many respects to GM plants. They both carry laboratory introduced DNA, or a gene, that is supposed to provide some benefit to the plant or animal. For plants, the new gene could provide insect or pesticide resistance. For animals, a new gene could increase the rate of maturity or have increased levels of important nutrients3. Other animals, referred to as “biopharm animals,” could be used to produce medicines for human diseases. Other versions, labeled “xenotransplant animals,” could provide tissue and organs so similar to human material that the chance of rejection would be minimal4,5. Even more categories of GM animals exist; however, they have been refused entrance to the consumer market. Aside from the obvious safety issues, many are afraid of what ecological damage could be done if one of these GM animals escaped into the wild.
Environment and Health Concerns
In 2002, the U.S. National Academies’ National Research Council grew concerned that the accidental introduction of one of these creatures could upset the current environmental balance6. If these GM animals were able to survive better and reproduce more quickly, they could push out the non-GM versions. Some are concerned not only about the environment but also their health, especially since the FDA has refused to require foods made with GM animals to be labeled as such, the same way they have refused to label food from GM crops5.
So far, only one GM animal has been released into the public realm. Although animals intended for food have not been released, in 2003, the fish Zebra danio was5. This fish was not meant to be eaten but to be seen. These modified fish, called GloFish, were able to glow in the dark and were something interesting for aquatic hobbyists. Animals meant for food could be released, however, if found to be safe. This could be particularly welcome if it could alleviate food shortages occurring around the world. Considering that most of the world, however, looks at GM crops with disdain and even horror, it is unlikely that GM animals would be received any more warmly.
If GM animals can succeed at the level GM crops have, even with so many people’s misgivings, prospects are optimistic indeed. In 2001, Bt cotton, for example, was able to grow with 50% less pesticide, or 10,500 metric tons, because it simply didn’t need it. Bt cotton allowed for more yield as well, increasing it by 25% in South Africa and 5% to 10% in China. For China, this equated to a gain of $500 million per hectare and $750 million nationally. In 2005, Syngenta, an agricultural biotechnology giant which sells GM seed, generated $8.1 billion while Monsanto believes their profits will climb to $8.5 billion in the next four years.
As for animals, cows have recently been genetically manipulated to prevent infection from mad cow disease. Considering the fear, both abroad and recently at home, of meat contaminated with this, resistant GM cows might deserve serious consideration. Furthermore, since the global population is expected to reach nine billion by 2040, the gains provided by GM crops and animals may become a necessity to continue feeding, clothing and medicating the world. With the apparently large amount of money that is on the brink of being realized by such an endeavor, there are sure to be numerous companies who will try to cash in on the idea.
1 – FDA press release on GM Animals
2 – Draft Guidance of GM Animals
3 – Science, September 18, 2008, FDA Issues Guidelines for GE Animals
4 – FDA GE Animal Fact Sheet
5 – FDA Consumer Q&A
6 – Science, August 23, 2002, Environmental Impact Seen as Biggest Risk
If you watch the news at all these days (and a case could definitely be made for avoiding this habit), then you already know that the United States imports way more cheap stuff from China than it sends over there for sale to the Chinese people. That big difference between the huge amount we import and the tiny amount we export is called the trade deficit, and you’ve almost certainly been hearing for eight years now about how it keeps going up and how that isn’t such a great thing.
What you may not realize, however, is that the recent federal bailout of the mortgage giants Fannie Mae and Freddie Mac stems in part from the strange and delicate trade relationship the U.S. has forged with China; a relationship that consists of lots of imported Chinese goods that Americans buy up with money that is essentially loaned to the U.S. by, you guessed it, the Chinese.
The Chinese do not issue loans directly to the U.S. the way that a bank would issue a loan to an individual. What the Chinese government does instead is buy up U.S. debt, mostly in the form of mortgage-backed securities. The recent tax rebate stimulus package designed to get shoppers out and spending money again to shore up the flagging U.S. economy came largely from this kind of investment by the Chinese in the debt held by American financial institutions.
While it may seem circular and confusing to think of the Chinese actually loaning the U.S. the money to buy Chinese products, the fact is that right now the U.S. government is heavily dependent on this kind of Chinese investment just for the continuation of its day-to-day business. In other words, without Chinese money being poured into the U.S. in the form of securities purchases, our government would experience such a budgetary shortfall, it would have to shut down.
The linchpin in this arrangement, obviously, is U.S. housing values. If the value of the properties backing the mortgage debt purchased by the Chinese remains stable or increases steadily, everything continues to hum along normally (or at least normally on the surface of it). The Chinese have an asset they see as increasing in value (that is, American mortgage-backed debt securities), and the U.S. government has the money it needs for its day-to-day operations. The Chinese make money off of their exports to the U.S. and off of their investments in U.S. housing-backed debt, and U.S. citizens continue to consume the cheap Chinese goods we have grown accustomed to buying.
That’s the U.S. consumer economy in a nutshell, and if it sounds a bit Orwellian, bizarre, and unbalanced, that’s because it is. Nevertheless, that’s how we roll these days, or did, until the housing bubble burst and the values of the properties actually backing all this mortgage debt began to drop precipitously. At first it was only subprime debt that went bad, but that spread to what is known in the mortgage industry as Alt-A debt (which is a notch above subprime and once considered quite a safe risk).
Now even homeowners who are in no danger of defaulting on their mortgages are seeing dramatic drops in their property values due to a badly inflated housing market and the subsequent bursting of that bubble. And as if that isn’t all bad enough, the problem is rapidly spreading to other kinds of U.S. debt: credit cards, car loans, home equity lines, and small business lines of credit.
To put it in just a few words: the actual assets backing U.S. debt are now depreciating instead of appreciating in value, leaving the Chinese holding substantial investments in the U.S. that are looking less and less profitable. The Chinese have been friendly to the U.S. because they are making lots of money from the relationship. With the bursting of the housing bubble, not so much. They have been growing more and more nervous about this fact.
What does that have to do with Fannie and Freddie?
Fannie Mae and Freddie Mac back most of the mortgage debt in the United States, but because they have always had a quasi-governmental status, they have not kept the kind of prudent reserves on hand that a private financial institution would be required to keep to mitigate such losses. As it became more and more clear over the course of the past year or so that Fannie and Freddie didn’t have adequate financial reserves to back the debt they held, the Federal Reserve and the Treasury Department began to talk about a bailout.
It’s a bad thing that housing values are plummeting in the U.S., but it has to happen because they were so wildly inflated during the boom years. That hard correction would be painful for the U.S. no matter what, and we are certainly feeling the pain already in the form of a major economic turndown that looks like it will last at least through the better part of 2009. But what would be even more catastrophic than the pain we are already feeling in our collective national pocketbook would be a decision by the Chinese to pull back on their investment in us. Such a move would literally throw us into a financial meltdown that would make the Depression era look pretty cheerful by comparison.
So, while it may or may not be true that Fannie and Freddie “are too big to be allowed to fail,” what is unquestionably true is that the U.S. government is too big to be allowed to fail, and fail it would without a steady influx of Chinese money.
All of this is more food for thought that I can possibly digest in a single sitting. If you pay close attention to the expressions on the faces of Bernanke and Paulson, you may well detect a hint of dyspepsia there, too.
The day is saved. Again. For now.
And yet once again, in the smoking (and indigestible) aftermath, a familiar and phrase rears its ugly head:
The present financial crisis – probably the worst in decades – is making the lawmakers in Washington, D.C., strongly consider the need to dust off a 1980’s era plan to help save the banking industry and stabilize the economy.
The idea of setting up a government corporation to deal with toxic assets has invoked strong interest among both Democrats and Republicans. Lawmakers are eager to find some solution to the crisis. Eleven banks have already failed this year, and there are questions surrounding the major financial institutions. On September 6, the federal government took over mortgage lending giants Fannie Mae and Freddie Mac as they teetered near collapse. Lehman Brothers has filed for bankruptcy. Merrill Lynch & Co agreed to sell itself to Bank of America. And the government has just bailed out American International Group, Inc., a financial behemoth.
The bailout of AIG, one of the world’s biggest insurers, cost the government $85 billion. Doubts remain whether the bailout will effectively help stem the ripple effect that failing banks and financial institutions are having on the economy. AIG’s cash squeeze is driven in large by losses in a unit separate from its traditional insurance business – the financial products unit, which sold credit default swap contracts designed to protect investors against default in an array of assets including subprime mortgages.
The Treasury Department is planning to sell bonds for the Federal Reserve in an effort to help it deal with the unprecedented borrowing needs resulting from the present financial crisis. And lawmakers are now appearing open to the idea of creating a government entity akin to the Resolution Trust Corporation (RTC). The RTC was formed amid the savings and loan crisis in the 1980’s. The RTC resolved and liquidated the assets of 747 thrifts with total assets of $394 billion.
What is needed is an institution or a mechanism of a supertrustee to handle incredibly large financial institutions which may be allowed to fail and how those assets get managed and ensure they are handled in an expeditious manner. The absence of such an institution or mechanism could in the future result in one failure after another. The failures will keep blossoming. Many lawmakers are calling the creation of such a mechanism a legitimate idea that merits consideration.
The creation of a new federal agency would only put taxpayers at risk for billions of dollars in bad debts. The parallels with the 1980’s are inexact. The mission of the RTC was to dispose of the assets as quickly as possible for maximum value and reduce taxpayer exposure. Unlike now, the government had no choice but to acquire the assets from savings associations because they were backed by federal deposit insurance. The mortgages, which are at the heart of the present crisis, are not backed by federally insured deposits.
When the Federal Reserve fronted $80 billion to insurance giant AIG last week, most people were blinded by the staggering size of the bailout. Few people took time to consider the fact that the Fed—a pseudo-private banking cartel with the government-granted monopoly power to create money out of thin air—made this purchase/loan with no approval from Congress. The Fed acts “independently,” and can do whatever it wants. Is this healthy for capitalism or democracy?
But hidden even deeper in the day’s news was an announcement from another government bureaucracy intended to “protect us”—the Securities and Exchange Commission (SEC). In an effort to thwart “speculators,” they banned the “short selling” of 79 financial stocks from now until October 2. There was very little (i.e. none) protest from the supposed champions of the “free market” in the Republican Party.
Speculators as Scapegoats
That’s because, as we investigated in the first installment of this series, “speculators”—and short sellers are generally considered such—are an easy scapegoat for politicians. The average man or woman with any money in the market only generates profits when stocks go up. How dare these short sellers make money as the market goes down! How un-American!
This is the reflexive, reactionary and ultimately ugly view. But the truth is that, like all speculators, short sellers perform a valuable function in capital markets. Banning them will only create a greater dislocation between the real value of a stock and its market value at any given time and create more volatility, not less.
First, we must answer the question: what is short selling? Luckily, “shorting” is easier to comprehend than “credit default swaps” or even call and put options. Most everyone is familiar with the stock-market saying, “Buy low, sell high.” Well, short selling allows traders to do things in reverse order—sell high and then buy low.
A “Main Street” Example
Let’s escape Wall Street and turn to the world of sports collectibles. Imagine it’s the summer of 2007, and the first murmurings of Michael Vick’s impending legal troubles are beginning to circulate. Your friend, a huge Atlanta Falcons fan, is going on a month-long cruise, and you ask him if you can borrow his Michael Vick autographed football. It’s a strange request, but he says, “Why not? Just be sure you return it to me, in mint condition, when I get home.”
Once your friend is on his way to the Caribbean, you immediately go on eBay and sell the ball for $500. Are you stealing? Not if you’re “short selling.”
A few weeks later, the story breaks, and the demand for Vick collectibles plummets. You buy a new Michael Vick autographed football—exactly like the one you borrowed—for $50 and return it to your friend when he comes home.
To recap, you borrowed something, sold it, bought an exact replica and then returned the replica to the original owner. So long as you “sold high and bought low,” you made a profit, and your friend is no worse for wear, either. After all, he lent you a Michael Vick football, and you returned to him a Michael Vick football—what you did with the ball is no concern of his.
Why Short Sellers are Good for the Economy
When applied to stocks, “short selling” works almost exactly the same way. The only difference is that you have an intermediary, a broker, who does the borrowing for you. The person who has their stock borrowed doesn’t even know about the transaction!
Of course, things can go horribly wrong. Imagine you shorted Apple stock at $125 right before they announced a big new product launch, and the stock jumped to $150. You could either “let it ride” and hope that the stock comes back down or buy back the shares at a $25 loss. Shorting is actually much riskier than buying stock since a stock cannot go lower than $0 (capping a short seller’s potential gains), but there’s no limit to how high it might go (meaning unlimited potential losses for short sellers).
So how does short selling make the markets safer? The answer: by putting a cap on “irrational exuberance.” After all, if a stock’s market value (current share price) becomes completely divorced from reality—as with the tech boom—short sellers can and do sell borrowed shares to push the price down. By banning short sellers, the SEC is asking for the prices of the 79 financial stocks to be kept artificially high. But they can’t fight reality forever, and eventually, the share prices and reality will have to coincide. Regulations only prevent the inevitable and make it more painful when it finally does come to pass.
Whenever there’s a financial crisis, governments like to find scapegoats. Short sellers and other speculators are blamed along with the “free market” they represent. Well, the fact of the matter is that it is the government itself, with its implicit line of credit to Fannie Mae and Freddie Mac and the moral hazard it imposes by so frequently stepping in to bail out banks and other financial institutions when they make poor business decisions, is to blame. Americans need to become more educated in the subjects of finance and economics or risk being hoodwinked by slick-talking politicians whose primary aim is to consolidate more power in their hands at the expense of individual and economic liberty.