Short Selling and Adam Smith

So you sell a security that does not belong to you: Is that a naked short? If yes, how can that be legal if they are not paying a fee to the owner?

Most of the talk about how bad is short selling is just not very informative: There is nothing wrong on this activity in itself. I think it is perfectly rational and ethical to short a stock from a company that you think is going down.The hedge funds that shorted Lehman or Enron not only were right and made money in between, they unintentionally signaled that something was rotten in those companies (yes, the invisible hand). Not the heroes of Ayn Rand, just another butcher providing dinner to itself and the community (yes, again Adam Smith).


Having said the above I do think short selling securities in a naked way (see an older on this subject) is just plain theft. What the custodian or borrower of somebody else securities should do is engage in a borrowing transaction with the owner of these assets and pay a fee if required --could be zero, my point is the transaction should exist. This is not only the ethical way to proceed, but the unintentionally efficient one as "sands in the wheels"  to this activity in markets prone to "overshootings" seems to me to be the best answer, or second best, given that markets are far from perfect (as much as I like Adam Smith).

OTC versus Exchange Traded

Now that health reform has been passed in the US it seem that the next piece of regulation that the Obama administration is targeting is Financial Reform. I haven't read yet the senate proposal, but it seems that among its clauses there is one that will require that financial derivatives to be traded in exchanges. This is in contrast to the current practice where the bulk of these trades are done in the OTC market. What is the difference? Well, simply put, an OTC derivative is a custom made contract, whereas the ones traded in exchanges are standardized products (you have, say, a limited number of maturities for futures or maturities and strikes for options, whereas in an OTC you can get for yourself any desired contract); but more importantly (and the reason the government wants to push the market in that direction), derivatives traded in exchanges are margined everyday, thus almost eliminating counterparty risk (i.e. the risk that one of the involved parties doesn't fulfill is obligation).

So far so good, the market will loose creativity so to speak in the area of Financial Engineering, but we will probably finish up with a safer financial system. What is not clear to me at all is if this requirement will apply to any financial derivative or if they have a subset of these in mind (it is clear that, for example, Credit Default Swaps will be pushed to exchanges; but I'm not sure if, for example, from now on all FX options have to be exchanged traded). I suspect it will finish up being the second one, and that implies that some government agency will have from time to time to cherry pick which derivative should stop being OTC to become market traded. That to me sounds like a very bad idea, moving derivatives from OTC to market based should be something that the involved parties have an incentive to do, and that can be achieved through higher capital requirements on OTC derivatives. There is no need for a super-bureaucrat, that will only end up in corruption and in another round of regulation.

Nacked

Yesterday it was announced in Germany that the short selling of certain securites would be suspended for some time. As soon as this was announced I saw several comments in twitter that this was a bad idea. Two things I'd like to mention: 


1. The measure is actually quite mild, it only covers what is known as nacked short, i.e., selling something you don't even own. Shorting securities is still feasible in Germany, you just need to find someone that lends you the security first. 


2. Why would anyone consider this a bad idea? What actually surprised me was to learn that in Germany nacked short selling was allowed. In the US that is not allowed except for market makers and I think that is the way to go. 


Don't get me wrong here, I do believe short selling performs a useful service (for hedging purpuses and for finding Lehman's and Enron's, for example), but markets tend to overeact (overshoot if you want to sound more fancy) and when they do so on the downside the results can be quite scary. Given this a little sand on the wheels does not sound ludricous to me and this one seems to be the least intrusive way. In short: I agree on this one with the German authorities--not that they care of course.

Will Greece Leave the Euro?

So I'll put my thesis up front: I don't think so; but let me first summarize where I got the idea of the subject.

Paul Krugman recently mentioned that it is a real possibility at this point. He basically says that Greece, even without debt restructuring, will need to somehow propel its economy so that it starts growing again. What he means by that is that somehow they need to become more productive (more output per worker). Now, in the short run, you really only have one alternative --lower wages. That you can achieve through two means: 1. Workers agree to a wage cut; 2. Devaluation (I'm following Paul Krugman here as far as I was able to understand him. There have been other proposals, you can check one of them in the suggested reading section at the end of the blog)

The first one seems hard given the riots we've seen in the news (and in general probably something you should discard first hand in a democracy), the second one is, in principle, also not feasible given that Greece is in the Euro area and any attempt in this direction would signal a bank run and make things even worst.

Paul Krugman then goes to say that considering the unthinkable (Greece leaving the Euro) is similar to what happened in Argentina in 2001 which had a convertible currency and whose government was committed (whatever that means, but I'm looking at things after the fact so he might as well be right) to exchange one Argentine peso for one American dollar.

So far, so good, I agree; but I think the analogy is erroneous because of: 1.Argentina was not in a monetary union like Greece (Greece leaves: whose next?!, with Argentina the buck stopped there). 2. France and Germany have a big investment in the Euro.

Point one should explain by itself, and I think we've seen it with the "shock and awe" policy that was  recently announced (will we ever find less disgusting analogies: "Shock and Awe"?, here is about saving an economy and a system that has made countries which have been for centuries at war to feel closer together).

Point two is, well,more dubious: bygones are bygones; but yet if a country like Greece is allowed to leave the Euro area: wouldn't that put into question the whole European Union?

Suggested readings:

http://krugman.blogs.nytimes.com/2010/05/05/greek-end-game/

http://www.voxeu.org/index.php?q=node/5018

Mandated Benefits

Just quickly reread "Some simple Economics of Mandated Benefits" by Larry Summers, it is amazing how much you can get out of a simple graph, and so sad that you rarely hear people arguing in a disciplined manner, just shouting.

The original article I was able to find it online at: http://www3.amherst.edu/~jwreyes/econ77reading/Summers.pdf

Efficient Transfer of Resources

Now, this is not only a smart idea; but it could potentially do a lot good around the world. Worth taking a look at this website:

http://www.fabcampaign.org/

Two Different Problems: Liquidity and Insolvency.

1. Liquidity.

At this point it is probably the only thing the US regulatory authorities know how to cope with, “thanks” to the Great depression of 1929.

2. Insolvency.

That is what the Great recession of 2008 (that is how it is getting fashionable to call it, although given what it is happening in Europe we might need to change that) should have teach us, but I am not sure it will given that we felt it as recession and not a depression.

Institutions to cope with default are what we need: Too Bigh to Fail is neither fair nor efficient.

Suggested Readings:

Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis (Hoover Institution Press Publications). John B Taylor.

Financial regulation: Can we avoid another great recession? John Van Reenen
(http://www.voxeu.org/index.php?q=node/4988. May 4, 2010)