In Defense of Short-Selling

Props to Dean Baker. 

Short-selling can play a very important role in the market. If
informed investors recognize that a stock is over-valued they perform a
valuable service by selling it short and pushing down its stock price.
This can both deprive the company of capital and be a signal to other
actors in the market that the company might not be as healthy as is
generally believed.

The economy would have benefited enormously if large numbers of
traders had shorted Fannie and Freddie 4 years ago when they were
buying up hundreds of billions of mortgages issued to buyers who bought
homes at bubble-inflated prices. This would have stopped the bubble
years ago. Similarly, we could have prevented the financial chaos at
Merrill Lynch, Citigroup, Bear Stearns and the rest, if traders had
recognized their financial shenanigans and aggressively shorted their
stock. In the same vein, heavy shorting by informed investors could
have prevented the boom and bust of the tech bubble.

The decision to intervene against short-selling is completely
inconsistent with the belief in the wisdom of the markets. Of course
short-sellers can be wrong and depress stock prices more than is
justified by fundamentals, but so what? The government doesn’t
intervene when it thinks investors have exaggerated the true value of a
stock. The public has no more reason to fear under-valued stock prices
than over-valued stock prices. This one-sided intervention by SEC is
hard to justify on any grounds.