What use short selling?
I’m noticing a theme chez John Hempton: a few weeks ago he was writing about the dangers of shorting frauds, and now he’s writing about the dangers of shorting an industry in terminal decline. At least he’s not doing this kind of thing at book length: David Einhorn spent 380 pages detailing the dangers of shorting Allied Capital.
The general idea here is that no matter how perspicacious and intelligent a short seller is, he can still be entirely correct and lose lots of money. As Hempton writes today:
If you understood the implications of digital photography in 1991 you were – at least on that item – the smartest guy in almost any room. And it did not help you make (much) money.
Well, yes. And, good. Hempton’s talking about an episode where Warren Buffett was talking to Bill Gates in 1991, and Gates said that Kodak was toast. Neither Buffett nor Gates thought that, even if Kodak was toast, they should go out and short the stock. But because Hempton’s a short seller, that was the first idea that sprang to mind.
Bill Gates, of course, had much better things to do in 1991 than short Kodak: he was using his intelligence and perspicacity to build Microsoft into a global giant which has fundamentally changed the lives of billions of people. Short sellers, by contrast, are what Adair Turner would call socially useless.
Let’s say I’m an intelligent and perspicacious short-seller who correctly believes that Kodak shares are going to fall. Kodak has shares in the first place, remember, because it needed to raise equity capital to build a global company capable of changing the world in fundamental ways. A large number of long-term investors then bought those shares, becoming part-owners of a then-successful real-world company. I then approach one of those large, long-term investors, and ask them to lend me their shares for a short while. I’ll pay them a modest interest rate for the privilege, and they’ll end up with just as many shares as they started with, so they agree.
The next thing I do is to immediately sell those shares on the open market, to someone else who believes in the future of Kodak. I then sit back and wait, as Kodak shares fall in price. Eventually, I buy them back cheap, return them to the original long-term investor, and pocket my profits.
Now I don’t think that this exercise is particularly harmful on a societal level, and at the margin it can help to make markets more liquid and efficient. But I can’t help but think of the opportunity cost of having all these intelligent and perspicacious people playing around on stock markets, rather than going out and putting that intelligence and perspicacity to more socially-beneficial use.
It’s not just short-sellers, either: most financial professionals are essentially parasitical on people who genuinely add value in the real world. Old-fashioned lending is important, and I’d say that stock markets in general also count as a positive financial innovation, since they make it vastly easier for companies to raise equity capital. But in my ideal world, people working for real companies like Kodak would make more money, in general, than people working for more parasitical financial-services companies. The fact that it’s the other way around worries me. While finance may or may not be good at the efficient allocation of capital, it seems to be positively bad when it comes to the efficient allocation of the labor of intelligent and perspicacious individuals.