Haven’t we heard this before? The causes of the Greek debt crisis and the subsequent decline of the euro’s value are the actions of speculators – hedge fund operators, short-sellers and the like.
Folks, the causes of the Greek debt crisis are too much debt, too little income and few prospects of that changing. The euro took a beating because it is only as strong as its weakest member’s finances. To blame speculators for this mess is akin to chastising the little boy who called out, “The King has no clothes on.”
Short selling is the process of borrowing a security and then selling it. Legally, you must at some point buy it back, hopefully at a lower price. As the nineteenth century financier Daniel Drew is quoted as saying, “He who sells what isn’t his’n must buy it back or go to prison.” If you already own the security (but don’t want to or can’t, for whatever reason, sell it) and borrow shares from someone else to sell, that is called a covered short sale. Naked short selling occurs when you borrow and then sell a security you don't already own. The purported idea behind banning naked short selling is that those sales are putting undue pressure on the euro.
All Germany will accomplish is to drive the small percentage of European naked short-selling business transacted in Germany to London, where most is done already. Consequently, the German response will have little economic effect and is merely political grandstanding.
The problem is not short selling. Short sales can help make markets efficient since those who think current prices are too high have a mechanism of backing up their opinion with money. What governments should manage is the level of margin (or leverage) firms can use when they sell short. Leverage got the US investment banks in trouble, not per se the investments they made; they had too little capital when the markets went against them.
So too with short selling. If world-wide regulators set standard margin requirements to assure firms cannot become overly leveraged, we get the best of all worlds. The hedge funds can do what they claim to do best (find mispriced securities and take contrary positions), the markets remain liquid and efficient through multitudes of buyers and sellers and the rest of us are protected against financial calamities when firms take on too much risk.
The lesson governments and regulators should be learning from the most recent financial meltdown (and the one before that and the one before that, ad infinitum) is to manage risk levels. The German action to ban naked short sales does nothing of the kind. If the public lets them off the hook of addressing the real issues, it will only be a matter of time before we have another worldwide economic crises brought on by unmanaged risk.