Demon short-selling

Every time there's a financial crisis, demagogues start criticising the short-sellers.  The government has now temporarily banned shorting financial stocks, as has Britain.   Short-selling, for curious readers, is the practice of selling a security you don't own, in the hopes that the price will drop and you can buy it back before you have to deliver the actual security.  Thus can large profits be made. 

Short-selling is extremely dangerous, compared to going "long" (buying a security in the hopes it will go up).  If you buy a security, the most you can lose is all the money you've invested.  On the other hand, if you sell a security short, your loss is theoretically potentially unlimited--if the price soars, you're on the hook for the difference between the current price, and whatever you sold it at.  I knew a guy who made a killing shorting the market in 2000.  But not before he almost went bankrupt doing the same in 1999.  As traders like to say, "the markets can stay foolish longer than you can stay solvent". 

Nonetheless, there's been a great deal of short-selling activity, especially, understandably, in financial stocks.  First Bear, then Lehman, and now Morgan Stanley have blamed their woes on the short-sellers.  Arnold Kling thinks this is ludicrous:

How can short-selling destroy a good company?

The simple answer is that it can't.

First of all, short-selling can't force down your share price. Short-selling only forces down your share price if buyers don't emerge to defend your share price.

Banning short-selling cannot protect a bad stock. If nobody is willing to buy XYZ at a price higher than $.02 a share, then the price at which XYZ will trade will be $.02 a share (or lower). It doesn't matter whether you have short-sellers or not.

What drives stock prices down is the lack of people willing to buy them at the higher price. If the company has sufficient value, there will be sufficient buyers.

I think this is a tad strong.  If short-sellers flood a market, they can overwhelm the buyers, especially when you have a massive credit contraction in the markets.  Also, short-sellers are not historically known to be above spreading untrue rumors in order to drive prices down further.  Felix Salmon speculates that institutions with deep pockets and long time horizons are probably going to do very well out of the market's current problems. 

Nonetheless, the short-selling ban is stupid, and McCain is both a dolt and a demagogue for helping push Chris Cox into it.  Successful shorts, like George Soros' spectacular attack on the British pound, usually work because there is a real underlying issue (in that case, the British pound's unsustainable peg to other EU currencies).  If there's no problem there, the shorts take a big bath.  As Tyler Cowen points out, if there is an underlying issue, the price pressures will prevail anyway:

If you read the above excerpt, you will see that the selling of some traders becomes a substitute for the short selling of others.  This is a very general mechanism in financial theory, namely the ability to recreate a desired net position in a synthetic manner through other markets.

Perhaps most importantly, while short selling is a problem for Morgan Stanley, and his shareholders, it is not the primary problem in this crisis.  The problem is in the debt markets, not the equity markets:  financial firms are finding it very, very difficult to roll over their paper.  (More on this later).  The ban on short-selling does nothing to combat this problem, and indeed, by shaking public confidence in the stock price, might push investors into being more conservative on the debt than they otherwise would be.