Short selling and monetary theory

Jacob Little, legendary short seller.
The Great Bear of Wall Street
1794 - 186

This is a guest post by Mike Sproul




To understand short-selling, start with three words: “Borrow and sell.” The short-seller in figure 1 borrows a share of GM stock from a stockholder and then sells that share of stock to a buyer for $60 cash. If GM subsequently drops to $50, then the short-seller can buy a share of GM on the open market for $50, repay that share to the stock-lender, and profit $10. But if GM instead rises to $70, then the short-seller loses $10, since he must pay $70 to buy the stock before repaying it to the stock-lender.                                                      

As the short-seller borrows one share of GM, he hands his IOU to the stock-lender. This IOU promises to deliver a share of GM stock. (It would also promise to compensate the stock lender for any dividends missed as a result of lending the stock.) Since the IOU can be redeemed for a genuine share, the IOU will be worth the same as a genuine share. This means that the stock lender does not have much reason to care whether he holds the genuine stock or the IOU (unless he cares about losing his voting rights in the corporation).

Figure 2 shows a simpler way to sell short. The short-seller simply writes up an IOU and sells it directly to a buyer. This kind of short sale gives the same payoff as the “borrow and sell” short sale of figure 1. If GM falls to $50, the short-seller gets a $10 profit, while if GM rises to $70, the short-seller loses $10. This method of short selling is so simple that it can happen by accident. Suppose you're a stockbroker, and a client calls asking you to buy one share of GM for him. You answer, “OK, you got it”, and hang up, planning to deliver the actual stock later in the day. You have just gone short, and you stand to gain $1 for every dollar the stock falls, while losing $1 for every dollar it rises.

A still simpler way to go short is to make a bet with someone, as shown in figure 3. The terms of the bet are that for every dollar GM falls, the buyer pays the short seller $1, while for every dollar GM rises, the short seller pays the buyer $1. The payoffs from this bet are the same as the other two methods of short selling. The bet shown in figure 3 is like a futures trade: There is no actual delivery of GM stock, and gains and losses are settled periodically, including adjustments for dividends. In contrast, the trade in figure 2 is like a forward trade: There is a promise to deliver GM stock, and gains and losses accumulate until the position is closed out.

Some common misunderstandings about short selling:

1. Are these IOUs counterfeit shares? Do they dilute the underlying stock and reduce its value?

No, no, and no. And never mind what Overstock.com CEO Patrick Byrne says. The short seller who issues the IOU puts his name on that IOU, recognizes the IOU as his liability, and stands ready to deliver a genuine share to the holder of the IOU. These are not the actions of a counterfeiter. But suppose there are 1 million genuine shares of GM stock in existence, and that short sellers have collectively issued 2 million IOUs. In a sense, the quantity of GM shares has tripled, and you might expect the share price to fall to 1/3 of its former level. But don't forget that GM did not issue the IOUs, and they are not GM’s liability. They are the liabilities of the short sellers. The issuance of IOUs through short sales does not affect the number of genuine GM shares, nor does it affect GM’s assets, so it can't affect share price. If short selling somehow did put share price out of line with the firm's actual value, then arbitragers would pounce. There will occasionally be liquidity crises when markets break down, stocks are hard to borrow or hard to buy, and arbitrage can't play its usual role; but in normal conditions, arbitrage assures that short selling does not affect share prices. Besides, short selling itself helps to keep markets liquid, and makes these liquidity crises less likely to occur in the first place.

2. What is a naked short?

In figure 1, a naked short would occur if the short seller failed to deliver the genuine share to the buyer within 3 business days. If this happens, the “borrow and sell” short of figure 1 reverts to the “forward style” short of figure 2. The buyer ends up holding the short seller's IOU, rather than the genuine share. If the short seller fails to deliver the genuine share even after an extended period, then the two traders could still settle up with each other in cash or other securities. The “forward style” short of figure 2 would thus revert to the “futures style” short of figure 3. If worse comes to worst and the short seller defaults, then either the stock exchange will make good the loss, or the traders will get a costly lesson in placing too much trust in their fellow man. Sometimes the SEC will step in, and traders will get an even costlier lesson in placing too much trust in the government.

Note that in all three methods of short selling, the dollar payoffs to both traders are identical. This highlights the futility of the numerous restrictions that governments place on short selling in general, and on naked short selling in particular. In the first place, any legal restriction on one type of short selling will only cause traders to switch to a different kind that is not so easily restricted. In the second place, studies show that when governments do succeed in suppressing short sales, markets become less efficient.

3. Short selling and money

When you buy a house, you borrow dollars and then sell those dollars for a house. This makes you short in dollars, just like borrowing and selling GM makes you short in GM (figure 1). Alternatively, you might buy that house by handing your IOU directly to the house seller. This would put you in a “forward style” short position in dollars (figure 2). If you are well known and trusted, then your IOU can actually circulate as money. But normally a bank would act as a broker between borrower and lender, and the bank would issue its own IOU (a checking account) in exchange for your IOU. The bank's IOU will circulate more easily than your IOU, so we commonly talk as if the bank has created money. This is not quite right because the bank is not short in dollars on net. The bank went short in dollars as it issued its IOU, but it took an offsetting long position in dollars when it accepted your IOU. The bank is therefore neutral in dollars, while the borrower is short in dollars. This is why it makes sense to say that borrowers are the original issuers of money, while the banks only help out by putting their name on the money.

It's reasonable to think that short selling of money is governed by the same principles that govern short selling of stocks. Specifically, the fact that short selling of stocks does not affect stock price makes us expect that short selling of money will not affect the value of money. I think this view is correct, but it puts me at odds with every economics textbook I have ever seen. The textbook view is that as borrowers (and their banks) create new money, they reduce the demand for base money, and this causes inflation. This is where things get weird, because the borrowers, being short in dollars, would gain from the very inflation that they caused! Nobody thinks this happens with GM stock, but just about everyone thinks that it happens with money.

If the textbooks are right, then the value of the dollar is determined by money supply and money demand, and not by the amount of backing the Fed holds against the dollars it has issued. For example, if the Fed has issued $100 of paper currency, and its assets are worth 30 ounces of silver, then the backing value of each paper dollar is 0.30 oz/$. But if the money supply and money demand curves intersect at a value of 1 oz/$, then the dollar will supposedly trade at a premium of 0.70 oz/$ over and above its backing value of 0.30 oz/$.

This is where short sellers pounce. They could borrow 10 dollars and sell them for 10 oz. of silver, as in figure 4. As they borrow dollars, the short sellers issue dollar-denominated IOUs that promise to repay $10 worth of assets (ignoring interest). These IOUs can either be used as money directly, or they can be traded for a bank's IOU, which could then be used as money. The proliferation of these IOUs will, on textbook principles, reduce the demand for the Fed’s paper currency, causing it to fall in value, let's say to 0.9 oz/$. Now the short sellers can repay their $10 loan with only 9 oz. of their silver, earning an arbitrage profit of 1 oz. (Note that they don't repay their loan with currency, since buying currency with silver would drive the dollar back up.). The short sellers profited from the inflation that they caused. As the short selling continues, the dollar will continue to fall until it reaches its backing value of 0.3 oz/$, at which point short selling is no longer profitable. (Reality check: Currency traders don't usually deal in silver. A more realistic scenario would have traders borrowing dollars and selling them for British bonds (denominated in pounds). This would reduce the monetary demand for dollars and the dollar would lose value, at which point the traders would swap their British bonds for depreciated US bonds, which they would use to repay their dollar loans.)

So here’s the problem with textbook monetary theory: If you think that money's value is determined by money supply and money demand, and that money trades at a premium over its backing value, then you'd have a hard time explaining how money holds its value in the face of speculative attacks by short sellers. You’d also have to wonder why central banks bother to hold any assets at all. But if you think that asset backing determines money's value, there's nothing to explain. Money's value is governed by its backing, just like stocks, bonds, and every other financial security, and short selling will not affect its value.