Monday, September 01, 2008

Unintended Consequences of SEC Intervention

Bailout Economics 101

A new study by Arturo Bris shows (again) the futility of the government trying to fix its past mistakes, and how (again) trying to fix them just makes it worse. The SEC forbade "naked short selling" of certain stocks in order to keep the stock prices from going down. Of course this is the worst type of bailout (how special does one need be in order for the government to step-in and prevent people from selling your stock, its (again) the unfortunately always predictable socialized risk and privatized return of government financial market intervention !).

The SEC forbade the downward bidding of the implicitly government-backed (and now over time we are learning more and more explicitly-backed, just like those who follow these kind of things could have predicted. Not much in the economy is predictable, but government policy towards favored clients is pretty much predictable) mortgage-guarantee companies Fannie Mae and Freddie Mac and investment bank Lehman Brothers, among others.

Bris shows that this trade-forbidance did exactly what it was not intended to do which was to increase the value of the protected stocks. In fact the protected stocks performed worse than the un-protected stocks. This of course is counter to the laws of finance which says that risker stocks should perform better than less risky stock during a bounce-back period. The whole point of the short-selling (and all trading) is to let the market value the companies listed on an exchange. There is no way that government experts, due to the ' knowledge problem ' (ie the reason for the economic fall of the Soviet Union) can out-guess or outprice hundreds if not tens of thousands of experts in the finance field.

But more than that, government picking and choosing winners is just plain unethical. Why should government coercion be applied to favor certain people over others? Especially, as we have seen, the very very wealthy who have perhaps become that way knowing that they were to be bailed-out from any negative repercussions for excessive risky behaviour and would be able to keep personally any positive returns from this behaviour? This SEC case highlights two of the UCLA-school of economics operating principles; that of moral hazard and unintended consequences.