Like quantitative easing, short selling is a term with which few were acquainted prior to the financial crisis. Like most of the obscure financial terms that have appeared in the public consciousness since the credit crunch, short selling is controversial. Reckless and perfidious "speculators" who engage in short selling are often cited as the cause of woes for companies or countries in economic difficulty. These speculators provide an easy target for politicians, but the truth is a little more complicated - yet still easy enough for the average citizen to get to grips with, as we all must if we are to make sensible demands of our politicians in the future.

Short selling occurs when an investor - and it could be anyone from an individual to a large hedge fund or investment bank - places a financial bet that something will fall in value. This is as opposed to "going long" (no-one says "long selling" for some reason), which is where you bet that something will increase in value, like most conventional stock market traders do. Unlike these traditional "long" positions, when you short sell you actually stand to gain money if something declines in value.

The mechanics of how it works are quite simple, and need not detain us for long. The short seller first borrows something - say, shares in a company - from someone else, agreeing that they will return the shares to the owner at a later date. The short seller then sells the shares and pockets and cash. When the time comes around to give the shares back to the owner, the short seller buys some shares from the open market with which to repay his debt. If the cost he buys at is less than the cost he sold at, he makes money. Nice work if you can get it.

Profiting from someone else's misery is never going to be popular, and short selling is not popular. When something declines in value, someone somewhere is experiencing economic pain, and it seems to many people to introduce perverse incentives into the financial system when people can profit from downturns as well as upturns. Of course, in truth, someone somewhere always profits from downturns as well - if oil companies crash then gas companies are probably doing quite well, and so on. But when entire countries are hurting - like Greece, for instance - it seems perverse indeed for someone to be profiting. This is partly why short selling financial stocks was banned in the United States at the peak of the financial crisis - it seemed a democratic outrage that people could profit from shorting Lehman Brothers as the economy collapsed.

There are yet other reasons that short selling is demonized, of which two are worth mentioning. Data is available about how much shorting is occurring on certain assets at any given point in time. For instance, at the moment, we know that more money is bet on a decline in the euro than at any point before in its history. This is highly politically inconvenient for those who wish to protect the value of the euro, and the fact that everyone else knows it is even worse, because it greatly undermines confidence. If short selling reaches a high enough crescendo, it is easy to see how it could become a self-fulfilling prophecy: as short trades on the euro pile up, still more people will sell the currency because they will be unwilling to bet against the accumulated wisdom of the market.

The final and least morally-ambiguous point which can be raised against short selling is that it creates the possibility for large financial institutions to reap huge profits by shorting something and then themselves doing something which brings about a decline in the value of that asset. Creating these sorts of incentives for economic destruction are what regulators fear the most.

What, then, can be said in defence of short selling? Actually quite a lot. Short selling is important in what economists call the "price-discovery mechanism", which means the correct valuation of assets like stocks or bonds. If people are shorting something, then they usually have a good reason for believing it will decline in value - after all, if it increases in value instead, they would lose money. It may be politically inconvenient for a country like Greece to have its bonds shorted - which means investors are betting Greece will find it more difficult to borrow money - but it happens because the market has lost faith in the country's ability to repay its debt. Trying to hide this fact only causes everyone more pain in the long run.

Hence, while it is important to regulate against the sort of economic vandalism described above and prevent investors actively creating misery for profit, short selling has an important part to play in the efficient allocation of money in an economy. When the economic fundamentals of a company or a country are not good, attempts to hide the truth will only spook investors further and make the situation worse. This is why Germany's decision to ban certain types of short selling yesterday caused a dramatic drop in the value of the euro, as investors conclude that the situation must be dire indeed if the country has to ban the wisdom of investors from being expressed. By revealing uncomfortable truths, short selling helps us confront them sooner. It is hence to be applauded, within limits.

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