How to deal with mass short-selling in a mature way

Spain has recently banned the short selling of its debt (government bonds). This move has been greatly critized by many analysts as shooting the messenger instead of solving the problem. But isn't shortselling part of the problem? That's what I will discuss in this post (hint: things are always more complex here..)

Short selling, or shorting, is the process of selling an asset that you don't posses.  This wikipedia page explains it all quite well. The short version: When you short you sell an asset that you have borrowed. Later you buy that same asset and return it to the borrower. With this proces you're actually betting on a decrease in value. A more devious business is naked shorting where you do not borrow the asset but sell it anyway. After the asset has decreased in price you quickly buy it and complete the previous selling transaction

Interestingly shorting is a neutral action, since there is both a selling and a buying transaction. This also holds true for naked shorting. It is because of this that traditional economics expects no long term effects from these practices. Actually shorting increases the value of the asset for two reasons. The first is that the buying and selling transactions create more liquidity in the market, giving other players the opportunity to easily buy and sell that asset. The other enhancing value is that it allows players to lend their assets to these speculators and thereby increasing the return of it.

So if shorting is good for the value of the underlying stock, why ban it? First massive shorting creates a surge of assets on sale thus depressing the price. This is later compensated, but it will depress the price for some time. In the case of naked shorting the number of assets on sale can actually be larger than the total number of assets, leading to a very unstable market.  There is also a psychological issue: massive shorting signals a distrust in the asset, and issuers of the asset (e.g. the Spanish government) generally do not like that.

Thus it seems that banning shorting is in fact shooting the messenger, but it is not the whole story. The financial markets have another unnamed aspect: uncertainty. Most players, mainly conservative ones, rely on other players to gain information on an asset. When an asset is massively shorted, many long term players will also leave the market out of fear that there is unknown information. Even if the players don't leave immediately the strong variations in price, due to massive buying and selling, will create a distrust by themselves. Therefore massive shorting does actually bring down the value of an asset.

There are many ways to deal with shorting: the most mature way is to accept shorting as an inevitable side effect of trading in your asset. For most cases shoring does not affect the price of the asset in a great matter itself. However there are cases were action needs to be taken.

This is when a massive shorting campaign on your asset is taking place. Simply banning the shorting of your asset will drive out most long term holders, since they can't rely on the liquidity and the extra income provided by shorting. This will then result in a non-neutral action on your asset driving prices further down. Even worse, since long term holders do not like to be in your asset anymore the price will remain depressed.

The only other way is to keep the price from your asset up, since shorting and especially naked shorting is often only for a small period of time. It is only necessarily to keep the price up for some time. This can be done by buying up the asset under covert plans. By doing so you actually reward the holders of your asset while you punish those that doubt you. Precisely what you'd want to achieve. Therefore don't ban the shorting of the stock but strongly discourage massive shorting.      

The real problem with economics

Abstract: I believe that economics should focus more external validation of models. It's refusal leads to an economic religion. With implementation of economic theories local factors and alternatives should be more prominent. If you want to know why, please read the rest of the article. 

For some time now, the attack on economics as a science has been made by the media, the politicians and even economists themselves. The main focus here is on mainstream macro-economics (aka neoclassical economics).  People criticize the simplistic nature of the science and mainly the weird assumptions that are being made. Now it is true that perfect rationality, homo economus, perfect competition perfect information and such do not actually exist. In fact they don't exist anywhere in the real world. But in my opinion and that, this is not the real problem

To assess the actual problem it is useful to compare economics to the science it wants to be: physics. In physics some very weird assumptions are also made: the existence of holes with negative mass in electric currents is but one example. Also extreme simplifications of reality are present: no gravity, no friction, no air, infinite time to relax a system and many others. Yet physics is not in any distress at the moment. Weird underlying simplifications and assumptions could not possibly be the only explanation then.

In fact economists are not that protective of their assumptions either. When I discuss with a more traditional economist, I find that challenging assumptions and replacing them with more realistic ones can often be achieved quite simply. This often happens when I introduce evolutionary models to them. Assumptions and simplicity are simply not the main culprit here.
Also the mathematical way of structuring the models, another thing critiqued by some, seems to work out reasonably well.  After all what better tools do we have that can provide such internal validity to any science?

The validation of the science is touching a critical part here. The external validation is where economics and physics diverge. In physics anything that can not be proven will remain a good theory, but not an absolute one, until proof is found. This is why we spend billions of euros on the CERN complex with a primary goal of proving the existence of the Higgs boson. Regardless of the field of physics this almost always holds true (fields in which this doesn't hold are often ridiculed by other for providing mathematical fantasies).

Economics is rather different. It is true that there are a lot of people, some of which great economists, working on external validation. This is not the problem. However, the main divide in economics seems to be occurring not between economists of different traditions (Classical, Keynesian, Austrian, Evolutionary etc.) but between those that make models and those that look at the real world. This leads to a situation in which great models are made but are never tested thoroughly. And great discoveries that are made in economic data and also within other sciences are not seriously being taken into economic models.  Rather they are added as outside features. This leads to so called fads, Naim has a good paper on this from the asia crisis.

The sad thing what then happens, is that models that were introduced with a very good intent are being used in the wrong way. They are also never really validated or adapted to new insights. In fact they are even more simplified into one concept or idea. Some examples are 'the free market' (Neoliberals), 'stimulus' (Keynesians) and 'class warfare' (Marxists).  This then leads to an orthodoxy and dogma in the economics science that borders on religion. This is most visible and most painful in the economic experiments from the 20th century.

It is therefore not a coincidence that I chose a paper about developing economies when it comes to fads. This is usually where the dissonance between economic macro theories and reality is often the most visible. Also this is where economic religions cause the most harm. A good example of this is the free market paradigm that is presented by neo-liberals. Look at Russia and the former Warsaw pact after the fall of the iron curtain.  If you want to know how the 'stimulus' experiment is working out just look at the US or for more historic reference: Japan. Finally the Marxist experiment (communism) does not need further introduction. 

The main issue with all of this is that the real world experiences are not used to update, alter or refine the existing theories. At the current time economists are still calling for free markets and stimulus, even though history has already shown that the economy does not behave according to these grand concepts.

In an additional note it is often astonishing how economic macro theory often fails to appreciate the different structures that are present in the economy. In a previous post I have addressed different institutions and their impact on economies. But not only institutions are different: culture and history are also of major influence of the economic workings in a country. Therefore a policy that succeeds in one country can fail completely in another even when economic factors (capital, labor etc.) are similar. I would still like to see a push into adapting global theories more into local contexts and also local experiences adapting the global theories.

In conclusion, the economic science needs to change. This change is not  better models or better data collection but a better communication between the two. This will actually lead to better models and better data to work with. Local contexts are important and are often missing completely from the theories. They should at least add to them that a given theory is only valid under a certain underlying structure of the economic system.

A final note: I don't think it is actually possible to find a grand unified economic theory as we can find it in physics. People are not electrons and at times behave unpredictably, also when in groups. Therefore be very wary when an economic solution is offered that can be summarized in one term. The world is just not that simple. This should not stop us from finding increasingly better ways to model economics as by doing so we can improve many lives.

The economics of the complaints book

We all know the feeling: you enter into a restaurant on a trip, things look well from the outside but when you enter things are quite different. The staff is rude; you are not being serviced; the food is cold/raw/burned/rotten and at the end you get a bill that is at least 50% more than the menu said. In most cases this is an exercise in bitter helplessness: you don't want to sue them because it is to small. Also you can't use your economic position, since you weren't really planning on coming back there in any case.

Enter the complaints book, a neat innovation from Portugal. The complaints book (livro do reclamações)  lets you file an official complaint against the business that has wronged you. This is how it works(the short version): you file a complaint in the book, the complaint is send to a smaller court. If you're complaint is deemed valid, the business is fined. Nothing to major for first offences, but in any case way more than they ever made of wronging you. For repeated offenders the fines get quite severe, up until forced closing. The system also has a safety in it: if you file a bogus complaint you will get fined.

So what does this mean from an economic perspective? Let's first assume that some people have been wronged enough for them to get a satisfaction out of writing it in the book. Even though it does not give them any direct benefits (like money or higher social status), psychologically it certainly does pay off.  I would call this  'revenge utility'.

Eventually these people complain enough for some businesses to get fines. This affects the selection environment leading to companies that will less frequently wrong customers. The higher the fines and the higher the propensity for customers to file a complaint, the faster this process will be. However this could lead to a situation where only non-risk seeking companies are left, therefore there needs to be some minimum level of wronging present (e.g. a minimum time waiting or a minimum threshold of bad food).

This can be instated by raising the difficulty of filing the complaint. This will mean that more wronging needs to be done for people to acquire enough 'revenge-utility' to make the complaint.  Or alternatively by simply instating minimum requirements. In practice both of these mechanisms are there. However the first one also reduces the frequency of complaining, thus reducing the speed evolutionary process.

But there is another thing that might happen: the customer might be bought of from filling his complaint. This can be done by giving him a free meal or just being very kind to him. In the case of actually providing services this creates a nice situation: the customer can replace 'revenge-utility' with real utility. This makes a nice two player game where the company needs to make sure it always outbids the revenge appetite of the customer and will therefore always overbid. In any case even if the book is not filled in the customer still gets refunded.

In conclusion: the complaints book reduces the number of bad experiences for customers by changing the system of companies through evolutionary systems. It gives customers the chance of being compensated properly for the wronging occurred. And if all else fails the book provides a 'revenge utility' to the angry customer. I think this is one of the better innovations of the last decade and I would like to see a European wide implementation of the system.