Short-Selling Ban Tomfoolery in Italy, Spain

NEW YORK ( TheStreet) -- You can always tell when stock market regulators have begun to panic. Beads of sweat form on their foreheads. Their hands tremble and their minds go blank. They experience memory loss. How else can you explain the decision of market regulators in Spain and Italy to reimpose a ban on short selling ( reported in the Chicago Tribune) that makes no logical sense?

Studies of previous short-selling bans have proven, time and time and time again, that short-selling bans are a bad idea. They're not just ineffective but do actual harm to investors and stock issuers alike.

Spain and Italy had both banned shorting last year and lifted the bans in February. "Given extreme volatility in European stock markets that could disturb the orderly functioning of financial activity it is necessary to review stock markets' operations in order to ensure financial stability," said a statement from Spain's market regulator, CNMV.

I can almost understand why market regulators do things like this. They have to do something, after all. The markets in those two countries are tanking. The political pressure must be intense. And short sellers are not exactly the most popular of market participants at any time, least of all when markets are falling and only shorts are making money.

The unspoken logic seems to be "If people who own stock can't make money, nobody can make money." The problem with this thinking, apart from its childishness, is the fact that banning shorting is as destructive as it is psychologically satisfying. It doesn't take a great financial genius to see why that is.

First of all, shorting enhances market liquidity. It means that people who dislike stocks are not just staying out of the market, but are participating, by selling stock that they've previously borrowed (or "located," under the increasingly strict rules governing such things).

Now, admittedly there's a cadre of people who just aren't comfortable with the mechanics of shorting, ancient as they are. Selling borrowed stock can temporarily expand the float of a stock. It also means that shareholders of dividend-paying stocks in the U.S. get "substitute payments" instead of dividends when their stocks are shorted. That's annoying, because substitute payments are taxed as ordinary income as not as dividends. It's not fair, and ought to be fixed.

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