Why Mrs Europe is bashing the bankers

The eurozone crisis is so serious that it threatens the European Union itself. German chancellor Angela Merkel said last week: ‘The current crisis facing the euro is the biggest test Europe has faced in decades. It is an existential test and it must be overcome. If the euro fails, then Europe fails.’

And so how did ‘Mrs Europe’, the leader of the eurozone’s largest economy, respond to this ‘existential’ crisis? By making a token gesture against financial speculators. Last week, Merkel joined the ranks of other Western politicians in blaming financiers for the economic mess and deflecting attention from themselves. And in acting unilaterally, the German government managed to anger its European partners and cause mayhem in the financial markets across the world.

Specifically, the German finance ministry imposed a temporary ban on ‘naked short selling’. Germany now prohibits the shorting of eurozone government bonds and the stock prices of 10 German financial companies, as well as sovereign credit default swaps.

The financial world uses arcane terminology that can be confusing. The key point to remember is that to ‘short’ is essentially to bet that the price of a stock or bond will decline. ‘Naked’ in this context is not as intriguing as it sounds: it refers to placing a bet without owning or borrowing shares or bonds. A ‘swap’ is not really a trade, but rather a form of insurance. ‘Sovereign’ refers to a country, and ‘credit default’ refers to debt – just as you can buy house insurance that would pay out if the house burns down, you can buy insurance against a decline in a country’s bond prices.

Germany’s financial regulator said that its purpose was to prevent speculators from ‘threatening the stability of the entire financial system’. Germany is not the first to target short-sellers. Shorts are often accused of spreading false rumours about companies, with the aim of driving down the stock. It is claimed that short-sellers, when operating en masse, can cause a market downturn. In the midst of the financial meltdown in autumn 2008, the US Securities and Exchange Commission (SEC) introduced a temporary ban on short-selling in certain stocks. In February of this year, the SEC placed a permanent restriction on short-selling stocks that are falling rapidly (at least 10 per cent in a day).

But bans on short-selling are misguided, for a number of reasons. For a start, they are illogical: there are no comparable restrictions on bets that stock prices will rise. Short-selling is also recognised in the financial arena as a normal part of portfolio management, to balance or ‘hedge’ against other investments. Moreover, there is no research that suggests that short-selling in itself leads to large downturns in the market as a whole, as the German regulators and others contend.

Historically, it has been primarily the weaker-performing companies that complain about short-selling, as they seek protection from the market’s negative verdicts. A prime example is Lehman Brothers. As described in Andrew Ross Sorkin’s Too Big to Fail, CEO Richard Fuld and others in the company continually blamed short-sellers and demanded that the government curb them. But it was a short-seller, David Einhorn of Greenlight Capital, who first blew the whistle on Lehman, pointing out that its accounting did not add up. The report from Lehman’s bankruptcy examiner, Anton Valukas, detailed the dodgy accounting tricks and essentially vindicated Einhorn and other critics.

Indeed, it has also become axiomatic that, once a company starts complaining about short-selling, it is a pretty good sign that they are in big trouble. If anything, short-sellers are arguably a benefit to the market, as they provide valuable information about poor-performing companies. Bans on short-sellers are borne of fear that the withdrawal of support for these poorer-performing companies could spin out of control. Ultimately, placing such curbs is a sign of a capitalism that wants to be protected rather than to live and die by the market. But restrictions on short-selling only delay the process; they do not solve the fundamental issues giving rise to the poor performance in the first place.

To put it bluntly: curbing short-selling is shooting the messenger bearing bad news. If a company or economy is in trouble, eventually the markets, including pure speculators, will turn against it.

In Germany’s case, the ban seems to suggest that evil speculators are to blame for the European crisis, rather than excessive credit expansion and debt, as well as underlying problems of competitiveness in the ‘real’ economy. And in this regard, it is worth emphasising that Europe’s current problems do not just emanate from overextended southern European countries like Greece; it’s just as much a problem of the banks in the largest economies, like those in Germany and France, that lent to the smaller ones. As historian Niall Ferguson rightly notes with regard to the €750billion rescue package: ‘This bailout wasn’t done to help the Greeks; it was done to help the French and German banks.’

Blaming speculators also let politicians off the hook for their role. Politicians in Germany and elsewhere portray themselves as victims of the market, struggling to cope, rather than admitting that they are now facing the consequences of their own earlier decisions. In grasping at cheap populist gestures like short-selling bans, politicians like Merkel are only trying to divert attention from their own cluelessness about how to deal with the crisis.

In the German context, the ban on short-selling is truly a token measure. Shorting of the 10 financial company stocks has, in fact, declined since the beginning of the year. According to Eurointelligence, ‘The political idea is to show one’s determination against the greedy speculators who are apparently destabilising the euro. The problem is only that there is hardly any CDS [credit default sway] trading in Germany. Most of it is in the UK.’ And the ban can be easily circumvented by trading from outside of Germany. All in all, it is heavy in symbolism, and not very meaningful in practice.

Merkel no doubt thought there would be political advantage in adopting a ban, but it was quickly derided as a cock-up and evidence that she is out of control. Taking such a step unilaterally angered other European Union members. Christine Lagarde, France’s finance minister, was especially critical, saying Berlin should have conferred with other countries in advance. Germany’s decision also furthered rumours that the eurozone was on the road to break-up. Following the German announcement, the Financial Times noted: ‘Investors now fret that Berlin would not have acted unless it knew something the markets did not. It would be ironic if this misdirected measure had the effect of summoning up the very wolf pack it sought to defer.’ Sure enough, the next day stock prices plummeted globally, in large part due to a sense that Europe lacked political leadership and unity. In witnessing moves like short-selling bans, investors see a panicked and divided political class in Europe, and wonder if the eurozone is cracking up.

The Financial Times and others believe that the ban was necessary for political reasons, in order to obtain agreement on Germany’s contribution to the eurozone aid package in parliament, which it did on Friday. In other words, it provided political cover to bring reluctant members on board, in the face of domestic opposition to what is perceived by many as a bailout for the Greeks. That may be true, but if so it is a cynical way to operate, and it will ultimately undermine confidence in political leaders’ intentions. And the financial markets will take a lesson that politicians are prone to act in arbitrary ways and accordingly add a risk premium.

Germany is not alone in blaming the financiers; as mentioned, American officials have taken pot shots at the shorts, too. Britain is not joining in the ban on short-selling, at least for now: asked about the ban during his visit to Germany to meet with Merkel, British prime minister David Cameron said that the issue was one for the UK Financial Services Authority to decide. But representatives of all three British parties have indulged in banker-bashing – it’s just taken a different form than short-selling bans.

German, American and British politicians are all ready and willing to play the blame game and seek to scapegoat financiers. This shows that the Western political class is more concerned about their own careers than they are in facing up to the tough decisions needed to address the crisis. Many more may soon join investors in seeing that Europe’s predicament is as much a political crisis as it is an economic one.

Sean Collins is a writer based in New York. Read his blog, The American Situation, here.