Steve Waldman continues
the debate
about short-selling by looking at markets in ethical terms:
For a capital market to be "good", in a strong normative sense,
it ought to compensate predominantly those who make wise judgments about the
application of capital to real world enterprises, and to punish those who
make poor judgments… What distinguishes a good capital markets from a bad
capital market is how well it does the economy’s thinking.
I’m sure Steve is a paid-up utilitarian. But even still, I think "good"
is a bit of a strong word to use here, if you’re really using it "in a
strong normative sense". Because what he’s describing isn’t a good
market, so much as an efficient market.
Steve continues:
Bondholders absolutely do not "deserve" to get paid, any more than
stockholders, or holders of derivatives, or any other financial position.
A bondholder who lends to profligates to fund consumption, for example, absolutely
deserves to lose, coupon and principal. And an investor who finds a firm that
needs capital, and who correctly judges the firm’s activities and management
as being of the sort that could put capital to good real world use, absolutely
deserves to be paid, regardless of whether that payment comes in the form
of capital appreciation, dividends, or interest. The purpose of capital markets
is to compensate managers of capital for putting scarce resources to good
use, and to punish managers who squander what is precious.
This is an interesting take on markets. Bondholders do have a contractual
right to be paid, which is much more than stockholders. If they’re not
paid, they can take the debtor to court in order to enforce that right. When
I said that bondholders deserve to be paid, that’s what I meant. Similarly,
if a stockholder owns 10% of a company which is sold for $10 million, then that
stockholder deserves – and has a legal right to – $1 million. Without
these legal rights, markets could not exist.
What Steve’s doing is layering a separate set of moral rights on top of the
legal rights which underpin the market. Just as a good man deserves to go to
heaven and a bad man deserves to be punished, an efficient allocator of capital
deserves positive returns while someone who allocates capital badly deserves
to lose money.
On a purely descriptive level, there is truth here. A bondholder might have
a legal right to money, but if he lent money to a profligate who spent it all
and has nothing left, then that legal right and $1.50 will buy him a cup of
coffee. Meanwhile, an investor whose capital was used to generate high returns
will reap the benefit of those returns.
But such determinations can only ever be made ex post. A lucrative
investment is a good investment, and an investment where the portfolio
manager loses all his money is a bad investment. The question of who
deserves what never arises. There are surely lots of companies with solid managements
who can put capital to good real world use. Some of them will return a lot of
money to their investors; others won’t. It’s silly to say that all those investors,
ex ante, "deserve" to make money.
The genius of markets is that they’re emergent
systems. On a tick-by-tick level, they’re completely random. But as you
take steps back in terms of timeframes and sectors and the markets as a whole,
they look less and less random, and start exhibiting describable behavior. Investors
are people who believe that behavior is predictable enough that they can make
money from it. Sometimes they’re right, and sometimes they’re wrong. But there’s
no normative function whereby an investor can deserve to make money and yet
still lose it. There’s simply an emergent function whereby certain behaviors
(such as allocating capital in a way we now consider to be "efficient")
are, in aggregate if not individually, rewarded financially.
Steve, on the other hand, sees a difference between actions which deserve to
be rewarded, on the one hand, and actions which are rewarded, on the other.
I believe that well-designed markets generally are the best way to make most
large-scale economic allocation decisions, and that market-like systems could
be productively employed in a variety of other contexts as well. But current
capital markets are frankly off the rails, in a manner that most people not
subject to ideological blinders are perfectly capable of seeing.
The problem here is that in order to make a determination the capital markets
are "off the rails", you need to have some non-market-based idea of
what rails you’re talking about. Steve does actually get specific:
If I am right about bad things down the road, good capital markets should,
on average, compensate me if I trade on my superior-to-market knowledge of
future bad outcomes. The repricing brought about by my trading and the trading
of many others who see what I see should work to make those bad outcomes less
likely and less damaging… But markets that are systematically biased towards
integrating positive information and ignoring negative information (until
sudden "Wile E. Coyote" moments), that have institutional biases
against short-selling or that delay price declines because some actors have
more at stake in market prices than real-world referents, may, on average,
fail to compensate shorts. If so, then rational people won’t short, prices
far higher than reasonable economic value will be stable for long periods
of time, "greater fool" strategies of investment will be profitable,
and "adjustments" will come sharp, large, and painful when underlying
economic realities can no longer be papered over. Markets compensate next-to-last
fools in preference to wise allocators of capital, and leave everyone else
with a mess. That, unfortunately, is the world we live in today.
What Steve seems to be saying here is that he has in his mind the Platonic
ideal of a perfect market, which reflects economic realities with some great
accuracy. In such a market, there are no sudden and catastrophic crashes, which
means less pain in aggregate. In such a market, people who buy overvalued assets
will always suffer, since those assets will simply go down, rather than going
up first.
But it’s also worth wondering how an asset could ever be overvalued in the
first place, in such a market.
If you have infinite time and patience and money, and some faith that over
the long term markets will reflect economic realities, then it’s possible to
play the markets as though they behaved in accordance with Steve’s Platonic
ideal. But none of those criteria obtains, in this world. In this world,
the markets can stay irrational longer than you can remain solvent. (If Steve
can quote Keynes, so can I.) And there aren’t any Market Gods who are capriciously
punishing the wise and ill-timed. There’s just an emergent system, which sometimes
goes up and sometimes goes down. I wish you all luck in working out what’s coming
next.