Why Bans On Short-Selling Reduces Market Efficiency
"Today at our finance lecture one student asked the teacher the following question:
"Is there any negative effects for the economy by a banning short selling?"
And the teacher answered by saying that he didn't know or couldn't think of any negative effects by doing this.
My instinct though says that a banning of short-selling is NOT good for the economy but I cannot explain why. I don't have any arguments except that it interfers with the free market.
Do you have a better answer on this question?"
Yes, I do. Banning short-selling delays price adjustment to the correct value. The efficient market hypothesis is based on the assumption (as well as many other assumptions) that short-selling is possible. While I don't believe in the efficient market hypothesis for other reasons (that is, many of those other assumptions are wrong), it is correct in noting that the ability to sell short helps move markets closer to that ideal.
If a certain stock (or other asset) is overvalued, yet the people who realize this have already gotten out of the stock, then the way for them to correct this overvaluation is to sell the stock short. That way, these informed investors can bring the price closer to its fair value. But if short-selling is banned, this kind of adjustment can't take place.
Another aspect of this is that people who for some reason believe a certain stock is too cheap can use their money or even borrowed money to buy stocks they think are too cheap. Yet people who come to the conclusion that a certain stock is overvalued can't do anything about it unless they already owned the stock in the absence of short-selling. And even those that already owned the stock are limited to their stocks, while people bullish about the stock could possibly borrow to buy more of it. This creates an asymmetric situation where people bullish about a stock will have much greater influence than those that are bearish about it, which increases the risk that some stocks will be over-valued.
This would be similar to say an election where both Republicans and Democrats had the possibility of voting for the Republican candidate , but only those who had previously voted for the Republican candidate could vote for the Democrat, while previous Democratic voters who wanted to support the Democratic candidate could only have the option of abstaining from voting (abstaining from buying, so to speak) for the Republican. It should be obvious just how great bias for the Republican candidate this would create. Similarly, bans on short-selling creates a significant bias for bulls that distort stock prices and makes markets less efficient.