Snake Oil Economics
Why Jon Stewart and Jim Cramer are both wrong about short-selling
"Look, we are both snake oil salesmen to a certain extent, but we do label the show as snake oil here. Isn't there a problem with selling snake oil and labeling it as vitamin tonic."
So spoke Jon Stewart during The Daily Show's recent "Brawl Street" segment, where Mad Money host Jim Cramer appeared to settle his high-profile feud with Stewart and came away, according to a general consensus, with his proverbial tail between his legs.
Stewart hammered Cramer and CNBC for taking so long to report the warning signs of impending financial disaster. For his part, Cramer begged for mercy and promised to be more of an advocate for small investors against Wall Street. "Absolutely, we could do better," he apologized, claiming he was shocked that "a lot of CEOs lied to me on the show…. I want kangaroo courts for these guys."
At the end, Stewart convinced Cramer to agree to a "deal" where, in Stewart's terms, CNBC gets "back to fundamentals on reporting…and I can go back to making fart noises and funny faces."
Yet for all of the kudos Stewart received for holding Cramer's feet to the fire, Stewart actually enabled Cramer to sell Daily Show viewers another type of economic snake oil: The false notion that short-sellers are a major cause of market downturns and should be severely restricted. "I have been trying to rein in short-selling, trying to expose what really happens," Cramer told Stewart. Curtailing short-selling, Cramer continued, "would cut down a lot of the games that you are talking about."
Short-selling figured prominently in the segment due to Stewart's airing of a 2006 interview Cramer did with The Street.com, where he recalled his past exploits as a hedge fund manager. In that interview, the hard-edged Cramer spoke with a sort of cynical bravado about sophisticated hedge fund strategies. It was a night-and-day contrast to the sunny television personality shouting "Buy! Buy! Buy!"
More notably, Cramer bragged about engaging in the very short-selling he now decries. He said he was often "position short" at his hedge fund, claiming "it is a very quick way to make money and very satisfying." He also said it was "very important to spread the rumor" and get out bad news about the company one is shorting.
Stewart was at once impressed and disgusted by this side of Cramer: "The gentleman on that video is a sober, rational individual. And the gentleman on Mad Money is throwing plastic cows through his legs and shouting, 'Sell! Sell! Sell!'… I can't reconcile the brilliance and knowledge you have of the intricacies of the market with the crazy bullshit you do every night."
Stewart then lectured Cramer indignantly about the insidiousness of those shorting strategies: "When I watch that, I can't tell you how angry I get…. You can draw a straight line form those shenanigans to the stuff that was being pulled at Bear and AIG and all this derivative market stuff that is this weird Wall Street side bet." He emphasized to his guest, "I want the Jim Cramer on CNBC to protect me from that Jim Cramer."
Yet it is precisely "that Jim Cramer"—and others who go against the grain by short-selling—who Stewart should be celebrating if he wants to deflate future bubbles. In the recent real estate run-up, the main problem with shorting and other "side bets" is that there weren't enough of them.
One of the most common forms of short-selling is borrowing shares from a broker, buying them back when the price drops, and pocketing the profits. There's a great risk of failure involved, of course, but short-sellers also send very important market signals about both individual companies and the economy as a whole. Most economists—both liberal and conservative—have seen shorts as a valuable counterweight to the market euphoria that creates bubbles.
As New Yorker business writer James Surowiecki observes in The Wisdom of Crowds, if the price of a stock "represents a weighted average of investors' judgments, it's more likely to be accurate if those investors aren't all cut from the same cloth." And as John Tamny, economist and editor of RealClearMarkets, writes in Forbes, "Short-sellers provide information, or what some call "feedback," to investors, (and) when their activities are made illegal, information that is necessary to correctly price securities is lost."
Indeed, in the mortgage bubble, short-sellers provided some of the earliest warnings about flaws in mortgage lending, securitization models, and the credit ratings process. According to The New York Times, William Ackman—who heads the hedge fund Pershing Square Capital Management and made a fortune shorting companies involved in subprime lending—publicly spelled out such risks as early as 2002. "What I said at the time to regulators and anyone who would listen is that this is a problem now, but it's going to be a bigger problem later," Ackman recalled in 2007.
Do short-sellers spread bad news, including rumors, about the companies they target in hopes of driving the stock price down, as Cramer described in his 2006 interview? Yes. But this bad news is exactly what Stewart and other commentators say should have been reported more often during the mortgage boom. Does it really matter if the information comes from parties who gain from it, so long as it balances the euphoria about "the next big thing"?
Unfortunately, Cramer seems to have influenced Stewart and his writers to spend more time bashing shorts. On a Daily Show episode a few days after the Stewart-Cramer confrontation, correspondent Samantha Bee lampooned the supposed evils of short-selling. Her segment featured a CEO who likened short-sellers to people who take out fire insurance on certain buildings and then burn them.
But in the mortgage bubble as in others, it was the companies themselves (aided and abetted by "pro-housing" government-created institutions such as Fannie Mae and Freddie Mac) that did the "burning" through their foolish practices. Short-sellers simply noticed the fire, spread the word, and profited from it.
Thanks to outdated restrictions on shorting for common investment vehicles such as mutual funds (compared to hedge funds that rely on an exemption for wealthy "accredited investors" that allows greater risk), however, middle-class investors were unable to enjoy many of the benefits of short-selling.
So rather than reining in hedge funds, lawmakers should liberate mutual funds from short-selling restrictions, which will produce both direct benefits for ordinary pension holders and the indirect benefit of having more shorts available to pop bubbles before they get too big.
Before Jon Stewart goes "back to making fart noises and funny faces," he should set the record straight on short-selling. Otherwise, Jim Cramer will have won and the joke will be on the American economy.