Shooting the Messenger European Style

Judging by the recent actions of European parliamentarians, one could be excused for thinking that the primary cause of the European sovereign debt crisis was short selling by foreign speculators in general and the existence of the small European Credit Default Swap market in particular. Since at the very time when the European sovereign debt crisis shows every sign of intensifying, European parliamentarians are now busying themselves with legislative proposals that would severely limit short selling of European sovereign debt.

And they do so despite recent separate findings of an ECOFIN task force, the IMF, and the OECD that there is no evidence to support the view that short selling played any significant role in the marked spread widening of the European periphery's sovereign debt over the past year. They also do so despite IMF and OECD warnings that curbing short sales is almost certain to hamper efficient price discovery and to blunt market discipline on the prevention of poor policy performance.

At times of serious economic and financial crises, politicians are wont to shirk responsibility for their policy errors and to seek scapegoats for their policy errors. European politicians are proving to be no exception to this tendency. For they refuse to acknowledge that years of fiscal profligacy or of unbridled housing market booms have rendered countries like Greece, Ireland, and Portugal to be for all intents and purposes insolvent. Instead, they choose to blame "the foreign locusts" in the financial markets for these countries' economic woes and they choose to address the symptoms rather than the causes of these countries' deep economic malaise.

Earlier this month, acting on the politically appealing narrative that financial market speculation by greedy foreigners has been the principal cause of the Euro-zone's sovereign debt crisis, the European Parliament voted to severely restrict short selling activity. It did so by voting to ban uncovered credit default swaps on sovereign debt and to effectively prohibit "naked" short selling of securities. The European Parliament's vote will now form the basis for negotiations with member states over the specifics of the new restrictions that, if approved by domestic parliaments, could come into effect over the next few months.

A dismaying aspect of the European Parliament's proposal to seriously restrict short selling is that it is not based on a shred of evidence that such short selling played any material role in the dramatic sovereign debt spread widening in Europe's periphery since Greece's admission in October 2009 that it had been consistently cooking the country's budget books. Indeed, a recent IMF study, which carefully examined the Euro-zone's spread widening, concluded that there was no strong evidence that short selling played any role in spread widening. Rather, the IMF found that the evidence suggests that most of the adverse spread movement in the current crisis is to be attributed to fundamental factors and to uncertainty due to partial or inadequate disclosure.

The findings of the IMF have been essentially echoed by similar studies by both the OECD and by a specially appointed European Commission task force. According to the European Commission study, it is implausible that the CDS market could have played much role in the spread widening since the total notional amount of European sovereign CDS's is around US$200 billion or only a small fraction of the European sovereign debt market.

It is equally dismaying that the European Parliament chooses to pay short shrift to IMF and OECD warnings about the potential long-run costs of severely curbing short selling. Based on a vast academic literature, these two institutions are forcefully arguing that reducing the potential to hedge positions runs the real risk of reducing liquidity in the sovereign debt market and of thereby raising government borrowing costs. On that basis, these institutions are arguing that any fears about abuses of short selling should be addressed not by blanket bans on such selling but rather by appropriate measures to enhance transparency, to ensure adequate collateralization, and to promote effective supervision practices in that market.

It would seem that if there was market failure over the past few years in the Euro-zone sovereign debt market it was the failure of markets to adequately discipline profligate governments in countries like Greece and Portugal through higher interest rates on their government borrowing. Similarly, it would seem that markets failed by providing the financing at very low interest rates that fueled the spectacular Irish and Spanish housing market bubbles. Before the European Parliament goes any further down the path of seriously curbing short selling, it might usefully ask itself whether such a ban might not do real damage by weakening the market's ability to discipline in a timely manner wayward governments or over-exuberant property developers.

Desmond Lachman is a resident fellow at AEI

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