What does a fortnight of share-trading turbulence in the United States tell us about the operation of financial markets in countries such as the United States and Australia, where the finance sector plays an increasingly outsized role?
In recent weeks, US share markets have been thrown into chaos by a group of small-scale speculators gathered on a subgroup of the Reddit social media site, called WallStreetBets. With coordinated buying of shares and plenty of publicity, they bid up the prices of shares in GameStop, a computer games shop, and AMC, a struggling theatre chain. Both companies had been subject to extensive "short selling" by large investment managers, most notably Melvin Capital, a firm based in New York with assets of US$8 billion.
Short sellers sell shares they have borrowed rather than bought. Their hope is that they will be able to repurchase the shares at a lower price by the time they need to return them to the lender. (In an older form of short selling, the "naked short," speculators simply sold shares without borrowing them first, hoping to cover their positions in time to deliver the shares they had promised. This practice was banned after the global financial crisis.)
By bidding up the prices of GameStop and AMC, the Redditors executed a "short squeeze," forcing Melvin Capital and other short sellers to pay much higher prices for the shares they had borrowed and then sold. The short sellers lost billions of dollars in the process.
For most of the participants in this attack, the share market looks like a casino rigged in favour of the big operators. The short squeeze was their chance to turn the tables, much as Tom Cruise's character did on casinos in the movie Rain Man.
The view that the share market was rigged gained credence when Robinhood, the online brokerage used by many of the Redditors, halted trading in GameStop, AMC and other securities. According to Robinhood, the restrictions became necessary after clearing houses raising the required capital reserves it needed to hold in order to execute share trades. This Redditor response, quoted in the New York Times, was typical: "We're living in a system where there's no such thing as justice anymore and the entire world is falling apart. Nothing really matters, so we might as well try to have fun while we're here."
As the action subsided, it became clear that, for the most part, the big guys had won again. Large-scale investors who held shares in the companies before the squeeze began were able to sell part of their holdings, reaping massive profits.
Once you strip away newsworthy bits like the role of Reddit and the scale of the price movement, this kind of squeeze can be organised by, and potentially profit, any group of traders.
Thanks to the increase in its share price, AMC was able to issue new shares, using the proceeds to repay debt and thereby stave off impending bankruptcy. AMC's bounce-back showed that the share market is not simply a casino, even if many participants view it that way. Corporations depend on equity capital to provide the capital they need for investment, and this is ultimately raised by selling shares.
Most of the time this link is obscured. New investment is typically financed from retained earnings rather than new share issues. But the capacity of firms to borrow depends on their share market value. And if a firm's share price is below the value of its capital, it will be a target for takeover, with the assets being stripped and sold.
More importantly, perhaps, AMC's luck in being the target of the short squeeze meant the difference between survival and bankruptcy. I don't have a view on whether AMC should go bankrupt, but this is the kind of decision about capital allocation that is driven in large measure by share markets. The idea is that investors direct equity capital to those corporations that can put it to its most profitable use.
The efficient markets hypothesis, the bedrock theory of modern financialised capitalism, says that share markets do the best possible job of estimating the value of assets, and thereby guiding the allocation of capital. Before the WallStreetBets push, the market had judged it would be better to steer capital away from AMC and into some other activity. During the push, the pressure was in the other direction.
One possible response is that WallStreetBets is an episode of craziness that will soon pass. But once you strip away newsworthy bits like the role of Reddit and the scale of the price movement, this kind of squeeze (or, conversely, a short-selling raid) can be organised by, and potentially profit, any group of traders who can mobilise the necessary few billion dollars. (Using options, those billions can be magnified a fair way.) That's part of the reason why share prices are far more volatile than would seem justified by the arrival of new information relative to future earnings.
If share prices are more volatile than underlying value, the two must differ most of the time - a fact that undermines the frequent claim that financial markets do a better job of allocating investment capital than, for example, a government enterprise using the techniques of benefit-cost analysis to choose its projects. And that, in turn, undermines the economic case for privatisation, which was central to the era of economic reform that began in the 1980s and 1990s and ended in the global financial crisis.
We haven't yet worked out how to deal with the failed model under which we are still operating.
But, as the greatest of all 20thcentury economists, John Maynard Keynes (himself a successful speculator), observed, "When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done."
- John Quiggin is a professor of economics at the University of Queensland and a columnist with Inside Story, where this article also appears.