The Adani Group is terribly annoyed with Hindenburg for telling us all that they have worries about the finances of the Adani Group. That's also a fair reaction as Adani Group shares lost $113 billion in value at one point. That'll put a dent in any fortune.
But what about the rest of us, what should we think about all of this? Give thanks for short sellers would be the appropriate reaction.
There are a lot of people who insist that short selling -- selling shares you don't own in the hope of buying them back cheaper -- is a really bad idea. It doesn't aid in financing companies at all and therefore should be banned. This is to miss the point entirely, and Hindenburg is an excellent example of why this is so.
A few years back Robert Shiller gained the Nobel for economics. This was soon after the great financial crash which most thought was brought on by excessive speculation in the financial markets. Shiller argued that the real cause was not enough speculation. Gotta be contrarian to get a Nobel these days.
His actual analysis was that you could “go long” housing. You could buy a house for example. Or buy the shares of mortgage companies, or buy mortgage bonds and so on. But you couldn't go short housing. You can't sell a house you don't own -- well, not without gaining your next housing in a prison.
The problem was that all those who bet that houses would increase in price could do so. But none of those who wanted to bet on house price falls could do so. So, the market was unbalanced, we were only hearing one side of the story.
This is why when people did bet short, as in that movie “The Big Short,” they did so on mortgage bonds -- it wasn't possible to do it with houses, the real thing.
Shiller then went on that if people had been able to go short housing then the bubble wouldn't have got so far and the crash would have been much smaller. So, his advice was that we should have more speculation in housing, not less. He's right, too.
This is also what is at the heart of what Hindenburg is doing. Or the value to us of what they're doing. Entirely leave aside whether their claims about Adani are true or are a pack of lies. What short selling allows is people to profit from checking whether a company's accounts are correct or not.
The incentive to do the research, to write the report, is to make that profit from the shares falling in value upon publication. So, we've now an incentive for people to check the claims made by corporations. Good.
If we ban short selling then we remove the incentive to check, which would be bad.
This good outcome remains even if the report itself is wrong. For what we want, in any market price setting process, is the views of everyone. This is known as the Wisdom of the Crowds, or even Galton's Ox. Galton had noticed a game played at a fair -- guess the weight of the cow. Each individual could be and often was wildly wrong.
But when you averaged out all of the guesses -- and it had to be all of them -- then the result was very close to the correct answer. And, if you deliberately excluded some answers for being obviously wrong, then so was the average result.
That is, to get prices right in a market we need the views of all. Those who think a company is just lovely and going to rise strongly, but also those who insist it's all a house of cards. Even when peoples' views are wrong we still need them in that process of reaching the correct answer.
So, we want to have the views expressed which are against the company valuation. Being able to sell short -- being right from thinking the shares will fall -- provides that incentive. For who would do all the work to try to show some story isn't right if there was no profit to be made from doing so?
The point here is not that Hindenburg is right about Adani, nor that it's wrong. I have no clue either way, not my area of expertise or knowledge at all. Instead, the point is that a system which hears all views is the only way we gain correct market prices. Therefore the system of incentives that being able to short sell provides is useful to us all, for it sparks the research of Hindenburg. Even if not happy news for the Adani Group.
Tim Worstall is a senior fellow at the Adam Smith Institute in London.
