Selling Short: The Morals and Economics of Margins
I
OF all the transactions which take place on the great stock and produce exchanges, that which is known as ‘short selling’ seems most mysterious. Perhaps that is why it is popularly regarded with so much suspicion. Certainly more hostile legislation is aimed at short selling than at anything else which takes place on the exchanges.
In the widest possible sense you sell short when you sell something of which you are ‘short.’ You are short of what you sell if you do not own it, or if you do not own as much of it as you sell. There is, however, a narrower and more specialized meaning of short selling. You are short in this special sense if you sell something which you cannot possibly deliver, or more of it than you can possibly deliver. It is this specialized form of short selling which does whatever mischief is done, and against which popular criticism, if it is discriminating, is aimed. It is useless, not to say disingenuous, to confuse the issue by trying to divert attention from this form of short selling to the other forms.
Ordinarily it would be regarded, both by popular and by expert judgment, as fraudulent to sell or contract to sell something which you cannot possibly deliver. The sharper who sells or pretends to sell the State House to a greenhorn is a short seller in this sense. It is fraudulent because, of course, he does not intend to deliver what he has sold. If haled into court he could not successfully plead that he fully intended to fulfill his contract, because everybody would know that he could not do so even if he wanted to.
There is really no comparison between this sharper and the wheat grower who sells or contracts to sell his crop before it is harvested, the tailor who contracts to sell a suit of clothes before it is made, or a factory which sells its product before it is manufactured. On the stock exchanges, however, it is possible not only to buy more than you can possibly pay for, but also to sell for immediate delivery not only what you do not own but more than you can possibly deliver. Both these feats are made possible by the highly developed system of buying and selling on margins.
II
There are two legally recognized forms of short selling on the exchanges — first, selling for future delivery, and second, selling for immediate delivery. Selling for future delivery is the prevailing form on the produce exchanges. It is called ’trading in futures.’ Selling for immediate delivery is the prevailing form on the stock exchanges. Immediate delivery is commonly defined as delivery before 2.15 P.M. on the day following the sale.
Selling for future delivery presents no real difficulty to the understanding.
It will be noticed that all cases of short selling of their own products by producers are sales, or contracts to sell, for future and not for immediate delivery. One may contract to deliver at some future time a thing which he does not now possess, provided he knows that he can either produce it or buy it in time to make the delivery. Such a transaction is easily understood and excites no suspicion. Such is the case of the dairyman who sells his milk, or contracts to deliver it, at a stipulated price, long before it is produced.
The speculator on the produce exchange who contracts to sell at some future time wheat which he does not own and does not intend to grow is also a short seller. He is not quite like either the sharper or the wheat grower who sells his own crop short, though he resembles the grower more closely than the sharper. While he does not have and does not intend to grow the wheat which he has contracted to deliver, he may have reason to believe that he can fulfill his contract if the buyer wants him to. He may, when the time comes, buy wheat on the market and deliver it to the buyer and thus defraud nobody. If, however, he has contracted to deliver more wheat than he has money enough or credit enough to buy, he may find himself in a tight place. If someone should corner the market by getting control of all the wheat, and through this control should be able to dictate prices, the short seller might find it very expensive to fulfill his contract. He is in a position to be ‘squeezed.’ ‘Squeezing the shorts’ is a pleasant pastime for those who are so situated that they can thus amuse or enrich themselves. It is fair to say, however, that it is seldom successfully done.
Why is short selling almost wholly confined to the exchanges? All legally recognized forms of short selling on a large scale are limited to special classes of commodities. Such commodities are sometimes called ‘fungible goods’ by lawyers and other learned persons. Fungible goods are goods which are so thoroughly graded and classified as to make the units interchangeable. One unit is exactly as desirable to the buyer as any other. The buyer of such goods does not care to pick and choose, but is willing to take the specified quantity of the specified grade without inspection or choice. The buyer of wheat, for example, on the produce exchange merely specifies the number of bushels and the grade and does not care to examine the wheat in the elevator where it is stored. If he does not specify the grade, a certain grade is assumed under the rules of the board of trade. This method of trading is possible also with cotton, corn, and everything else which is traded in on the produce exchanges. It is equally possible on the stock exchange. One share of a given issue of a given corporation is exactly as good as any other share of the same issue. The seller’s contract can be fulfilled by the delivery of the specified number of shares without regard to the individual shares that are delivered.
This method of trading is not possible with other classes of commodities. The buyer of a house, for example, wants a particular house. The seller cannot fulfill his contract by delivering a house of the same grade and general description. The owner of such a house may, of course, sell it for future delivery. When he does so, he is not selling short — that is, he is not selling something which he does not own. No other person would dare sell that house short, either for present or for future delivery, without first having a binding contract from the owner. If anyone proceeded, without such a contract, to sell short a house which he did not own, the owner could squeeze that short seller to his heart’s content. He could merely refuse to sell except at his own price. The short seller would have to pay that price or break his contract. The owner would, in that case, have a more effective corner on what the short seller had sold than any operator ever succeeded in getting on the produce or stock exchange. The same rule will apply to all commodities which are not sold on grade. On the great exchanges, the short seller is not limited to specific units when he delivers what he has sold. He is permitted to deliver a specific quantity made up of any units which he can get. This fact is what makes speculative short selling possible. The short seller knows that, unless someone should get a corner by acquiring the entire available supply, he can fulfill his contract. He can fulfill it by going on the market, buying the quantity which he formerly sold, and delivering it to the buyer.
A transaction in futures proceeds somewhat as follows: Two men, to whom we will attach the surnames of Buyer and Seller, strike a bargain on some day in the autumn or early winter. Seller contracts with Buyer to sell ten thousand bushels of wheat for $1.20 a bushel, agreeing to deliver the wheat in the following May. Buyer agrees to pay for the wheat when it is delivered. Seller does not have any wheat, but he has every reason to believe that he can get it in time to deliver it in May. Buyer does not want the wheat either now or in May, but he agrees to take it and to pay for it anyway. That is the form of the agreement. In form, at least, it is a valid contract. Either party can hold the other to a literal fulfillment of the agreement.
If, in May, the price of wheat should have fallen to $1.15 a bushel, Seller could then buy it at that price and deliver it to Buyer, according to the terms of the contract, receiving $1.20 a bushel, thus making a profit of five cents a bushel. If, on the other hand, the price should have risen to $1.25 in May, Seller would still be bound by his contract. He would have to buy it at $1.25 and deliver it at $1.20 a bushel, thus losing five cents a bushel or $500 on the whole deal.
Why do they do that? For the same reason that men bet on a horse race — that is, because of a difference of opinion. Each expects to make money by backing his opinion as to the course of wheat prices. Seller expects to make money because he thinks that wheat in May will sell for less than $1.20. Buyer expects to make money because he thinks that wheat in May will sell for more than $1.20. When the last of May arrives, it is easy for them to calculate which has won, and how much. Seller does not need to go to the trouble of actually buying wheat on the market and delivering it to Buyer. The loser merely hands the winner a check for the amount lost by the one and won by the other.
III
There can be no real difference of opinion as to the essential nature of a transaction of this kind. It is as definitely a gambling contract as a bet on the outcome of a horse race or a throw of dice. It must be approved or disapproved on precisely the same grounds as other forms of gambling. While it goes through the form of a purchase and sale, the participants know, and everyone else knows, that there is no more merchandising about it than there is in a crap game. The difficulty is that there are also many real sales of real grain on the exchange which perform a real merchandising function. The form of the contract is precisely the same in the case of a gambling as in that of a merchandising contract. Only the omniscient searcher of hearts can tell, in any individual case, whether the seller really intends to deliver and the buyer to receive the grain or not. If haled into court, both buyer and seller can protest that it is a real purchase and sale, the one that he intends to receive and the other that he intends to deliver the grain. In this respect, they have a great advantage over the participants in a game of craps who are similarly haled into court. The real nature of the transaction is not determined by legal forms, but by the motives which are behind it.
This is the kind of transaction against which much proposed and some actual legislation has been aimed. The Cotton and Grain Futures Act, which was before Congress in 1926, attempted to stop it. This act would have forbidden the transmission of any message through any government or interstate agency offering to sell cotton or grain unless the sender of such message could establish his intention to make delivery. He would have been compelled to furnish an affidavit that he was either the owner or the grower of the grain or cotton offered, and that he intended to deliver it if sold.
They who have a moral aversion to betting in all its forms will naturally try to justify the purpose of such legislation even though they regard it as futile. With the moral aspects of the question we are not here concerned. It has its economic aspects, however, and they are important. Above all, it will not help the cause of reform to accuse those who participate in this form of gambling of crimes which they have not committed. It is argued, for example, by the friends of the farmer that short selling must necessarily depress the price of farm products. They point out, correctly, that every day more wheat is sold than there is in sight, and every month several times as much is sold as there is in existence. They argue that this selling of more wheat than there is in existence must necessarily depress the price of wheat.
This argument, however, is canceled by the fact that there is just as much buying as selling. Every time a bushel is sold, that same bushel is bought. If several times as much is sold as there is in existence, it is also true that several times as much is bought as there is in existence. There is exactly as much overbuying as overselling. If overselling depresses the price, overbuying should raise the price. The argument is as broad as it is long, at least in normal times. The general level of prices, over long periods of time, is not affected. The most that can possibly be said is that fluctuations are made more violent.
In fact, the argument is used in both ways. When prices are depressed, the blame is laid on the short sellers. When they are too high to suit buyers and consumers, the blame is laid on the long buyers — that is, the buyers who buy more than they can pay for or more than they expect to have delivered. When, in the early years of this century, we began to be agitated by the rising cost of living, we were frequently reminded that every day more grain and other produce were bought on the produce exchanges than there were in sight. This, rather than the increasing supply of gold, was given as the cause of high prices. Again, during the World War, inflated prices were sometimes blamed on long buying by speculators, rather than on the inflation of the currency. A more reasonable explanation in either case was that these changes in gold and the currency caused the rise in prices and that the long buyers were merely trying to make money by betting on the rise.
Another fact to be remembered is that the short seller of to-day becomes a buyer, potentially at least, at some later date. If he intends to deliver what he has sold, he must become a real buyer when the time comes to deliver. If it is a ‘wash sale,’ — that is, if there is no intention to deliver, — he is at least as much of a buyer at the end of the transaction as he was a seller at the beginning. Over long periods of time, therefore, the short seller cancels himself. If he had any influence on the market when he sold, he must have a counteracting influence when he buys. In normal times, at least, these wash sales have no more influence on the market than straight and uncamouflaged betting would have. The results are just the same as though farmer Jones said to farmer Brown, ‘I’ll bet a dollar that wheat will sell for a dollar twenty or better in May,’ and farmer Brown should reply, ‘I’ll bet a dollar that it will not.’
But how about abnormal situations such as a speculative boom or a panic? May not long buying accentuate the boom and short selling the panic? A boom is a time when there are few sellers at existing prices, most owners holding their stuff for a higher price; and when there are many buyers at existing prices, each non-owner being anxious to become an owner in order to sell again at a higher price. Under such conditions prices must rise enough to induce owners to sell as much as buyers will buy. A panic is just the opposite. It is a time when there are few buyers at existing prices, most potential buyers waiting for a fall of prices, and many sellers, each owner anxious to sell before the fall. Under such conditions prices must fall enough to induce buyers to buy as much as owners will sell. Even if we were to assume that which is probably not true, — namely, that long buying and short selling accentuate the ups and downs of prices, — it would seem that the long buyers were fully as much to blame as the short sellers.
It is true that at the height of a boom, when dealers are becoming a little nervous as to the stability of the price level, a sudden wave of short selling may seem to break the market. It always accompanies a sudden wave of real selling by real owners, and this is what does the mischief. Granting, however, for the sake of argument, that a combination of real selling by owners who have something to sell and of short selling by gamblers who have nothing to sell is worse than a wave of selling by owners alone, it is still possible to show that short sellers do no more harm than long buyers. Long buyers, especially those who have nominally bought more than they can pay for, —that is, have bought heavily on margins, — are a factor of instability. When prices start sharply downward, they, the long buyers, are the ones who become panicky. They must sell quickly or lose their margins — which means bankruptcy. If they had paid for what they bought, they would not be in so dangerous a position, nor would they need to be in such haste to sell. They would still own what they had bought and, whatever its value, it would be theirs. While short sellers may have something to do with starting a slump in prices, it is the long buyers on margins who make it a panic. With them it is sauve qui peut.
To repeat, therefore, long buyers are quite as much to blame as short sellers for anything which occurs on the exchanges.
Popular approval and disapproval, however, are not thus evenly distributed. The long buyer is more popular than the short seller, the bull than the bear, the booster than the knocker. The reasons are psychological rather than economic. The statement attributed to George Peabody, that the man who was persistently a bear on America was headed for inevitable bankruptcy, was only an expression of confidence in America. It was not intended as a condemnation, either on economic or on moral grounds, of bearishness, nor as an approval of bullishness. The advice, attributed to the elder Morgan, ‘Don’t sell America short,’ was a similar expression of confidence and in no sense a condemnation of short selling in general.
The short seller is, of course, a bear from the time he sells until he has bought again to deliver what he sold. He hopes that prices will go down instead of up, and he will do all he can to make them go down. He has already sold and now wants to buy at a lower price. From now on he is a potential buyer and not a seller, and therefore a bear. They who have something to sell naturally want prices to go up. They therefore hate all bears and love all bulls. But they who want to invest their money — that is, to buy things — have an equally good reason for desiring that prices should be low. They therefore have as much reason for hating bulls and loving bears as the sellers have for the opposite feeling. For some reason, however, they who have something to sell have always been the loud hawkers. Those who are looking for something to buy never make quite so much noise. Sellers manage to maintain the superiority of ballyhoo. Wherever noise counts, it is on the side of the bulls and against the bears.
Again, producers want high prices and consumers low prices. Producers therefore love the bulls and hate the bears. Consumers might be expected equally to hate the bulls and love the bears. For some strange reason, consumers are not so vocal in their likes and dislikes as are the producers. This difference shows itself in tariff controversies as well as in the relative popularity of bulls and bears. The producers who want high prices manage to make more noise than the consumers who want low prices.
The heavier barrage is maintained by those who tell people that the way to prosper is to buy and consume more than their incomes will pay for, using the installment plan, rather than by those who tell people that the way to prosper is to live within their incomes and invest the surplus wisely. Lavish buying and overconsumption tend to bull the market for the moment, though they always produce a bearish reaction later. Prudent buying and rational consumption tend to prevent a boom and are disliked by the hawkers of toy balloons, automobiles, stocks, and real estate. Of course, prudent buying means more money to spend later on, but that does not interest the present boomers. This same psychology leads to an approval of the long buyer, and a disapproval of the short seller. The man who buys more than he can possibly pay for is mistakenly supposed to be helping business.
If the short seller becomes, psychologically at least, a bear as soon as he sells short, it is equally true that a little later, in the very act of buying in order to fulfill his contract, his actions tend to bull the market. No one ever sells short unless he thinks the price is too high to last. He inevitably buys again when he thinks that the price is as low as it is likely to get. If, therefore, the short seller has any influence whatever on prices, it is to steady them — that is, to depress them when they are high, and to lift them when low.
If the long buyer has any influence whatever on prices, it is to unsteady the market. He keeps on buying even when prices are high, and is forced to sell when they begin to fall. He is forced to sell because he buys more than he can possibly pay for. That is, he spends all his money on margins, buying more than he could buy if he paid the full price. As soon as a fall in prices starts, he is forced to sell. However, there is no clear and adequate reason for believing that either speculative short selling or speculative long buying has any influence on prices. The real sellers and buyers, who bring real wheat into the market and take it off the market, are the ones who determine prices. The others merely bet on the outcome. They may make the buying and selling a little more fast and furious, and the fluctuations of price may show themselves more promptly. Quotations may change from minute to minute, instead of from day to day, as the result of this fast and furious bidding. Aside from this, their activities have about as much effect on the course of the market as Chanticleer’s crowing had on the rising of the sun.
Short selling for future delivery by real producers is sometimes a means of reducing risk. The dairyman who contracts for his milk in advance at least knows what he is going to get. One risk is eliminated. So with manufacturers and other producers who can manage to sell in advance. These, of course, all expect to deliver what they have sold. Manufacturers and shippers sometimes manage to insure themselves by selling short what they never intend to deliver. This is called ‘hedging.’ A miller or a cotton manufacturer who buys wheat or cotton to supply his mill runs the risk of a fall in the prices of his finished product before it is manufactured. He can insure against that by the simple device of selling short as much raw material as he has bought. No matter how the market goes, he can neither win nor lose by a change in the price of his raw material. That risk is eliminated, and he can give his mind to other things. The manufacturer can therefore insure himself by selling short in either of two ways. First, he can sell his product before it is produced; second, he can hedge — that is, sell short as much raw material as he buys. Both these forms of short selling, however, came under the general head of selling for future delivery. It is difficult to see how one can insure one’s self by selling for immediate delivery.
IV
Let us now turn to the other method of short selling — namely, selling for immediate delivery as it is practised on the stock exchange. Anyone can see how it is possible to sell short for future delivery so long as one can buy the commodity in time to make the delivery. The lay mind has a little difficulty in seeing how one can sell short for immediate delivery. How can one sell and deliver at once that which he does not own? Of course he can’t, but he can pretend to. We may as well admit at once that there is a good deal of subterfuge and pretense about the whole business. The rules of the stock exchange require that the seller of shares shall actually deliver them. The short seller seems to accomplish this feat through the connivance and coöperation of his broker. The broker simply borrows the stock and delivers it to the buyer. So far as the buyer is concerned, delivery has been made. He or his broker has the stock, and if he is a real buyer ‘subsequent proceedings’ need interest him no more. The seller, his broker, and the lender of the stock can attend to the rest of the transaction.
The process of short selling for immediate delivery proceeds somewhat as follows. Seller decides that Python Steel is selling too high. It is quoted at 98, whereas current earnings would not justify a price of more than 85. On the basis of anticipated earnings the bulls have pushed the price up. Seller decides that these anticipated earnings are only imaginary and that the market is likely soon to find it out. He therefore orders Broker to sell a hundred shares at the market price.
Since Seller has n’t any Python Steel stock to deliver to Buyer, Broker must, before 2.15 the next day, borrow a hundred shares from someone and deliver them. It is Broker’s business to know, among other things, where stock of all kinds can be borrowed. He succeeds in borrowing the hundred shares from Lender and delivers them to Buyer or his agent. In order to borrow them, Broker has to deposit their full price, $9800, with Lender.
This may look as though Broker had bought the hundred shares from Lender, but he has not. He has only borrowed the shares and lent Lender the money. In the first place, Broker will receive interest on the $9800 which he has deposited with Lender. In the second place, Lender can call for a return of the stock at any time by returning the $9800, and Broker can demand his $9800 at any time by returning the borrowed stock — that is, an equal number of shares of the same issue. In the third place, if the market price of the stock goes up, Broker must deposit more money with Lender, enough to cover the added value. If the market price of the stock goes down, Broker can demand a part of his money back. He only needs to keep the actual price of the stock on deposit with Lender.
In order to compensate Broker for his time and trouble, Seller must pay Broker a commission. In order to eliminate as far as possible all risk to Broker, Seller must put up a margin — say $25 a share, or $2500 altogether. This is necessary to protect Broker, because the stock may go up instead of down as Seller had expected. If the price goes up, Seller is certain to lose unless he defaults. Broker takes no chances on Seller’s defaulting. That is why he requires Seller to put up a margin before taking a single step. If the price of Python Steel rises less than $25 a share, Broker is still protected by the $25 margin. If it shows signs of rising more than $25 a share, Broker demands more margin from Seller. If Seller is too slow in responding, Broker, on his own initiative, buys a hundred shares of Python Steel, hands them to Lender, and gets his $9800 back. That closes the transaction between Broker and Lender.
Broker now has to settle with Seller. If he had to pay $123 a share for Python Steel, the stock cost him $12,300. This would lose him $2500 if he were not protected by Seller’s $2500 margin, which he keeps. As it is, he may lose his commission, but to guard against that he probably bought, unless he was pretty slow, before Python Steel quite reached $123.
Whenever Seller decides, on his own initiative, that it is time for him to close the deal, he merely informs Broker of his decision — that is, he orders Broker to buy 100 shares ol Python Steel. Broker buys them, hands them to Lender in return for those formerly borrowed, gets back his $9800, or whatever he has deposited with Lender, and then proceeds to settle with Seller. If the price has fallen, as Seller hoped, Broker paid less than $9800, say $9000, for the shares which he bought. This leaves $800 profit on the transaction. Broker deducts his commission from this $800 and hands the balance, along with the $2500 margin, back to Seller. If, on the other hand, the price has gone up, Broker will deduct the loss and his commission from Seller’s $2500 margin, and hand the balance back to Seller. That closes the whole deal.
The whole organization of the stock exchange is so designed as to make it as easy as possible for men to gamble. The once famous Louisiana lottery was not better designed for the stupendous and lucrative business of separating fools from their money. Yet it would be absurd to say that the stock exchange is a den of thieves or a gambling hell. Much legitimate business, without which the country could not prosper, is done there. The commissions of brokers, however, are greatly swollen by the gambling which is done, and a broker would as soon have a gambler’s money as any other person’s. So long as it is profitable to cater to the gambling spirit, brokers may be expected not only to make it easy for men to gamble, but to lure them on. Any reform must come, if it comes at all, from the outside; but the evil is so well hidden by the good as to make reform from the outside exceedingly difficult.
The apologists for this kind of gambling sometimes try to confuse the issue by using as a blind the owner of stocks who lives a long way from New York. If he wants to sell on the New York Stock Exchange he must, of course, deliver his stock there. If he sells by wire and cannot get his stock to New York by 2.15 of the day following the sale, he is declared to be a short seller. As a matter of fact, he is nothing of the kind. No dictum of the stock exchange can make a thing true if it is not true — powerful as that organization may be. He is not selling or trying to sell something which he does not own.
The rules of the exchange require his broker, to whom he has wired his order to sell, to treat his order precisely as he would treat the order of one who was selling something which he did not own. That is, the broker must borrow enough stock in either case to make delivery by 2.15 the next day. That, however, is merely a matter of arbitrary stockexchange rules. It does not affect the real nature of the sale in either case. The short seller who goes through the form of selling for immediate delivery what he does not own is a gambler. The owner who sells his own property which, because of distance, he cannot deliver until after 2.15 the next day is not even a short seller, much less a gambler.
It would not be impossible to plan a zoning system and permit delivery at later hours by real owners who live at a distance from New York. It would be still easier to call the seller who lives a long way off a seller for future delivery. What motive has the New York Stock Exchange, or the brokers, for doing this? None whatever. Why should they distinguish between gamblers on the one hand and real buyers and sellers on the other? A gambler’s money is as good as an investor’s. Why should the Wall Street crowd try to stop gambling? They have the same reason that the owners of a lottery or a gambling den have — namely, none at all. If brokers, either Individually or as a whole, were to limit themselves to legitimate business with real buyers and sellers, their commissions would be much smaller than now. Unless they have moral scruples against gambling, they have no reason for thus reducing their own incomes.
The short seller on the stock exchange is in no sense a producer trying to insure himself by selling his product before it is produced or by hedging to cover a possible fall in the price of his raw material. On the other hand, he is not to be blamed for what he does not do. His effect on market prices is negligible. He is to be judged precisely as other gamblers are to be judged, for he is nothing else. The same may be said of the long buyer who merely puts up a margin for the purpose of betting on the market and not for the purpose of buying and paying for what he buys. However, it is one thing to show that ihe hypothetical short seller and long buyer are gamblers. It is a different thing to say who among the multitude of buyers and sellers are real buyers and sellers and who are gamblers. The sheep and the goats all look alike.
There is a strictly economic aspect of gambling. A certain amount of human energy and intelligence is expended in gambling which might otherwise be expended in productive work. That is a distinct loss to the nation and to the world. Again, while professional gamblers, as a class, may not gain any money from one another in the long run, the losses balancing the gains, they do gain something from the inexpert — the lambs. Even if the lambs were on the average as rich as the professionals, it could be demonstrated that their losses as measured in real utility are greater than the gains to the professionals. If two men, A and B, hazard their fortunes, which we will assume to be equal, on a game of chance or a turn of the market, one will double his fortune while the other will lose his. The one who loses his fortune deprives himself and his family of the necessaries of life. The one who doubles his fortune only provides himself and his family with an equal amount of luxuries and superfluities. The loss in utility to the loser’s family is really greater than the gain to the winner’s family even though in dollars the gain equals the loss. The difference is accentuated if we assume, which is probably true, that the inexperienced losers — the lambs — are, on the average, less rich than the experienced or professional winners.
It is not improbable that many people are now, since the Wall Street debacle, convinced of the evils of gambling. If, perchance, it should lead many to return to the paths of economic righteousness, the panic will not be an unmitigated loss. ’The Devil was sick, the Devil a monk would be.’
The issue is sometimes confused by insisting that every producer is a gambler and that the farmer takes long chances whenever he plants a crop. But the chances which he takes are unavoidable incidents to the essential work of production. If nobody took such chances we should all starve. No such dire calamity would follow if no one took such chances on cards, craps, or roulette. The chances taken by those who bet on such things are not the unavoidable risks of any kind of productive enterprise. The world would be vastly worse off if no farmer were willing to take the unavoidable chances on bad weather and other disasters which he must take if he plants a crop. The world would be better off if they who gamble on nonproductive hazards would devote their time and energy to productive work and assume the unavoidable hazards of such work.
The hazards assumed by the farmer are, in this respect, like those assumed by the merchant, the manufacturer, and every other useful person. They are all unavoidable incidents to productive work. Real producers try to avoid them as much as they can by extreme care and watchfulness, and also by various forms of insurance. The insurance company avoids risk by applying the law of large numbers. It really runs no risk, or at least very little. If its calculations are accurate, it can predict with a high approximation to certainty what its income and expenditures will be. At the same time, it relieves the individual of a great deal of risk and uncertainty. The net result of sound insurance is that the unavoidable risks of production are considerably reduced but not eliminated.
V
As suggested earlier in this article, it is the practice of buying and selling on margins, rather than that of buying long or selling short, which does whatever harm is done. One might spend his whole fortune in buying something for the sole purpose of selling it again and not bankrupt himself, if he would only buy as much as he could pay for. Even though the price should fall to half what he paid, he would still have half his fortune left. On the other hand, if he spends all his money on margins, a relatively slight fall in the price of what he bought might leave him without a cent. This is not offset by the fact that if the price goes up he gains more if he has spent all his money on margins than if he has spent it on a complete purchase. One does not gain as much in utility if he doubles his fortune as he loses if he loses his fortune. If he gains, he only gains the ability to buy luxuries and superfluities; whereas if he loses, he loses the ability to buy necessaries. He hazards necessaries on even terms against superfluities, and that is never a good bet. In terms of utility, the odds are always against the gambler, and the more he bets the more the odds are against him.
Similarly, one might sell short without endangering his solvency if he only sold as much as he could produce in time for settlement, or buy if he could not produce it. This is what is done by the producer who sells his crop short, and by the manufacturer or shipper who hedges. The short seller who puts all his money on margins is in a dangerous position. True, if he gains, he gains more in dollars — and if he loses, he loses more in dollars — by this process than by the other. But, as shown above, his losses exceed his gains if measured in utility instead of in dollars.
Buying and selling on margins is what causes so many bankruptcies in times when markets are unstable. Losses and gains there would be if men could not deal in margins, but not so many stupendous fortunes and complete bankruptcies. So long as brokers will finance buyers and sellers who want to plunge by buying or selling more than they can pay for or deliver, and so long as banks and other agencies will finance the brokers through brokers’ loans, we shall probably have plungers. So long as we have plungers we shall have large winners and heavy losers. Then we shall have the mathematical certainty that the losers will lose more in utility than the winners gain, which means a net social loss.
So far as the theoretical aspects of the problem are concerned, the case is clear. The producer who sells his own product before it is produced, though technically a short seller, is not a gambler. He is trying to eliminate one hazard and to avoid gambling on one of the chances which he must take. The producer or the shipper who hedges by selling short is likewise no gambler. He is trying to eliminate another hazard and to avoid gambling on one of the chances which he must take. The owner of stock who lives at a distance from New York is neither a short seller nor a gambler when he sells his own property on the New York Exchange, even though he cannot conform to the arbitrary ruling of that exchange as to the exact time of delivery. The investor who buys stock, paying in cash only a part of the price of what he buys, intending to complete the purchase and receive and hold the stock, is a real buyer. Though he may technically be called a long buyer, and though he runs considerable risk of a fall in the price of what he buys, still he is not a gambler in the same sense in which the ordinary long buyer is. He is a real buyer who is using his credit. All those who go through the form of buying and selling but never receive or deliver, or even intend to receive or deliver, are gamblers as clearly and definitely as though they did not even go through the form of buying and selling, but merely bet on the market, the weather, the election, or any other contingency.
The practical question, however, is quite different from the theoretical question. The practical question is what to do about it. Shall we attempt to prohibit such transactions, knowing how difficult it is to prohibit anything, or shall we let the fool killer do his perfect work? When we find, as in the case of the long buyer, that it is impossible to tell whether he is a real buyer who is paying a part of the price in cash or a gambler who is merely hazarding his margin on a change in the market with no intention of buying, we may decide that it is better not to try to prohibit long buying. The same rule may well apply to short selling for future delivery. It may not be easy to distinguish between the producer who wants to insure himself either by hedging or by selling his product before it is finished and the one who is merely hazarding his margin on the opinion that the price will fall. In all these cases the tares and the wheat look so much alike to the physical eye as to be indistinguishable. We may decide that it is best to let the tares alone, lest we uproot the wheat at the same time.
There is something to be said, on the other hand, for a repressive law merely as an expression of public disapproval, even though it is powerless to repress. That is the chief reason for laws against prostitution and some of the more furtive forms of gambling. No one pretends that these laws are well enforced, or that it would be possible to enforce them. On the other hand, it is not seriously proposed that such laws should be repealed, much less that the government should in any way reverse its attitude of disapproval.
Short selling for immediate delivery presents a somewhat clearer case, but it is not free from difficulty. The short seller could at least say, and truthfully, that he is no worse than the long buyer. He could also say, and probably he would say, falsely, that he was no worse than the producer who sells his own product for future delivery, the hedger who insures himself, or the seller of stock who lives west of Chicago. He could say a great many things which would be confusing to non-analytical minds and to minds which were not familiar with the casuistry of nullification and evasion. The issue would become as perplexing and confusing as other prohibitory laws. That being the case, perhaps the best rule to follow is Caveat venditor.