Teach them young how markets work

In the US, there's a gap in understanding between Wall Street and Main Street. This much is well known. Across California last week students and teachers took the streets to protest against rising college fees. Questioned by CNN where the money required to stave off fee hikes might come from, a college lecturer was emphatic: "From the rich, tax the bankers."

A day later, one of those bankers was up in front of the Congressional Oversight Panel in Washington. Vikram Pandit, Citigroup's Chief Executive, had to answer some pretty fiery questions on the bank's near-collapse towards the end of 2008.

Specifically, congressmen (and women) wanted to know why Citi had to be bailed out twice – first with $25 billion (Dh91.82bn) in October 2008 and then another $20bn in December, along with $300bn of government guarantees.

Bizarrely, Pandit chose to blame market speculators – so-called short sellers, who had supposedly driven Citi's stock price into the gutter.

Meanwhile, on the other side of the Atlantic, politicians were busy blaming the markets for problems across the Eurozone, but centred for the moment on Greece. There's been swirling talk of restrictions being placed on credit default swaps, securities which can be used to bet on sovereign default risk, on the basis that these instruments have undermined Greece's reputation in the financial markets, making it difficult for the country to role over its debt.

There are so many disconnects going on here, it is difficult to know where to start.

One common theme is the apparent inability of people – both ordinary and those from the establishment – to take responsibility for their own actions. The "market" gets it in the neck because no one really understands what the financial markets are, and how they work.

Greece is in a mess because successive governments took on too much debt, spent the money rashly, while corruption festered and the country's economic output plummeted. The markets have forced the Greek Government to take corrective action, even if it is painful, rather than allowing it to pretend that nothing was wrong.

It is not healthy to have governments that will not face reality. Financial markets shine a harsh spotlight and too many politicians across Europe in particular want to turn that light off. Yet such thinking is not restricted to non-financial experts.

Vikram Pandit, appearing in Washington, was guilty of exactly the same sort of delusional rhetoric. And since he's got his job running Citigroup because he is supposed to know all about markets, his attempts at blaming the markets for Citi's woes are all the more shameful. He really should know better.

Here are his direct words, as uttered to the Congressional Oversight Panel on Thursday:

"This was not a fundamental situation. It was not about the capital we had, not about the funding we had at that time. But with the stock price where it was — and, by the way, a lot of that was driven by short sellers. And short sellers started selling stock, the stock started going down. And when that gets to that point, perceptions become reality…

"There are ways in which fear overtakes it, and particularly that's the tool that short sellers need to make money. And so, that was a very dominant activity. And there were no real circuit breakers to stop the short selling. And that's one of the things that took our stock down."

Now, the reason we know that Pandit is 100 per cent wrong on this is that there is data available that gives a pretty accurate reading of how much stock is being "sold short" at anyone time. That data shows, beyond doubt, that there was no increase in the amount of shorting as Citigroup's stock sufferered its precipitous fall in the last two months of 2008.

The price went down simply because holders of the stock sold it. Simple as that.

Except that the whole notion of "going short" is not "simple" to many people – making the concept of a "short seller" an easy bogey man when it comes to apportioning blame.

Banning short selling, so the cod thinking goes, helps remove the threat of market panics.

But it doesn't remove the underlying problem – in fact, it stops those problems being identified. I should stop here for a moment and explain what "going short" or "shorting a stock" actually means.

It is the act of selling something you do not currently own, with a view to buying it back at a cheaper price in the future.

That may sound confusing, but it is actually integral to markets of all kinds, not just financial.

Here's an illustration. You visit your butcher to order a special bird for an up-coming festive meal. You pay him $50 and he tells you to come back in a week's time. At that moment the butcher is "short" one bird at $50. But he knows a bird farm supplier that will sell him one at $30, so he is happy. Unfortunately, the next day a plague strikes the farm and half the birds are slaughtered and burnt. Suddenly the supplier is demanding $60 for each of the birds he has left.

So now your butcher is "short" and "wrong" to the tune of $10.

It is the same in financial markets. Shorting, like other forms of speculative activity, creates liquidity and helps markets to operate efficiently.

If your butcher was not able to order a special bird for you in advance, he would have to have much higher inventory on hand, with all the associated costs. Because he was able to go short with you he was able to fulfil an order he might otherwise have lost. So here's a proposal: we should teach our kids how markets work. Then, when they grow up and become politicians or (worse) bankers, they will be able to do their jobs effectively – and honestly. And, as a result, teachers and students alike would be less likely to take to the streets and shout "Tax the Rich."

- The author is associate editor of the Financial Times

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