September 30, 2009
The goals of market regulation should be a) to minimize volatility b) to maximize liquidity c) to maximize market efficiency. Minimization of volatility is essential to minimize the "surprise factor" that is so detrimental to business planning. Maximizing liquidity is essential to make sure that anyone who wants to buy/sell can do so with a minimum of market impact, and thus market friction. Maximizing market efficienty is the whole point of financial markets: it is only if the coupling between quoted prices and true equilibrium prices is as close as possible that the markets can serve their necessary price discovery function.
While short selling can sometimes increase volatility, I believe that its role in maximizing liquidity and efficiency more than makes up for this. As a daytrader, I know that other daytraders are quite fearful of short covering rallies, so they don't enter into short positions lightly. In contrast, index investors enter into long positions in companies that they heve never heard of, simply because they happen to be a part of some index. Proper discrimination between good and bad stocks therefore seems necessary to efficiently get prices back in line. Short selling is one way to do this.
Having admitted that short selling sometimes increases volatility, I would be willing to support a ban on short selling as a "circuit breaker". Such a rule would prevent the "bear raids", the price distortion that arguably CAN be caused by short selling.