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Pittsburgh Tribune-Review: “Who you callin’ ‘Shorty’?”

In my column for the May 27th, 2010, edition of the Pittsburgh Tribune-Review I defended speculators – and in particular, short-sellers. You can read my column beneath the fold.

Who you callin’ “Shorty”?

Just as every day is followed by a setting sun, every financial turmoil is followed by seething politicians blaming the economic woes on “speculators.”

Of course, each investor — from the 15-year-old who uses his paper-route earnings to buy a U.S. Savings Bond to Warren Buffett — is a speculator. Each one assesses the future and puts his money (or money entrusted to him) in those assets that he believes promise the best ratio of return to risk.

And because risk there will always be — because the future is never perfectly predictable — every investor is a speculator.

So when the German government recently blamed “speculators” for the falling value of the euro, it, in fact, blamed investors.

But blaming investors sounds lame and uninteresting. So the word “speculators” is trotted out in an effort to fool voters into thinking that a special species of financial ghouls suddenly materialized to wreak unjustified financial havoc.

Such accusations, though, are always and everywhere excuses for politicians’ harmful intrusions into the economy.

In the case of the euro, the European Union recently committed to spend nearly $1 trillion on bailing out heavily indebted European governments. Investors are responding to this plan in a perfectly rational way: with fear.

Bailing out fiscally irresponsible governments, such as the one in Greece, encourages further irresponsibility. It also commits the wealthier governments that will bear the brunt of the bailout burden to raise taxes or to inflate the money supply as a means of paying down the debt they incur on behalf of their more-irresponsible fellow governments.

When investors realize what’s going on, they naturally figure that both the bailed-out governments and the bailing-out governments are headed for a rocky economic future. And so these investors, shall we say, bail. They stop buying assets whose values are tied to the success of those economies and they sell such assets that they currently own.

Even more: Investors who are especially bearish on these economies can make money by “going short” in such assets — for example, by “shorting” the euro.

Such an investor can borrow, say, 10,000 euros today and promise to return to the lender 10,500 euros one year from now. (The extra 500 euros represent an interest rate of 5 percent that the lender demands.) The investor who borrows these euros can then sell them for, say, dollars. If today’s euro-dollar exchange rate is one-to-one — that is, if today each euro is priced at $1 — then the investor receives $10,000 in exchange for the 10,000 euros.

If this investor’s pessimism about Europe’s economy proves correct, the value of the euro will fall significantly during the coming year, enabling this investor to earn a profit on his correct assessment.

Let’s say the price of a euro falls over the course of the year from $1 to 50 cents. This investor can then, when he must repay the lender the promised 10,500 euros, repurchase the euros he’ll use to repay his debt for a total of $5,250 – which is what 10,500 euros cost at a price of 50 cents each.

The investor profits to the tune of $4,750 — the difference between the $10,000 that he received when he sold 10,000 euros one year ago and the $5,250 that he must spend today to repay his euro debt. (To all you economic sticklers: I’m aware that, because of interest-rate considerations, this investor’s profits are actually slightly less than $4,750. But this quibble does nothing to change the story.)

Is this investor doing any good beyond making a personal profit? Yes.

His actions help signal the market that Europe’s economy is, in fact, in bad shape. When this investor sells his borrowed euros, he puts downward pressure on the price of the euro. This falling price of the euro is part of an early-warning signal to less-savvy investors that Europe likely faces a tough economic future.

Of course, it’s possible that our pessimistic investor is mistaken. In that case, he’ll lose money by shorting the euro — and those investors who were more optimistic about Europe will profit.

Either way, all investing — whether “long” or “short” — reflects the considered judgments of people who risk their own money. So when the bulk of investors go “short” on the euro, as they’ve recently done, that’s good evidence that Europe’s economy is indeed in bad shape.

For German Chancellor Angela Merkel and other European officials to complain about short-selling “speculators” is for these officials to complain that people with skin in the game are helping to expose the flaws and contradictions that mar Europe’s current economic policies. Such speculators deserve our attention. The predictable squawking of European politicians deserves only to be ignored.