Short selling and financial crises

The other day The Daily Show ran a piece on short selling, which is basically betting on the failure of a stock. The clip certainly is not favorable towards the practice, as summarized in the correspondent's comments to a short seller explaining the practice: "just because you rob the grave, doesn't mean you killed the guy."

Back in 2008, the SEC put a hold on short selling in hopes of stemming the stock market decline. But is short selling so bad?

In a working paper at the Federal Reserve Bank of Atlanta Bubbles in Experimental Asset Markets: Irrational Exuberance No More, the authors ran an experiment where an asset market was created and individuals traded two goods in a laboratory. They found that bubbles did sometimes arise, but that "price run-ups and crashes are moderated when traders ... are allowed to short sell."

Why would this be so? Because short selling sends a message to the rest of the market that a group of investors thinks current prices are too high and will fall. In effect, traders are telling other traders the bubble will burst.

Short selling certainly increases market efficiency, and without it, we could arguably see a much longer financial crisis. Of course, there are certainly unethical ways of using short selling, as Jim Cramer of CNBC once described (or was he promoting it?).