On September 19, the SEC issued an emergency order to suspend short selling. The ban lasted until October 8, a few days after the U.S. Treasury’s $700 billion bailout plan was signed into law. Professor Charles Jones, chair of the Finance and Economics Division, used the rare suspension to measure the ban’s effect on stock prices. According to preliminary research Jones conducted with colleagues, which he recently outlined in an Ideas at Work article, stocks protected by the ban experienced only a temporary price bump and had their market liquidity degraded. That result, says Jones, should not have been surprising given the historical precedent.

“We want all kinds of information to be part of a stock price, including positive information, negative information, optimistic views and pessimistic views. That’s the way we get the best prices, if they reflect all the information that’s out there. Short selling gives a way for people to trade based on that negative information or opinion,” Jones says.

“But when prices fall dramatically, this kind of ban gets trotted out. There are a lot parallels with 1931 in terms of what we’re doing to harass short sellers. The last time there was a ban was in September 1931 during the Great Depression. The ban was put in place after stock prices had fallen by two-thirds. It was a two-day experiment and it went badly. We don’t repeat history, but it certainly does rhyme, like Mark Twain says.”

“During the three weeks of the ban [in 2008], stock prices cratered, falling by about one-third. Financials fell even more, completely reversing their initial gains,” says Jones. “Even more troubling was the ban’s effect on market liquidity. Stocks subject to the ban suffered a severe degradation in liquidity, as measured by bid-ask spreads.”

For the complete article about Jones’s preliminary research and data on the short selling ban, see “Assessing the Shorting Ban” in Ideas at Work.