GameStop makes the case for financial regulation

It's funny to see hedge funds lose to Redditors. But there are better ways to fight financial predators.

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The business press and many ordinary Americans have been transfixed watching the stock of GameStop soar into the stratosphere. At the time of writing, its price had leaped to well over $300, driven in part by an army of Redditors making an organized attack against Wall Street hedge funds who had bet against the company.

In the context of an extractive financial sector, this is hilariously satisfying. But it also makes the case for root-and-branch financial reform. Reckless gambling and wild speculation is not a great foundation for a prosperous and stable economy.

Here's what is happening. As Brandon Kochkodin explains at Bloomberg, GameStop is a classic brick-and-mortar retailer that has struggled against online competition. Its long-term prospects have only gotten worse during the pandemic, as people are reluctant to leave their homes and shop for fear of catching COVID-19. Thus Wall Street traders had bet heavily against the company, expecting it to declare bankruptcy soon — which puts still more financial pressure on it.

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To bet against a stock, you typically "short" it. This means you borrow the stock and then sell it with the agreement you will return it at a later date. If the price goes down, then when you buy back the stock, you pay less and thus pocket a quick profit. Wall Street was so confident GameStop was toast that more than its entire outstanding stock had been sold short (possibly because of re-shorting shares that had already been shorted once).

However, shorting involves some risk. If the price goes up instead of down, then you pay more than you originally did and lose money. The higher the price, the more you lose — and if the price goes up a lot, you may be forced to buy it back. Short sales typically have a due date, and so short sellers may calculate that it's better to get out now to avoid still greater losses, or their creditors might demand they do it for fear that mounting losses will drive them bankrupt.

Redditors thus plotted to execute a classic "short squeeze" using day trader services like Robinhood and TD Ameritrade. The idea was to dive in and buy all at once to drive up the price, causing the shorts to take losses. The higher it went, the more shorts would get spooked or be forced to sell — causing them to buy the stock back and drive the price even higher, and so on. This cycle can feed on itself, because as the price rises, others will be tempted to jump in and short the stock. If GameStop was arguably overvalued at $40, it is surely overvalued at $300. But then if the squeezers are determined, organized, and have enough cash, they can keep driving the price up and rinsing the shorts, at least for awhile.

And that at least is how this all started. (As Elizabeth Lopatto explains at The Verge, the actual process was a bit more complicated than this, because a lot of these Redditors were trading options instead of actual stocks, but that doesn't change the basic mechanics.)

On one level, this is all very funny, and richly deserved. The hedge fund Melvin Capital had to be bailed out by its competitors, and reportedly ended up booking a $3.75 billion loss. Another famous short-seller, Andrew Left, tried to bet against the stock and ended up running for his life. These hedge funds are some of the most ruthless and extractive companies on Wall Street, and ones who specialize in short-selling often deliberately cause the business failures they are supposedly predicting — destroying productive businesses and laying off thousands of people for a quick buck. It is deeply satisfying to see some of them get pantsed by "unsophisticated" normal people using the exact same coordination and media pressure tactics they constantly use themselves.

But on another level, this is an indication of how warped and socially destructive the financial sector is. For one thing, it was not just Redditors raking in cash on all this. These day trader apps can let ordinary people trade for free because they contract with other Wall Street firms to actually fill the orders. The fact that companies like Citadel Securities or Virtu actually pay a large premium to fulfill Robinhood orders is evidence many of its users are getting rooked. Then with all the attention to this story, other professional traders and ultra-wealthy investors are certainly getting in on the action, and possibly make up the majority of it by now. Other financial firms got a huge benefit just by virtue of what they happen to own. The gigantic asset manager Blackrock has long owned 13 percent of GameStop, and they may have netted something like $2.4 billion with a quick sale. (Amusingly, the government of Norway also owns 2.6 percent.)

For another, while a lot of Redditors are gleefully posting their gains (or "tendies," as they say, God bless them), GameStop is definitely not going to remain at $300 forever. Eventually it will nosedive, and if history is any guide, quite a few naive or unlucky people will end up losing their shirts.

But most importantly, all this wild speculation and profiteering is not fundamentally different from what Wall Street is doing all the time. Contrary to economic textbooks, the stock market does not have much to do with actual business investment, even if the occasional company might raise some money there. As Doug Henwood shows in his classic book Wall Street, the great bulk of business investment is "internally financed, through profits and depreciation allowances." On net, shareholders take more money out of companies than they put into them — indeed, over the years whole economic sectors have turned themselves inside out disgorging cash into the shareholder gullet. America's bloated financial sector is associated with a lower rate of overall business investment than in peer nations today or our own prior history.

The United States was a much more equal and prosperous place when Wall Street was clapped in regulatory irons, and the economy was a lot more stable. It is momentarily glorious to see arrogant hedge fund guys get beaten at their own game, but the fact is that the Wall Street casino is rigged. The average person will almost always be beaten by the big, deep-pocketed players — particularly if he or she can't even afford to buy stock, which is the case for most Americans.

If we strictly regulated Wall Street with large capital requirements, a financial transactions tax, simply banning most of the complicated derivatives and options used today, and so on — aimed not at the retail investor but mainly at the big financial firms — the American economy would be a lot healthier. If we scooped most stocks into a social wealth fund owned equally by every American, normal people could benefit from the market without having to take crazy risks. There are better ways to beat the rich than pump-and-dump schemes.

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