Given the recent turmoil in the financial markets, it’s a bit hard to keep up with the morality plays and the villains.

After the Enronesque fall of Bear Stearns, the villains of the moment were the two Bear Stearns executives who were indicted for not throwing in the towel timely.

Then, over the past several weeks, speculators who facilitate markets to hedge energy costs became targets of the demagogues.

And now this week, with the demise of Fannie Mae and Freddie Mac, SEC Chairman Christopher Cox issued an emergency order attempting to curtail naked short-sellers of the stock of the embattled government sponsored entities and also the stocks of Lehman Brothers, Goldman Sachs, Merrill Lynch and Morgan Stanley.

What on earth is Christopher Cox, a supposedly sophisticated securities lawyer, doing issuing orders that hinder the efficient functioning of markets?

Folks, the problem is not that stock prices of the GSE’s and the investment banks are low because some nasty market manipulators have been targeting them. Larry Summers has a much more rational explanation for the GSE’s demise. Instead of rethinking those misguided policies that led to the bubble in the GSE’s stock price, Cox is engaging in a classic case of shooting the messenger by attempting to limit a price-setting mechanism for shares of stock.

Short selling — the act of betting against a stock by borrowing it, selling it and then purchasing the stock later at a lower price to repay the loan — plays an important role in well-functioning markets. If short selling is repressed, then optimists will dominate in the marketplace, which generally results in stocks becoming overpriced. Stated simply, persecuting the short-sellers contributes to stock bubbles. Larry Ribstein summed up the absurdity of the Cox’s action well:

“[I]n our wacky world of regulation, as we step up liability to get out the truth about securities, we stomp down an important mechanism for getting the truth out about securities.”

And in addressing the above question about Cox, Craig Pirrong had an interesting 1993 encounter with the SEC chaiman regarding short-selling (and with Hillary and Bill Clinton, too, but that’s a sideshow) that prompts him to make the following observation about Cox:

Given my 1993 experience with Chris Cox, I have my suspicions that the new short selling restrictions aren’t based on any empirical evidence or deep economic reasoning -– instead they are a reflection of Cox’s anti-shorting prejudices (and the prejudices of like-minded folks at the SEC) -– prejudices that he displayed in 1993.

When are we going to learn that knee-jerk regulatory responses such as Cox’s latest often do more economic harm than good, not the least of which is the perpetuation of myths that distract investors from prudent risk allocation?

Update: Chron business columnist Loren Steffy agrees with me. And Don Boudreaux today identifies the underlying human dynamic behind such witch hunts:

We humans have a long and embarrassing history of blaming devils for distressing aspects of reality that we don’t understand.   Droughts, floods, plagues, and erupting volcanoes have all been ascribed to the machinations of unseen super-powerful entities – as ill-defined as they are ill-intentioned – who manipulate a reality to which they are immune but to which we mortals must inevitably bend.

Today’s witch hunt for speculators who allegedly are driving oil prices to heights unconnected with the realities of supply and demand is just the latest entry in this pageant of ignorance.

This post from two years ago addressed the same dynamic in connection with the death of Ken Lay. And Arnold Kling chimes in with an absolutely spot-on analysis about the folly of attempting to limit the pricing mechanism of markets:

In the mortgage market, people saw risk-takers outperforming prudent lenders. So they took more risks. There is no simple fix for that. For the foreseeable future, we can count on investors sticking to prudence when it comes to mortgage lending. We don’t need any regulations to close that barn door.

But somewhere, some time, in some other market, there will be another outbreak of excessive risk-taking. You can’t make the system idiot-proof. They’ll just build a better idiot.

Update II: The SEC is already retrenching from its "emergency" order (W$J article here).