There’s been a lot of controversy about a practice called “naked short selling.” In normal short-selling, a trader who expects prices to fall will borrow shares of stock and immediately sell them. He must buy shares at some point in the future to give back to the person who lent him the shares that he sold short.

Naked short-selling dispenses with the borrowing of shares. It’s been around for a very long time, and the rules have frowned on it for a very long time, since it’s always been associated with market manipulation. At issue now is some proposed new rulemaking to make naked short selling more difficult and costly to do.

Today we’re reading dueling posts by Matt Taibbi and John Carney. Taibbi sees naked short selling as one of the root causes of the financial crisis. And Carney thinks naked shorting is fine and dandy because it promotes market efficiency and liquidity. Taibbi has the better of the argument in economic terms. Too bad he’s making a political rather than an economic argument.

Many have supposed that widespread naked shorting was partially responsible for the rapid meltdown of Bear Stearns and Lehman Brothers last year. Frankly, there was chicanery going on in these events, but it’s wrong to ascribe the bankruptcies to short sellers, naked or otherwise. Bear was caught in a liquidity squeeze because they suddenly lost their ability to borrow overnight funds. With Lehman, CEO Dick Fuld was too pigheaded to line up additional sources of capital while he still had the chance. Short-selling in these companies’ stocks was the result of their failures, not the cause.

Economically, a naked short is something like an American-style call option but with the exercise right vested in the counterparty. In essence, the seller says to the buyer “I will deliver shares to you on a date of my choosing, in return for payment at today’s market price.”

On this analysis, you could simply say that the naked short-seller must deposit margin with his broker to cover the risk that the market will move against him, just as with any other forward transaction. And beyond that, it’s all good.

But what’s the buyer’s economic incentive to engage in this transaction? None whatsoever. Indeed, he expects settlement of his buy overnight or the next day. Instead he takes open-ended risk that the seller won’t execute the transaction, and he gets no compensation for the risk. That’s why naked short-selling is fraudulent. The naked short is essentially hoping that the buyer won’t recognize the risk he’s inadvertently assuming.

Jim Carney’s argument from liquidity and market efficiency is a red herring. There must be an avenue for short selling because the market needs a way to punish bad companies. But the short seller must not be allowed to shift risk to parties that are not compensated for bearing it. It’s also easy to use derivatives to bet on an anticipated decline in a company’s stock, but again, you have to put up the right amount of margin.

Short selling is technically complicated and difficult to do in size, compared with normal selling. There are good reasons why that should be so. Carney appears to argue that naked short selling is good *because* it reduces the friction associated with short selling. To me, that’s a bad thing, and entirely representative of the kinds of risk-shifting that precipitated the financial crisis in the first place. It’s a good idea to impose tougher constraints on naked short-selling.