By Kevin Meyer
I've always considered insider trading a crime, unfair to those without the knowledge to make informed judgment calls on investments. But leave it to our friend Don Boudreaux of Cafe Hayek and a professor at George Mason University's economics department to twist traditional thinking on its head. His opinion piece in Saturday's Wall Street Journal brings up a side of the issue I had never thought about.
It's Halloween season, and the scariest demons in the world of business
are insider traders, lurking behind every stockbroker's desk and
four-star restaurant banquette. They whisper dark corporate secrets
into the ears of venal speculators, and inflict pain and agony upon
Time to stop telling horror stories. Federal agents are wasting their
time slapping handcuffs on hedge fund traders like Raj Rajaratnam, the
financier charged last week with trading on nonpublic information
involving IBM, Google and other big companies. The reassuring truth:
Insider trading is impossible to police and helpful to markets and
Uh… "helpful"?? You've got to be kidding, right? That got my attention.
Far from being so injurious to the economy that its practice must be
criminalized, insiders buying and selling stocks based on their
knowledge play a critical role in keeping asset prices honest—in
keeping prices from lying to the public about corporate realities.
Prohibitions on insider trading prevent the market from adjusting as
quickly as possible to changes in the demand for, and supply of,
corporate assets. The result is prices that lie. And when prices lie, market participants are misled into behaving in
ways that harm not only themselves but also the economy writ large.
Boudreaux goes on to support that statement with a couple of pretty good examples. Enron's a good one.
As argued forcefully by Henry Manne in his 1966 book "Insider Trading
and the Stock Market," prohibitions on insider trading prevent asset
prices from adjusting in this way. Mr. Manne, dean emeritus at George
Mason University School of Law, pointed out that when insiders trade on
their nonpublic, nonproprietary information, they cause asset prices to
reflect that information sooner than otherwise and therefore prompt
other market participants to make better decisions.
According to Mr. Manne, corporate scandals such as Enron and Global
Crossing would occur much less frequently and impose fewer costs if the
government didn't prohibit insider trading. As Mr. Manne said a few
years ago in a radio interview, "I don't think the scandals would ever
have erupted if we had allowed insider trading because there would be
plenty of people in those companies who would know exactly what was
going on, and who couldn't resist the temptation to get rich by trading
on the information, and the stock market would have reflected those
problems months and months earlier than they did under this cockamamie
regulatory system we have."
But here's the part that really got me: the impact of "non-trades." In effect, an insider is prohibited from trading… but not from "not trading." If you have inside information that other half of the trading pie can be just as valuable financially.
So, too, though, does the insider profit who, upon learning the same
information, abandons her plans to sell 1,000 shares of the company.
But because insider "nontrading" is undetectable, only the former
insider is practically subject to prosecution and punishment.
And because opportunities to profit through insider "non-trading"
might well occur with the same frequency as opportunities to profit
through insider trading, as many as half of those investment decisions
influenced by inside information might be undetectable.
This bias is not only a source of prosecutorial unfairness; its
existence casts doubt on the assumption that insider trading is so
harmful that it must be treated as a criminal offense. After all, if
capital markets continue to function as well as they do given that many
investment decisions potentially influenced by inside information are
unstoppable because they are undetectable, why believe that the
detectable portion of investment decisions influenced by inside
information would be harmful if they were legal?
That is something I had never thought of. By focusing on what is seen, there is ignorance of what is unseen and potentially a greater problem.
So does a prohibition on insider trading actually decrease transparency, allow an equal number of "non-trades" and delay the identification of fraud or other problems thereby create even greater scandals? I'm not necessarily convinced yet, but now more curious.
And the bottom line point is to challenge even seemingly-obvious ideas – there may be side you haven't even considered.