Let Insiders Trade

The SEC is ramping up prosecution of insider trading, now that hedge fund manager Raj Rajaratnam is accused of trading stocks based on info he got from executives at companies like IBM and Google. He could face 20 years in jail.

But what will be gained? Insider trading seems like cheating, but traders like Rajaratnam (assuming the accusations are true) let stock prices better reflect the real value of the companies. And accurate prices help investors send money to those who will use it best, as economist Don Boudreaux points out in this excellent op-ed from this weekend:

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 ...

Suppose that unscrupulous management drives Acme Inc. to the verge of bankruptcy. Being unscrupulous, Acme's managers succeed for a time in hiding its perilous financial condition from the public. During this lying time, Acme's share price will be too high. Investors will buy Acme shares at prices that conceal the company's imminent doom. Creditors will extend financing to Acme on terms that do not compensate those creditors for the true risks that they are unknowingly undertaking. Perhaps some of Acme's employees will turn down good job offers at other firms in order to remain at what they are misled to believe is a financially solid Acme Inc.

Eventually, of course, those misled investors, creditors and workers will suffer financial losses. But the economy as a whole loses, too. Capital that would otherwise have been invested in firms more productive than Acme Inc. never gets to those firms. So compared with what would have happened had people not been misled by Acme's deceitfully high share price, those better-run firms don't... expand their operations as much. They don't create as many good jobs.

Milton Friedman made a similar case in 2003:

There are people going to jail for insider trading and I think it has been a great mistake. You should want more insider trading, not less. You want to give the people most likely to have knowledge about deficiencies of the company an incentive to make the public aware of that.

Laws against insider trading don’t stop the practice.  They mostly just conceal it.    And the attempts to police it grow a vast wasteful class of bureaucrats and lawyers who serve mostly to obfuscate and delay—thereby stifling innovation in financial markets.

To be sure, insider trading isn't good in all cases. Often insiders profit at the expense of other investors.  But companies and shareholders, not the government, are in the best position to weigh the costs and benefits and decide what to allow and what to punish.

Each corporation should be free to specify in its by-laws the types of information that insiders may not trade on. Any insiders who trade on such information would violate that firm's by-laws and, hence, subject themselves to suit by that firm.

Relying upon competition and the self-interest of shareholders and creditors... removes politics from this vital task.

One size rarely fits all. Leave insider trading up to the market.