More laws won’t make markets more efficient
THE “clean government” bill bans American politicians from using their inside information for personal profit, for example, by trading securities. It passed the Senate last week by a vote of 96 to 3. Which is a pity. Prohibitions on insider trading should not be extended; they should be repealed, not only in America but everywhere.
Insider trading is a kind of whistle-blowing. An insider may have information to which outsiders are not privy. Perhaps his firm has discovered oil in Canada or invested in dodgy mortgage-backed-securities. While such information remains hidden, the firm’s shares and bonds will be mispriced: undervalued if the suppressed information is good, overvalued if it is bad.
By trading on his privileged information, the insider moves the firm’s shares towards their proper price. Outsiders then make better decisions about investing in, working for or trading with the firm. By improving the accuracy of the market’s price signals the insider trader improves the allocation of capital in the economy. He is a public servant.
Of course, insider traders do not aim to serve the public. They are not trying to punish their evil corporate overlords, save the planet or achieve any other noble goal. They aim to profit themselves.
This may explain why this public service is banned by law. Insider trading strikes many as an unfair use of a privileged position. According to a Californian court, it is “a manifestation of undue greed among the already well-to-do, worthy of legislative intervention if for no other reason than to send a message of censure on behalf of the American people.”
Perhaps insider trading really is a sign of greed. But, as Adam Smith taught us, that does not stop it from improving capital allocation. Nor does this greed harm outsider traders.
Imagine an outsider who has decided that shares in the Salvation drug company are good value at anything under £10 each. They are trading at £9, so he buys some. Suppose a Salvation insider simultaneously sells his shares because he knows some unannounced bad news about the firm. This does not mean the outsider has been cheated. If the insider had not traded, the outsider would still have bought the shares for £9. And he would still have been making a mistake.
“Asymmetric information” is a universal feature of market transactions. It would be miraculous if buyer and seller ever knew the same things about the traded good, be it a company share, a car or a lemon. Yet, outside of securities markets, no one recommends banning those who are likely to know more from transacting. Car mechanics are allowed to buy cars and farmers may sell fruit.
Never mind. Insider trading laws do little harm because they are unenforceable. A determined insider will always be able to find an apparently unconnected outsider to transact his business. And it is impossible to tell when someone chooses to hold rather than sell his shares on account of inside information.
Politicians know their legislation is impotent, of course. Its real function is only to allow politicians to make a show of their virtue and, on those rare occasions when someone is careless enough to get caught, as the lifestyle guru Martha Stewart was in 2002, to make a public sacrifice to the god of envy.
Jamie Whyte is a senior fellow of the Cobden Centre.