Insider Trading is Good for Everyone

Posted on October 25th, 2009 by admin in Finance

Casual intuitions in the world of finance and markets often break your heart. A fascinating piece in Wall St. Journal this week reveals how we generally fail to think carefully about one of the recent boogeymen: insider trading. It’s obviously a bad thing, because it lets some people enrich themselves at the expense of others, right?

Not really. Consider this excerpt from the article:

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.

Remember the 1970s-era price ceiling on gasoline? By causing prices at the pump to lie about the scarcity of oil, that price ceiling led Americans to waste untold hours waiting in lines to fuel their cars. Similar wastes occur when corporate assets are mispriced.

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 enhance their efficiencies as much. They don’t expand their operations as much. They don’t create as many good jobs. Consumers don’t enjoy the increased outputs, improved product qualities and lower prices that would otherwise have resulted.

In short, overall economic efficiency is reduced.

You can read the whole article here.

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