My last post ("A Strange Industry, or, When the Market "Breaks Down"") reminded me of the many bad laws which have been justified by the argument of "market defects". Now, these don't always take the form I described in the last post, claims that the market is not functioning properly, some also take the form of arguments about "unequal information", as if one side having an advantage is a sign that the market is defective. First, what is apparently an advantage to one side may not always be so, second, even if it is, that does not mean the government needs to intervene, unfairness is not justification to remove the rights of individuals ("Life Is Not Fair - And Trying To Make It So Makes Things Worse"). And finally, intervention, though well intentioned, may cause worse results.

First, let us look at imbalances of information. Every stock exchange, excepting those that are pure gambling, are based upon the traders thinking they know something the other side does not. No, this is not just about "insider information", it can be that each trader's analysis points in a different direction and he thinks he is right. It could be that one has heard rumors the other hasn't. It could be any number of factors, but the fact remains, so long as we do not want the stock exchange to become a large casino, we have to accept apparent imbalances in information, or no exchanges would take place. Of course, we do not know at the time of the exchange which side had the better information, but obviously one side or the other will be proved right in the end.

My second point is likely going to be more controversial, but it makes sense. There should be no restrictions on "insider trading". First, because the term is ill-defined. As some theories define it, anything other than outright guessing would be disallowed. But even using the most restrictive definitions, there is no way it should be disallowed. Yes, firms can write employment contracts to prevent their employees from trading on information aimed through their jobs, but, as a matter of law, there should be no prohibition.

Let me first make the political argument, which will likely not convince anyone. Just because an imbalance of knowledge exists, there is no justification for limiting one's right to contract, which is all a stock trade is. Rights are not contingent upon fairness. One's actions can only be restricted when his actions interfere with the rights of others, and, under no definition does an unfair stock trade constitute a violation of another's rights.

And now to the practical argument. Forbidding insiders from trading on their knowledge prevents the rest of the market from sharing in that knowledge. Yes, the insiders will make a large profit on this information, but all stock trades benefit those with better information, we should not allow envy to prevent us from looking at the other effects*. Once an insider makes a trade two things happen. First, his trade moves the market slightly, giving a sign to traders. Second, traders will notice WHO is selling, and will act on it, as well as informing others. And so, thanks to the actions of the insider, others, who would not normally have this knowledge, can now act, either cutting their losses, or enjoy some part of the gains. And, as the knowledge ripples through the market, either through direct information, or just as others respond to the market trend, the market as a whole can act on this information more quickly and well in advance of a formal announcement. In short, it allows the market to adjust more quickly.

Let me just ask this simple question. Do you think Enron investors would be worse off had Enron insiders been allowed to act on "insider information"? Those who lost everything probably would have still suffered a loss, but having hints much earlier that something was wrong would have allowed them to sell earlier and maybe suffer a smaller loss. Yes, Enron insiders would have benefited, but ask anyone who was bankrupted if they would let Enron middle managers gain a few million if it would give them back their investments, and those who aren't completely consumed by rage or envy would probably answer "yes".

And in the end, that is the best argument for allowing "insider trading". The argument against it always is the "inequity" of having differing levels of information, but allowing insider trading actually acts to equalize the levels of information more quickly. If insiders are prevented form trading, then the insiders are privy to information about which everyone else has no knowledge right up tot he moment of announcement, and they can act on it then to their full benefit. On the other hand, if they can act early, it will allow others to gain this knowledge early, enjoying some part of the benefit, with the knowledge gradually trickling out throughout the market, allowing the market to adjust more rapidly, and without as many sudden shocks as occur when information is dramatically presented.

Now, granted, even with insider trading there may be such sudden shocks. If the CEO of a company dumps every share he owns, likely the market will still react with shock and the stock will plummet. On the other hand, smaller news will likely allow for more gradual adjustments, which will be better for the market.

And there is one additional benefit. Even if companies include clauses preventing trading in their contracts, it is likely employees will find ways around them, using family members or friends. Presently, the illegality of such acts make them less likely. Were they legal, the companies would be well aware that employees could leak unfavorable (or favorable) information at any time, and that would encourage them to make public adjustments to earnings estimates and other financial projections, even without legislation. With the possibility that any unfavorable information might be leaked, companies will be wary of relying on information remaining secret.

Of course none of this is original to me, many who do not obsess on "imbalances" and "unfair competition" have pointed out the same, that allowing free trade, even when information is unevenly distributed helps to level out the information over time and is the most efficient system. In many ways this is similar to the arguments for the free market in general. While many malign the free market  because of inequities of wealth, or ability, or of other positional advantages, the truth is, allowing those with advantage to exploit them actually benefits everyone and tends to levels out advantages over time**.

Perhaps one day I will write something tying all of this together. The arrogance which inspires individuals to call the market "broken" ("A Strange Industry, or, When the Market "Breaks Down"", "Bad Economics Part 2") or to seek to impose their values on the market ("The Inherent Disappointment of Authoritarianism"), the leveling tendency which seeks to eliminate inequities ("Life Is Not Fair - And Trying To Make It So Makes Things Worse"), the utopian trend which refuses anything short of perfection ( "Utopianism and Disaster "), which seek to give control to human whim and arbitrary choice rather than constant principle ( "The Wrong People", ""Empathy" Threatens not "Justice" but Predictability ") and the anti-man perspective which informs so many theories ("Juvenile Intellectuals", "Anti-Man Intellectuals", "The Lie of Environmentalism"). They all tie together in many ways, all have so many features in common, that whenever I write about one I find myself mentioning the others. Yet I have not yet written a more general post explaining how they all relate to one another.

Perhaps when I have enough time that would be an interesting undertaking.

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* The other thing to recall is that insiders are not prevented from acting once the information they have becomes public, so they are likely going to act right at the moment of whatever announcement, making just as much of a killing. Insider trading simply allows the market to get that information early and act more quickly.

** For example, the inherited fortunes many malign are the source form which venture capital is raised allowing new fortunes to be made. If we were to expropriate inherited wealth, we would end up making it harder for newcomers to break into industry. In fact, most measures proposed to "level the playing field" have a similar outcome, reducing everyone to the lowest level, rather than elevating them even slightly. (See "Greed Versus Evil" and "A Great Quote".)

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POSTSCRIPT

As was mentioned in passing above, this post relates to two others. First, "Bad Economics Part 2", which focuses specifically on "destructive competition", one of the more popular versions of "broken free market" arguments (also mentioned in "Saving Us From Lower Prices"). Second, "Life Is Not Fair - And Trying To Make It So Makes Things Worse", which explains the many reasons that trying to even out the inequities of reality does more harm than good. I suppose I should also mention  "Fairness and the Free Market", "Planning For Imperfection" and "Greed Versus Evil ", all of which argue that the free market, by its nature, is best adapted to handling imperfect situations, producing the results most beneficial to all involved, regardless of the inequity of the starting positions. I do not claim it is "fair", in fact I dislike the word "fair" (see "Protean Terminology " and  "A Question of Fairness"), but as reality does not ensure equity, we are forced to deal with that reality, and the free market, starting from that inequitable origin, produces the greatest benefit for all involved. And, if an inequitable situation is unavoidable, isn't the best response to see that that inequity is turned to the general good?

Best of all, though it does benefit everyone, promotes the general welfare, the free market does so by allowing each individual to pursue his own interests. In other words, unlike most solutions promising "general good", the free market does not do so by yoking the stronger for the benefit of the weaker. Instead, it is simply designed in such a  way that while the stronger pursue their own desires, the actions they take benefit the rest. The benefit is not from coerced cooperation, but simply an outcome, the result of their pursuit of their ends.

But that is a point for another essay.