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Article Excerpt
I. Introduction
This paper investigates economists' opinions on insider trading. More particularly, it investigates the policy recommendations that economists give, with a special focus on whether insider trading should be regulated and whether the government should be the main force behind the regulation.
Insider trading is probably the most known and publicized white-collar crime. The media often depict the perpetrators, the insiders, as cutthroat, manipulative, greedy individuals. In addition, since the 1930s, insider trading has been subject to ever-increasing attention on the part of the government. The Securities Exchange Commission, created in 1934 to regulate financial markets, has seen its budget dedicated to enforcing insider-trading laws increase exponentially. At the same time, Congress has supported imposing more and more severe sanctions against insider trading. By criminalizing insider trading and imposing monetary penalties as well as sanctions involving jail-time, the government has made this fight against insider trading a true "witch-hunt." (1)
On the other hand, not until 1966, when Henry Manne published his book, Insider Trading and the Stock Market, do we find some economic analysis of insider trading. In this book, Manne challenges the commonly accepted idea, at least among legal scholars, that insider trading should be prohibited. Manne's seminal work starts with a simple observation: No rigorous analysis of insider trading was ever done. According to Manne (1966b, p.113), economists did not pay attention to the issue, and lawyers were too incompetent to engage in a serious scientific analysis of the subject. There was a unanimous, dogmatic agreement among commentators, lawmakers, and policymakers that "insider trading is a sin, and the war against it is a holy one" (Manne, 1966b, p.113). Insider Trading and the Stock Market can be viewed as an attempt by Manne to put some sense and analytical rigor back into a debate in which "logic has been totally lost to emotion" (Manne, 1966b, p.113). As Bainbridge (2001, p.65) observes, "it is only a slight exaggeration to suggest that Manne stunned the corporate law academy by daring to propose deregulation of insider trading."
Whether we agree with Manne's arguments that insider trading ought to be deregulated for efficiency considerations, there is no doubt that his arguments are at the origin of the prolific debate that followed among lawyers, economists, financiers, and policy-makers. Moreover, the recurrent insider-trading scandals publicized in the media continue to fuel the seemingly endless debate.
At this point in time, it seems interesting to see what opinions economists have formed on insider trading. After all, as Manne argued, economists seem better equipped than others to analyze this issue, which receives a lot of attention from government officials, and is regularly the object of media attention every time a new major insider trading case arises. Therefore, if we agree that economists use the same set of analytical tools in their research, it seems reasonable to argue that they would be using these tools to form an opinion on insider trading when asked about it.
To examine what economists have to say on insider trading, we first review the economic literature and attempt to review the policy implications economists reach when they analyze insider trading. Second, we survey 3,000 economists and ask them to share their thoughts on insider trading.
In Section II, we present Manne's thesis regarding insider trading. In Section III, we review the literature and analyze the policy conclusions economists derive from their analysis. In Section IV, we discuss the results of a survey we conducted among economists. In Section V, we offer some concluding remarks.
II. Insider Trading and the Stock Market: Toward an Economic Analysis of Insider Trading
Manne's Insider Trading and the Stock Market (1966) can be viewed as the first attempt to develop an economic analysis of insider trading. His work rests on one big idea: A rigorous analysis of insider trading demonstrates that it is no longer certain that insider trading is harmful to society. Therefore, it does not necessarily follow that we should come down with "hobnail boots" on insiders, to use the expression that John Shad used when he took office in 1981 (Henry, 1986, quoting SEC chairman John Shad).
To support this idea, Manne advances two seminal arguments, which initiated the debate on insider trading. The first argument relies on the informational role of prices in improving capital market efficiency. The second argument relies on the entrepreneurial role played by corporate managers and how insider trading could be used to compensate those insiders for their entrepreneurial activities. (2)
Manne argues first that insiders trading on nonpublic material information contribute to improving the informational efficiency of stock prices. The argument recalls Hayek's (1945) "The Use of Knowledge in Society." (3) Hayek believes that prices are crystallized pieces of local knowledge signaling to market participants where to allocate means of production. Similarly, securities prices could be seen as signal mechanisms to inform investors where to allocate the capital that will be used to produce the goods and services. The more accurate these prices are, the more likely it is that market participants will invest their capital in the correct lines of production. According to Manne, insiders, by trading on nonpublic material information, are going to contribute to moving securities prices toward their accurate value. Securities prices will move toward the value that market participants will give to the securities "if all information relating to the security had been publicly disclosed" as a result of the insider's trades (Bainbridge, 1999, p.777). Therefore, the investors benefit from this increased efficiency, as they will be more likely to invest their capital in lines of production that consumers value. Overall, the society at large benefits from insider trading.
Second, Manne argues that insider trading could be an efficient compensation scheme. More exactly, he argues that allowing trading on the information that the corporate entrepreneurs contribute to create would be an efficient way of compensating them. The profits realized through the use of the information these entrepreneurs produce acts as an immediate compensation for their entrepreneurial activities. In addition, as Manne (1966b, pp.117-118) explains, compared to other compensation schemes, insider trading is far superior to bonuses or stock options because price increases resulting from public disclosure of the information provides, even though imperfectly, a comparatively accurate measure of the value of the information created by the entrepreneur. By allowing the entrepreneur to profit from this information before it is disclosed to the general public, he can recover the value of his discovery. According to Manne (1966b, p.119), compensating entrepreneurs for their innovations by allowing them to inside trade will stimulate even more innovations on the part of these entrepreneurs.
As a result of Manne's work, a great deal of the literature including the legal, financial, and economic literature took the issue of insider trading and Manne's arguments very seriously and attempted to find answers to the questions Manne raised. We now focus our attention on the economic literature on insider trading.
III. Economists and Insider...
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