Should Insider Trading Be Legal?

The Wall Street Journal ran a thought-provoking story on the front page of the Weekend Journal section this past Saturday, in which George Mason University economist Donald Bourdreaux argues that insider trading should be legal. This article proved particularly timely given the charges being brought against hedge fund investor Raj Rajaratnam this month. Boudreaux draws heavily on the classic work of Henry Manne to make his case.

How could Boudreaux argue that insider trading should be legal? He makes the case that insider trading could actually improve the efficiency of our capital markets. Here's the crux of his argument:

"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."

Henry Manne has actually made the argument that we might have fewer corporate scandals such as Enron and Worldcom if we allowed insider trading. The idea is that some insiders would have perhaps started selling the Enron stock given their knowledge of the firm's actual inner workings. They would have pushed the stock price downward, curbing the incredible run-up that took place and sending a very clear signal to outside investors that all may not have been as rosy as it appeared. Without such insider trading, outside investors sometimes remain in the dark for far too long, continuing to plow capital into a sinking ship because they are unaware of the actual condition of the firm.

I find the arguments about capital market efficiency to be compelling, yet I cannot help but wonder whether equity concerns trump these efficiency concerns. While it may be good for the market as a whole to have such insider trading, one wonders whether it is fair that a few well-placed insiders with unique access to information might profit handsomely in the process. It's a classic efficiency-equity tradeoff in some sense. Having said that, there are some reasons to believe the current system isn't so equitable either, given that many believe that only a small fraction of actual insider trading situations are identified and prosecuted.