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Perhaps one of the most well-known and highly publicized white collar crimes is insider trading. It was the basis for Oliver Stone's famous movie Wall Street. It was even part of what sent America's favorite homemaking expert Martha Stewart to prison.* So it might come as a surprise that some would argue to make insider trading legal. Reasons for doing so were outlined this weekend in a Wall Street Journal op-ed by Donald J. Boudreaux, Professor of Economics at George Mason University. Some of his arguments are quite compelling. I still think, however, the potential harm outweighs the benefits he suggests.

First, I'm not a proponent of excessive government regulation. But I think some regulation is definitely called for. I further believe that the best kind of regulation is that which enhances information availability. Better information makes for more efficient markets.

I have always seen insider trading an information issue. If some people have information and others don't, then those who do have an unfair advantage. Thus, insider trading is an area where it makes sense for the government to step in.

But from a strictly economic standpoint, who has information that might cause a stock's value to rise or fall is irrelevant: the price will ultimately change no matter who does the trading. As a result, if nothing else, Boudreaux's view is grounded on that simple fact. Making insider trading legal would amount to a transfer payment from all investors to insiders. Without the laws, insiders would have far more substantial returns, since they could utilize nonpublic information sooner. That would come at the expense of outside investors.

Boudreaux does have some very strong arguments, some of which I am quite sympathetic to. The piece is also quite long, however, so I can't rehash it all here. But here's the general idea, which he provides greater detail to in the piece:

Insider trading is impossible to police and helpful to markets and investors. Parsing the difference between legal and illegal insider trading is futile--and a disservice to all investors. Far from being so injurious to the economy that its practice must be criminalized, insiders buying and selling stocks based on their knowledge play a critical role in keeping asset prices honest--in keeping prices from lying to the public about corporate realities.

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.

The whole "It's so hard to enforce!" argument I find to be a red herring. While true, it's also pretty difficult to catch smart serial killers, but obviously that's not a reason to stop trying. What I find more valid is the argument that there are certain efficiencies that you get when you allow insider trading. It does cause stock price to change more quickly, which might be desirable, as Boudreaux mentions.

Fewer Corporate Scandals?

Boudreaux makes another interesting argument in which he recounts one made by a George Mason colleague Henry Manne:

According to Mr. Manne, corporate scandals such as Enron and Global Crossing would occur much less frequently and impose fewer costs if the government didn't prohibit insider trading. As Mr. Manne said a few years ago in a radio interview, "I don't think the scandals would ever have erupted if we had allowed insider trading because there would be plenty of people in those companies who would know exactly what was going on, and who couldn't resist the temptation to get rich by trading on the information, and the stock market would have reflected those problems months and months earlier than they did under this cockamamie regulatory system we have."

The idea here is that people might be less inclined to cover up bad corporate performance if they could just sell their stock. I'm not so sure. I think the same evil sort of greed that drives such individuals to cover up bad results might cause them profit by legalized insider trading in a different way.

For example, if you are an insider with some control over a company doing very well, you could suddenly sell all your stock when everything is fine. The stock price would plummet, because the investing community would assume something has gone very, very wrong inside the firm. But then you could buy the stock back at a huge discount. When it became clear that the company had no issues, the stock would go back up and you would make a great deal of money. The point is that unscrupulous greed will always find a way to take advantage of the system, no matter the laws in effect.

In spite of the positives that Boudreaux explains, I find a few big negative ones:

Investing Apathy By Outsiders

Imagine that you're someone with some money to invest in the current environment with insider trading laws. You believe that there's a relatively level playing field, where everyone gets the same information to evaluate whether to buy or sell a stock. That sounds like a fair situation where you might be able to make smart investments if you are good at analyzing that data.

But imagine if there weren't any insider trading laws. It would be virtually impossible for you to ever have an edge over insiders. You'd get the information eventually, but only after insiders have already acted on the data and the stock price has changed accordingly. As a result, your analysis would be pretty much useless.

Some outsiders might still believe they have savvy that even insiders can't fathom. But I fear that most outsiders would feel that the advantage that insiders have is simply too great. Outsiders would be deterred from investing. This would obviously be a big problem for equity markets, as it would reduce trading and investment.

Oddly, Boudreaux sort of concedes this point in a round about way, saying that corporations would have an incentive to have policies banning certain insider trading so to make sure its capital costs stay low, and investors want to buy their stock. He asserts:

Competition is a beautiful thing: It will punish firms that are either overly inclusive or under-inclusive in the sorts of information that they shield from inside trading.

Huh? But doesn't that harm his argument that insider trading is a good thing? If corporations would do worse with insider trading, I'm not sure how it would be a good thing to legalize.

Following Insiders Instead Of Fundamentals

But what about those handful of investors who still think they can compete with insiders if the laws were lifted? Well, I'd argue that they're going to pay a lot more attention to insider trading than fundamentals. That's bad.

For example, let's say that the CEO of a pharmaceutical company sells 20,000 shares of his stock at $20 per share. Investors get wind of this and sell the stock: they assume that the insider must have got wind of a test drug failing or something similar that would debilitate the stock price. In reality, he decided to make a 20% down payment on $2 million mansion in Palm Beach and just needed to cash out some of his shares to pay for it. Even if he releases a statement indicating a home purchase was the reason for the stock sale, investors may or may not choose to believe him. They don't know the truth for sure, because they don't have all the information that he does.

The last thing you want is for investors to stop concentrating on the legitimate information and care more about the buying and selling habits of insiders. After all, insiders will have more information, so their actions might speak very loudly if savvy investors are trying to get an edge on what's going on within the walls of a firm. Watching insiders will fuel speculation and poor investment decisions instead of buying and selling stock based on solid analysis.

As mentioned, Boudreaux has some very good arguments, so I urge you to read his whole piece if you want some more of the positives he outlines. Insider trading laws definitely aren't as clear cut as most people think. I'm just not convinced shareholders or firms would benefit in the long run if these laws were repealed.

* As a commenter was nice enough to point out, Stewart wasn't convicted of insider trading, but of obstruction of justice for lying to a federal agent in conjunction with an insider trading case.