Bryan Caplan  

Manne More Than Ever

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Stiglitz’s The Roaring Nineties partially blames the big accounting scandals on market fundamentalism. But I’m inclined to agree with Henry Manne that one of the best cures for fishy accounting is to legalize insider trading. Here’s an excerpt from an interview with Larry Elder:

Elder: Let's talk about the recent state of corporate accounting scandals: Enron, Global Crossing, etc. What impact would insider trading have had on these kinds of scandals?

Manne: 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.

Take one of the simpler complaints about U.S. accounting: failure to count the cost of stock options. If insider trading were legal, then insiders – like accountants at Arthur Andersen - could sell the stock of firms the knew to have poorly disclosed but seriously expensive stock options. The information pours into the market, the exaggerated earnings statements fail to impress, and Mr. Small Helpless Investor doesn’t get any rude surprises from his broker when news finally trickles down to the New York Times.

I guess Stiglitz would deride my proposal as "market fundamentalism," but I call it common sense.


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COMMENTS (11 to date)

This post reminded me of the movie "Ransom" in which Tom (played by Gibson) announces bounty on the head of his son's kidnapper. The "whistleblowers" inside the company need some encouragement to expose the malpractices as they face the risk of not only losing their jobs but also their whole career. If insider trading is legalized then "whistleblowers" can profit themselves while at the same time exposing the top boses at the company.

You can even compare this to the deals that DAs sign with some of those accused of a crime in order to catch the bigger "fish".

To get the same effect, insider trading should be legalized for everybody except the top boses (CEO and the chairman of the Board of Directors).

spencer writes:

Two wrongs make a right?

I think allowing insider trading would have the desired effect, but it has to be controlled properly. I wrote an article on this topic about 18 months ago.

I proposed allowing insider trading at any time for any reason, but trades by insiders would have to be flagged in the trading computers and executed manually.

This would have two effects: the market would immediately know the volume of insider trading (amplifying the signal); and insiders would get a slightly worse price to compensate for the asymmetical information. A small number of different flags (i.e. "Employee," "Officer," "Director") would make the signal even clearer and minimize the price penalty low-level employees pay.

anon writes:

"I guess Stiglitz would deride my proposal as "market fundamentalism," but I call it common sense."

Glad to see the apple doesn't fall too far from the tree. You have the same sort of childish, naive blind faith in markets as Arnold does.

I feel sorry for students at George Mason who have to learn economics from people who are half as bright and twice as earnest as the average economist.

Michael H. writes:

Do you really believe that in a world where insider trading were legal that firms would grant carte blanche to even the lowliest employee to profit from the information that might come their way? Firms would immediately declare that any such profit from insider information belonged to the corporation and any employees acting on inside information without the consent of the firm (which the firm would never grant) would face immediate dismissal. The only people to benefit from this change would be the top echelon of management. And this change would not have helped prevent the Enron scandal in any way.

Lawrance George Lux writes:

Insider Trading is relatively unenforceable anyway, and occurs approx. a hundred times more often than it is reported. Arnold's barometer for Accounting control fails because the Market is too huge and Worldwide. My own Investment schedules have proved of interest to many people, and they are disappointed to find little activity; I could, though, trade 10 million shares of any of the Top Five Hundred Corporations without anybody the wiser. lgl

Paul N writes:

I, for one, like the idea of legalizing insider trading. On balance I think regulations on insider trading hurt people more than they help. I believe that you can't effectively keep profitable information secret (I'm actually skeptical that Enron's price path would have been drastically different were insider trading legal).

Brad Hutchings writes:

This is just like price gouging after a disaster, meaning... after the big hurricanes this fall, I was sitting around the table with my Dad and brought up how the gas stations on the east coast of Florida near expected landfall ran out of gas early on in the exodus inland. I said this was an example where price gouging laws pretty much screwed everyone. Florida's AG was on the prowl for price gougers before the hurricane could figure out which trailer park to wipe out. So I asserted that if the gas stations on the coast had the legal prerogative to raise their prices to $8 gallon, the gas would last longer and probably be distributed fairer. He said that only the rich could buy it then, and that to ensure fair distribution, we should call out the National Guard, impose martial law, and ... at that point he stormed off and said he was ashamed to raise such a heartless son. So go political arguments with my Dad. But he came to realize I was right, and in our collective desire to be fair and charitable, we sometimes screw up. In fact, it often seems morally superior to have good intentions and screw up miserably than to let things be.

We're never going to get rid of price gouging laws. Reason is suspended to arrive at them. We're never going to allow insider trading. Perhaps the best we can do is use the issue in the aftermath of disaster to point out the folly of good intentions and encourage people to think critically about how these systems end up working.

cb writes:

The problem that contributed so much to Enron, etc., is that the auditors were getting paid a lot of money to come up with the off-balance sheet entities. Removing that incentive (splitting the consulting and auditing function), as well as significant settlement fees would go farther than allowing insider trading.

Bernard Yomtov writes:

Not sure I agree about the benefits. If insiders can trade on the difference between the firm's actual situation and the market's perception don't they have an incentive to maximize the discrepancy?

And isn't there an issue of fairness and ethics here? If I'm a shareholder and an insider buys my stock at what he knows to be a bargain price isn't he withholding information that properly belongs to me, as an owner, and using it to profit personally at my expense?

And wouldn't this discourage people from investing in equities and thereby reduce the benefits of our financial markets?

Jon writes:

This support of insider trading is more naive adherence to dogma. First, insider trading is a breach of trust between the present or future shareholders and the management. Second, there is no empirical support for professor Manne's view. If it were correct, then before insider trading laws were inacted, there would have been no insider trading abuses---cases where executives profitted by selling shares shortly before a negative announcement. Such incidents prompted insider trading laws. Also, people would not lose much money in cases in which insider trading occurred. I don't think one could devise a good empirical test for this.

Finally, Manne completely neglects the "agent" problem--Managers act in their own interest, not in the interest of shareholders and shareholders lack the knowledge to prevent this. It is funny that those from the George Mason school, who developed public choice economics, seem to neglect how the same aspects of human nature that applies to government apply in the private sector as well (though corporations go out of business more often then governments!).

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