Tuesday, March 22, 2022
The following comes to us from Professor Mike Guttentag in response to my recent post on his excellent and thought-provoking new article, Avoiding Wasteful Competition: Why Trading on Inside Information Should be Illegal. This is a worhy discussion I look forward to continuing--and I hope others will engage in the comments below. Now, here is Professor Guttentag's response:
As always, I am honored and impressed by the seriousness and respect with which Professor Anderson approaches my work. I would, however, take exception to the reasons he offers for rejecting my conclusions.
The debate about insider trading over the past five decades has suffered from limited evidence of either benefits or harms. Those who have objected to a strict insider trading prohibition have reasonably asked: what evidence is there that the harms of insider trading justify a broad prohibition?
In my article I believe I have answered that challenge. First, I explain why there is a significant mismatch between private gains and social gains when trading on inside information. This mismatch arises both because of how inside information is produced (largely as a byproduct of other activities) and how trading on this information generates profits (at the expense of others). I next show how this mismatch between private gains and social gains (perhaps the defining economic feature of insider trading) leads to an unusual problem: the problem of too much or wasteful competition. This is not just a theoretical concern. I offer concrete estimates of the magnitude of the costs of this wasteful competition problem. One very conservative estimate puts the costs of wasteful competition in United States equity markets in the range of tens of billions of dollars a year. The logic is compelling, and the amounts involved substantial: insider trading is a socially wasteful activity that should be outlawed.
The time has now come for those who would do less than outlaw all trading when in possession of inside information to provide either equally compelling evidence of the benefits of an alternative regime or an explanation as to why my calculations are flawed. I do not believe that Anderson’s critiques meet either of these challenges.
I will go through Anderson’s critiques one by one. The first concern Anderson raises is that he believes my argument hinges on the claim that all inside information is produced as a byproduct of other activities. Anderson has read my argument as relying on a stronger claim than I think it needs to rely on. I do not aim to refute the vast body of work by the likes of Henry Manne and many, many others on the various costs and benefits of insider trading. These lists of the potential costs and benefits established over the past decades are largely correct. However, there are two problems with these lists. First, these lists have consistently failed to realize the magnitude and importance of the wasteful competition problem created by insider trading (I have addressed the reasons for this oversight elsewhere, Law and Surplus: Opportunities Missed). Second, once the costs of wasteful competition are included in the calculus the appropriate starting point shifts. Given how significant the wasteful competition problem is, we need more than just a list of plausible but hard-to-quantify costs and benefits to rebut the presumption that all trading when in possession of inside information should be outlawed. That is the extent of my claim.
The second point that Anderson raises in his comments is that he does not think I have carried out an adequate “comparative institutional approach to market failure.” In fact, I think I do a fair job in the article of addressing this question, and show, for example, why private ordering is not an effective alternative to legal intervention as a way to address the wasteful competition problem created by insider trading. Moreover, the correct comparison should be between the cost of our muddled and confused current regime and the simple proposal I offer, a proposal, by the way, that is similar to the insider trading prohibition already in place in Europe (albeit with less enforcement capability in Europe). I do not see what institution Anderson thinks could do a better job addressing the problem I have identified than the federal government. As a side note, if we want to minimize the kind of rent-seeking by government officials that Anderson also mentions, then a bright-line such as the one I propose might well be preferable to the murky waters that now surround the insider trading prohibition.
The third point Anderson raises is that he finds my consideration of internal compliance costs lacking. My response to this observation is: internal compliance costs as compared to what baseline? The current system is a quagmire, whereas the one I propose would be more straightforward to implement. It seems to me that when it comes to minimizing internal compliance costs my proposal is preferable to the status quo. But even if I am incorrect about the relative costs of internal compliance under different regulatory regimes the larger point remains: discussions of these kinds of second order, difficult-to-quantify cost simply do not offer enough evidence to justify accepting the costs of wasteful competition that a very conservative estimate puts in the range of tens of billions of dollars a year in only one marketplace.
The fourth point Anderson raises is yet another potential cost of my proposal as compared to the status quo. Anderson correctly points out that my rule may be over-inclusive and prevent some individuals from gathering and trading on information for which social gains are equal to or greater than private gains. This is true. However, again, where is the concrete evidence that these costs of over-inclusivity are anything near the magnitude of the quantifiable costs that result from wasteful competition. The evidence in support of a sweeping prohibition remains.
Finally, Anderson raises the specter of criminal punishment. I did not hope, as Anderson suggests, to fully “detach my model from the debate over the morality of insider trading.” I only rejected current efforts to base an insider trading prohibition on fairness concerns. In terms of advancing my own arguments, I felt that as a practical matter the topic of links between solutions to a wasteful competition problem and criminality was too vast to fit in an already long article. For those who are interested, I have begun to further explore these connections elsewhere in work on the relationships between evolutionary psychology and the use of law as a tool to share resources.
The one point I did make in the article relevant to the question of criminal liability for insider trading was to observe that engaging wasteful competition can trigger moral outrage in some circumstances. Such feelings can be observed, for example, when others react to people cutting in line. We have normative reactions to people who pursue their naked self-interest in situations where payoffs through cooperation are greater than those that can be realized through competition by, for example, refusing to honor a queue. Anderson investigates this analogy by asking about someone who has permission to cut in line. Presumably, he means to draw a parallel to issuer-sanctioned insider trading wherein firms allow employees to trade on material nonpublic information. The question of whether or how permission to cut in line might be granted is quite complex and is a topic for another day. I only hoped in this article to suggest why there might be a link between my conclusion that avoiding wasteful competition justifies an insider trading prohibition and the choice to criminalize insider trading.
Again, I truly appreciate Anderson’s honest engagement with my work. However, I think he fails to provide a compelling rebuttal. What we need now in the United States is a prohibition on all trading when in possession of inside information.