Insider trading leads the news again, casting a cloud over Steven Cohen’s SAC Capital Advisors $14 billion hedge fund.

The SEC charged Mathew Martoma, who used to manage a SAC Capital division, with using inside information about tests on an Alzheimer’s drug to trade stock of the company working on it.

The media love this stuff. I imagine reporters sitting around saying: “The SEC finally will punish greedy Wall Street! These tycoons rig the game – cheating is how they acquire $14 billion – and now noble government prosecutors will bring justice.”

But this is nonsense. Government prosecutors are as ruthless and greedy as anyone.

It’s easy to hate the rich – and in our bailout economy there are reasons for suspicion. But capital doesn’t find the best outlets by itself. Hedge funds spot promising opportunities and quickly direct capital that way. Their reward is profit. When government interferes with that, we all suffer.

Under current law, insider trading still happens. Stock prices routinely rise before takeovers.

The line between research and felony is very fine. One famous investor asked visitors, “What do you know that others don’t?” Active funds like Cohen’s may get information first because they trade frequently, so brokers want their business. One stock picker even calls CEOs and then buys stock based on the tone of the answer. What’s legal? Even the lawyers can’t agree. The SEC says it is illegal to trade “securities after learning of significant, confidential corporate developments.” Aha! The “insider” has more information than the rest of us!

But people in a stock trade never have the same information. One does exhaustive research about a company, another does less, and a third trades based on some market theory. In no way are these three “equal” in what they know.

Yes, you say, but the prosecutors allege inside information. One trader may be an employee of the firm. Why should he be free to use that information to buy or sell a stock?

Because America should be a free country.

Investors say the law persuades more people to invest. “It makes markets more robust. That gave us biotech, Wal-Mart, Microsoft,” says hedge fund manager David Berman. “Companies raise capital in U.S. markets because of that confidence.”

Sure. But in America, a free market would take care of that. If a stock exchange or company wants to have a rule against insider trading, fine. Some of us will invest only in those companies or that exchange. But imprisoning select people who catch a prosecutor’s attention stifles the flow of information.

Think about the role of prices in a market economy. They aren’t arbitrary numbers. They are bearers of information that guide people in buying and selling. Prices are never perfect, but whenever government regulation stifles this information function, it leads market participants astray.

In an actual free market, a company’s stock prices embody traders’ expectations about its future. Information confirms or upsets expectations, and that is reflected in prices. The sooner relevant information gets built into the stock price, the better for everyone.

As economist Warren C. Gibson writes: “When the dissemination of significant news about a company is blocked by insider-trading restrictions, that company’s shares are mispriced relative to where the price would be if the news were out. If the news is bad, investors will buy at prices they would not have paid had they heard the news. Movement of capital toward more productive uses is inhibited. If it is good, some sellers will let go of their shares at prices they would not have accepted. … In either case, there is a net loss to the economy.”

Vague anti-insider trading laws distort prices. Prohibiting people from profiting from their access to information makes the economy less fair and less free.

Also, these laws, like all regulation, create a false sense of security. They lead people to think stock traders play on the same level field. Far better to encourage investors to be wary – not complacent – when they buy stocks. For every buyer, there’s a seller. What does the other party know that you may not know?

If you object to insider trading, avoid companies that permit it.

But government should butt out.

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