In his State of the Union address, President Trump called for a ban on Congressional insider trading. Although he didn’t spell it out, Trump’s innuendo referred to the popular theory that Nancy Pelosi’s $250+ million in net worth flows (partly) from profitable trades that she (or her husband) made due to her political office.
As a libertarian economist, for decades I’ve though the public misunderstands “insider trading,” and that the government shouldn’t prohibit it. (Back in 2012 I was on John Stossel’s show making my case.) Yet I realized just how “obvious” it is to conservatives that the government should stop people like Pelosi from personally profiting in this way.
Fortunately, I think I have a consistent and principled way to maintain my standard defense of insider trading, while also throwing red meat to the right-wing populists who want Congress to follow Trump’s imperative. In the next section, I’ll review my original economic analysis of the benefits of insider trading, and then in the final section I’ll explain why that framework can still allow one to endorse Trump’s proposal.
Why Insider Trading (in General) Should Be Legal
The quick case for allowing insider trading is that, in general, we want people with specialized knowledge using that information to move market prices in the right direction. On this score, the source of their specialized knowledge is irrelevant.
For example, as I write this post, the United States and Israel have just launched massive air strikes on Iran. Analysts are warning that, based on Iran’s response over the next few days, the global price of oil could rise by $10 to $20.
However, suppose a small group of investors employ sophisticated geopolitical models, as well as AI analysis of facial tics in world leaders as they have been discussing the Middle East on camera. These investors are firmly convinced that there is going to be a protracted war involving China and Russia, and that there will be serious disruptions to the flow of oil for the rest of the year. Suppose for the sake of argument that they are absolutely certain that, come September, the global price of crude oil will be at least $150 per barrel.
Now how could our investors profit from this outlier view? There are all sorts of strategies involving ETFs, futures contracts, or call options. But for our purposes here, it will help to make our broader point if we suppose they buy forward contracts that contractually commit them to buying (say) 1 million barrels of crude on September 1, at (say) $80 per barrel. Because forward contracts are bespoke, we can further suppose that the investors require evidence that their counterparty physically stockpiles the million barrels, while their counterparty requires proof that the investors have posted the $80 million. (For purists: Given their beliefs, our speculators could make a higher ROI if they loaded up on deeply out of the money call options. But they might be worried that their counterparties would default on a paper contract, and/or that the government might cancel such countries months into a hot war, saying speculators shouldn’t be getting rich off “war profiteering.” So it’s probably safer for our investors if they effectively hire someone to store the oil for them ahead of time.)
If things develop as our investors anticipated, and oil is indeed above $150 per barrel by September when the forward contracts mature, then they make at least $70 in profit per barrel, times the million barrels. (Note that they don’t have to take physical delivery, they can just sell their contracts to a refiner or some other appropriate party as the maturity date approaches.) The crucial point is that their successful speculation was not only privately profitable, but also socially beneficial: It effectively transported a million barrels of oil from a time of plenty into a future time of extreme scarcity.
In this example, to make things obvious I supposed that the investors would insist on proof of inventory. But in general, even if they merely bought standardized derivatives (such as a call option on September oil futures with a strike price of $130), it would have set in motion processes that would push up the spot price of oil right away. That would (a) incentive oil producers to bring more barrels to market and (b) incentive oil consumers to economize on their usage. The boost in supply coupled with the fall in demand would lead to rising inventories, which again is exactly what the world wants if farsighted investors (correctly) predict that the spot price of oil will be much higher in six months.
Now that I’ve spent so much time walking through a particular example about oil, notice that this generalizes: It helps allocate resources when market prices are correct. Whether we’re talking about the price of a barrel of oil or a share of Tesla stock, successful speculators “buy low, sell high” (if they think the item is undervalued) or “shortsell high, cover low” (if they think it’s overvalued). Their actions serve to move the (incorrect) price today towards a more correct price tomorrow. Successful stock speculators make the stock market less volatile than it otherwise would be. If expert analysts predict that a lawsuit verdict that will be released in a month will cause a company’s stock to plummet, they can shortsell now and start pushing the price down immediately. That actually helps the average (passive) investor, because it makes stock prices movements more gradual, rather than having huge crashes (or spikes) when news is announced.
But step back and realize that all of my commentary above is just as applicable to “insider trading” as it is to “outsider trading.” The social benefits of stockpiling oil (when a supply disruption is coming) accrue whether the investors are simply good at assessing facial tics, or got a Signal message from their brother-in-law who works at the Pentagon.
It Might Make Sense for Employers to Contractually Prohibit Insider Trading
Although I’ve long argued that the government shouldn’t have outright bans on insider trading (for the reasons given above), I always acknowledged (e.g. in my 2011 article) that a firm might want to contractually bind their employees from personally profiting on their insider knowledge (or giving tips to their buddies).
For example, a law firm wouldn’t want potential clients to be worried that intimate details from their merger, or defense against a lawsuit, could be leaked by lawyers in order to fuel lucrative stock trades. Consequently, it would make perfect sense for the law firm to contractually prohibit its employees from such behavior, threatening to fire them and claw back their pensions if caught doing so.
Conclusion: Why a Libertarian Can Support Bans on Congressional Insider Trading
And now we come full circle: Just as a private company might prohibit its own agents from insider trading, so too might the federal government want to prohibit members of Congress from the activity. So notwithstanding the general rule that the government should defer to private companies and individuals to work out the rules governing their relationships, there’s nothing in libertarian theory that insists members of Congress should be free to trade on their insider knowledge.
Given the scope for abuse—where policymakers might put certain items in bills with their own stock trading in mind—Trump’s support for a ban on Congressional insider trading makes eminent sense. On this issue, there’s no conflict between libertarian economics and populist pitchforks.
Dr. Robert P. Murphy is the Chief Economist at infineo, bridging together the dependability of Whole Life insurance policies with the benefits of blockchain-based finance.
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