How the Advertised Cure Can Actually Cause the Disease

Last Friday, the House of Representatives passed its version of new legislation (the STOCK Act) restricting ‘insider’ trading by government workers.

The STOCK acronym stands for Stop Trading On Congressional Knowledge.  Members of Congress (and the staff) can be aware of legislative developments that impact the fortunes of publicly-traded companies, and have traded on that information.  This incentive does not apply only to stock trading; for example, a new book called Throw Them All Out dedicates a chapter to land deals, where members of Congress (including a name known to many Boiling Frogs fans, Dennis Hastert) have purchased land whose value benefited from later Congressional actions aiding infrastructure and highway development projects. 

Legislation often has ‘unintended’ and/or more curious consequences.  When bills like this pass the House 417-2 and 96-3 in the Senate, well, it can be useful to consider what might go wrong.  One angle here arises from critical analysis of insider trading bans more generally.  There is an interesting strain of argument (led by people like Henry Manne of George Mason University) that insider trading laws should be abandoned.  Manne and others have argued that informed trading by insiders does no harm to longer-term investors, and that stock prices more accurately reflect value than they do if informed trading is not allowed to take place.  In fact, this latter implication can illustrate how the advertised cure can actually cause the disease, an outcome frequently worth considering in financial market policy. When insider trading is forbidden, stock prices are more likely to be at odds with their ‘true value.’  When those discrepancies get larger, they can provide a greater incentive to break the law, and lawbreaking gets rewarded to a greater extent than it would if insider trading laws didn’t exist.

How might this perspective help us understand ‘insider’ trading by Congress?  Well, Congress is a different beast.  Members of Congress are not corporate insiders serving, among others, their shareholders.  Members of Congress are serving all of us.  If they trade on nonpublic information that helps them make money, it can make security (and land prices) more accurately reflect their true value.  But a large majority of the public sees this form of advantage in the market as simply unfair, and more unfair than insider trading in the corporate world.  It resonates with concern about Congress as a business more generally, how they pass laws to make their closest friends happy, with campaign funding and other benefits coming in return, while the public interest in lawmaking lies low on the totem pole. 

But the perspective from criticism of anti-insider trading regulation can still provide a cautionary note about the STOCK Act.  While members of Congress may be restricted from trading themselves, that doesn’t make the inside information any less valuable to other people.  A debate has arisen in recent days about a late-breaking development in passing the law.  A long-flowering business among ‘political intelligence agencies’ is another piece of the puzzle.  These firms are paid by their clients to seek out political information and developments valuable not only in securities markets but commerce more generally.  An amendment led by Sen. Charles Grassley (R, Iowa) would have added disclosure requirements for these firms, but that amendment was deleted in final version of the House bill.   A conference committee lies ahead to compromise over the differences in the House and Senate versions of the bill.

The ‘political intelligence agencies’ term raises some other questions, including the scope of the new restrictions within the Congress and federal government more generally.  The preamble to the Senate version of the proposed legislation (S. 2038, sponsored by Sen. Joe Lieberman) calls itself …

An Act to prohibit members of Congress and employees of Congress from using nonpublic information derived from their official positions for personal benefit, and for other purposes.

In other words, this legislation appears focused on the Congress.  But Congress is certainly not the only government entity privy to valuable information.  For example, real intelligence agencies, like the Central Intelligence Agency, certainly have that capacity as well.  The intelligence agencies and other sensitive places like financial regulatory agencies and areas in the Executive branch have had their own internal policies to restrict ill-gotten gains.  But so did the Congress, and the Congress has now seen fit to add some more teeth to these restrictions. 

The details of this legislation have yet to be ironed out, through compromise and conference committee work.  The House version of the bill extended the scope of people covered, and employees of the executive branch and independent regulatory agencies and intelligence agencies may still be included in the final version of the legislation.

Some valuable perspective on the scope of the issue can be had in a new book that quickly landed on the New York Times bestseller list a couple weeks ago.  It is called Secret Weapon, by Kevin Freeman.  Pages 6-12 provide some useful background on still-pressing questions about market trading and sensitive information in July and August 2001, soon before the shattering events of 9/11.

Bill Bergman has 10 years of experience as a stock market analyst sandwiched around 13 years as an economist and financial markets policy analyst at the Federal Reserve Bank of Chicago. He earned an M.B.A. as well as an M.A. in Public Policy from the University of Chicago in 1990. Mr. Bergman is currently working with Social Movement Sciences LLC, a new enterprise developing evaluation and funding services for not-for-profit organizations.

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