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Insider Trading and Nontrading

The most gratifying part of paying attention to the economy is watching, at the end of every bubble, almost as a natural part of the financial cycle, the predictable spate of arrests.

There’s Madoff, of course, but his Ponzi scheme seems to have been a one-off (unless you think the whole stock market is a Ponzi scheme, which makes sense—after all, the problem with a Ponzi scheme is that nobody can take a dollar out that wasn’t put in by someone else, and that’s true of the stock market as well). More typical, though, are the arrests of insider traders.

What is insider trading? Let’s review the case of Martha Stewart, just because she’s famous: Some years ago, she sold her ImClone stock when the CEO of the company—who happened to be her friend—told her that they were about to publicly announce a big setback. She avoided losing money when the stock plummeted, which sounds good except the sucker who bought her stock—who we’ll call Shmo—took Stewart’s loss, for no better reason than Stewart was buds with the CEO and Shmo was not.

EDIT: Normdeplume, at Daily Kos, where I sometimes crosspost under the name manfromporlock, points out that I had my facts a bit wrong; the CEO’s involvement was never proven (in Stewart’s case, at least–he was guilty of other things). Shouldn’t go trusting my memory. /EDIT

The problem is obvious—insider trading makes Wall Street a way for people who are already rich and well-connected to fleece the Shmos of the world. And that’s why the government steps in and sends insider traders to jail, right?

Well, not exactly. A few high-profile arrests after a bubble pops—Stewart, Michael Milken way back when, the ones today—don’t make sense as a way to prevent insider trading. If that was the point, the arrests would come during the bubble (when the crimes are usually taking place) and there would be a lot more of them.

The way we do things does make sense as a way to restore public faith in a shaken system. Which sounds good, but think about it: these arrests are designed, not to prevent us from being fleeced (which is what we worry about), but to stop us from taking our money and going home (which is what Wall Street worries about).

Still, let’s put that aside and imagine a perfect system where every insider trader is quickly caught and punished. In that system, insiders will still fleece shmos, and there’s no way to stop it.

That’s because an insider’s tip to sell a stock is also a tip to not buy that stock. And a tip to buy a stock is also a tip to not sell it. So even if Martha Stewart had dutifully held on to her ImClone stock, she might well have still benefited from the CEO’s tip if she’d been planning to buy more. But she would have stayed a free woman, because there’s no way to prove—or even to know—what she planned.

Now: when I first thought of “insider nontrading” I believed it was a new term and a new insight, and was all proud of myself, but as with most original thoughts it turns out that others beat me to it. Still, it’s not widely understood, and it’s worth stressing because it means that over the long run we shmos who buy stocks right before they drop and sell them right before they pop will always lose to insiders, who know not to do these things simply because they’re on the inside and we’re not. It’s time to take our money (those of us who still have any) and go home.

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