Financial Regulation as a Balancing Act

This was almost an aside in DeLong vs. Kling on the New Deal, but I thought this bit from Prof. DeLong was interesting.

Still, financial markets only work well when they find and transmit information about the likely future of companies and industries and bake information into prices. To do that, there must be incentives for uncovering important scraps of information and clear lines between what you can and can't do -- that is, between research and illegitimate insider trading.

The SEC has always found it tough to draw such a clear line. That's because its crisis origins have led it to focus on a different, though important, problem: shoring up investor confidence. Besides transmitting information, markets need to bundle great masses of savings from scattered individuals. To do that, investors must be confident investments can be bought and sold fairly. This doesn't work if you buy a share of a company from the corporate director's cousin, who happens to know the firm's market share collapsed during quarter. It also doesn't work if you sell a drug company's shares to someone who knows that, say, the latest test of a potential blockbuster treatment was extremely encouraging.

Financial regulation is a balancing act. And some worry that New Deal left us with a system that's too focused on leveling the field for buyers and sellers, and not focused enough on having the best informed buyers and sellers in the market. That, in turn, might give too much power to entrenched managers and not enough power to insurgent financiers.

It seems to me that prohibition of insider trading mitigates a "market for lemons" problem in the stock market. If people were allowed to trade on insider information, every transaction would fall under the sort of suspicion you have when purchasing a used car: if the stock is any good, why does this person want to sell it to me? This would drive the selling price of a stock down, making the seller unwilling to sell. In theory, the entire market could collapse because of lack of trust in sellers.

(This is analogous to the problem of adverse selection in insurance markets, where the collapse is caused by lack of trust in buyers.)