If Greed Is Good, Why Is Insider Trading Bad?

The limited logic of capitalism

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Last week’s sentencing of Mathew Martoma for insider trading may signal the end of the SEC’s efforts to bring down his former boss, Steven A. Cohen, but it will almost certainly guarantee another round of debate over the legal regime that has sent Martoma behind bars for the next nine years.

Like other laws that attempt to maintain a spirit of equity, insider trading is a legal distinction that rests on a moral misgiving. It identifies a way of gaining information for a financial transaction that seems (there is no better word for it) unfair. In the case of Martoma, his crime was convincing doctors to provide him confidential information about drug trials involving two companies in which SAC Capital, the hedge fund he worked for, had made a $700 million investment. A day after he passed along the information to Cohen, SAC’s founder, the fund began selling its shares in both companies before the information became public, allowing it to avoid losses and book profits totaling $275 million.

The U.S. Attorney who led the prosecution’s case, Preet Bharara, described Martoma’s crime as akin to buying “the answer sheet before the exam,” which is to say, he and his employer cheated.

It may seem surprising, given the widespread repudiation of insider trading in polite society, but not everyone agrees. “[I]t’s essential that capital reach the best, most growth-enhancing ideas as quickly as possible,” John Tamny, a Forbes columnist, wrote in June. Insider trading expedites this process, ensuring that capital isn’t “under-utilized or destroyed to the economic detriment of us all.” And while it is true that tips like the one Martoma obtained can allow for substantial “first-mover profits,” any shrewd investor is working to get better and faster information. For “naysayers to suggest that none of this is “fair,” Tamny declared, “is for them to misunderstand basic economics.”

Arguments like Tamny's are familiar to those of us who teach business ethics. Whether it is debating the merits of insider trading, raising prices during a natural disaster, or taking advantage of a customer’s ignorance, many students seek to resolve the tension between ethics and economics by claiming the moral mandate of self-interest. An article of faith among free-market enthusiasts, the mandate holds that, over the long term, the pursuit of commercial self-interest inevitably contributes to the common good. The problem with this formula is not that it’s flawed—it may be, but that is a matter for economists, not business ethicists—rather that, so baldly and blandly stated, the moral mandate of self-interest becomes a get-out-of-jail-free card for any bad behavior.

This possibility haunted Adam Smith, the Scottish philosopher who, by turns, was an economist and an ethicist. As the mainspring of commercial development, the pursuit of self-interest played a central role in The Wealth of Nations, his seminal work which is widely regarded today as the cornerstone of modern economic thought. Yet while Smith was honored in his lifetime as one of the great minds of his age, he struggled to distance his system from the sinister shorthand private vices yield public benefits.

That idea had been popularized long before Smith by the boogeyman of 18th-century philosophy, Bernard Mandeville, in his scandalous book, The Fable of the Bees. As the title promises, the book opens with a lengthy allegorical poem about a thriving beehive that bore more than a passing resemblance to the England Mandeville called home. Inside the hive, industry flourished, the arts and sciences steadily advanced, and prosperity reigned. What made for such a boon? Not virtue, Mandeville contended. Instead, the lust for power and the vanity that attends personal success kept the wheels of commerce turning:

Thus Vice nurs’d Ingenuity,
Which join’d with Time and Industry,
Had carry’d Life’s Conveniences,
Its real Pleasures, Comforts, Ease,
To such a Height, the very Poor
Liv’d better than the Rich before,
And nothing could be added more.

Passages like this one provide the intellectual origins for the moral mandate of self-interest. The contention underlying it is so familiar to us that it bears emphasizing how shocking and counterintuitive it seemed to Mandeville’s readers. On his account, the fate of the poor and vulnerable rests not with our best intentions, but with our worst. A vile tide lifts all boats.

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Yet Mandeville went ever further. He not only asserted that private vices yield public benefits, he contended that the inverse relationship between wickedness and wealth amounted to an iron law of human affairs. The achievements of an advanced society could only be maintained by immoral longings.

Mandeville makes this point in the poem when “Jove” gets fed up with the hypocrisy of the bees wringing their hands over vice while enjoying the ease and luxury it supplies. Deciding to teach them a lesson, he relieves the bees of their wanton ways. “Honesty fills all their Hearts,” and the economy of the hive promptly begins to sputter. With the bees no longer motivated by baser passions, the taverns shut down, the retailers go bankrupt, and the courthouses are closed for business. The industry that remains is so small it can no longer support so many bees. The population swiftly declines, leaving the hive vulnerable to its enemies. They attack, and though the courage of the bees saves them from destruction (virtue, it appears, has something to commend it) they are forced to retreat from their spacious hive and take refuge in a hollow tree. The moral, for Mandeville, is clear:

Fraud, Luxury, and Pride must live,
While we the Benefits receive

During his life, Bernard Mandeville fancied himself a truth-teller who wielded the weapon of satire to wound hypocrites and “mortify Pride,” but given his insistence that the price of virtue is the prosperity of the poor, he offered a shield for the self-indulgent and a rebuke to the restrained. As such, many readers regarded him as little more than an evangelist for iniquity. Clerics took to the pulpit to denounce Mandeville, with the Anglican theologian John Wesley going so far as to say that not even Voltaire had done so much to commend wickedness. Meanwhile, philosophers from Montesquieu to Rousseau lined up to take on The Fable of the Bees, which grew in length (and offense) with subsequent editions. Most eventful for Adam Smith was the ink his mentor, Frances Hutcheson, expended on the work. He wrote an entire book aiming to rebut Mandeville, whom he accused of being “well vers’d in the Defects of Man-kind, but unacquainted with the Excellences of human nature.”

Born almost 20 years after the Fable was first published, Smith began his career in the shadow of Mandeville, whose views darkened the ongoing debate about the essential qualities of human nature. Smith was drawn into these debates as a moral philosopher, the vocation that first brought him fame, but also as the framer of a new economic science. His problem was not that he seconded Mandeville’s assessment of human nature or its implications for the wealth of a nation, but that, between their systems, there wasn’t nearly enough light of day.

As opposed to the hopeful philosophy of Hutcheson, who regarded human beings as naturally inclined toward virtue and, therefore, benevolence, Smith saw us as self-interested creatures who were occasionally diverted by flashes of empathy. Our primary bent was especially pronounced in commercial activity. “It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest,” he said in the most famous passage of The Wealth of Nations. “We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.”

Because he believed that we were hard-wired for such exchanges, Smith concluded that economic development was best ensured not by the visible hand of government organizing commerce toward some enlightened end or forcing its citizens to assume the instinct of angels. Instead, individuals should be liberated to pursue their economic interests, the benefits of which would be greatest for those who had the least.

Fair enough, but this sounds an awful lot like Bernard Mandeville. In Smith’s mouth, the moral mandate of self-interest may be blunted of its cynicism, but that only increases its power. Smith knew this, which is why he took aim at Mandeville in his other great work, The Theory of Moral Sentiments. He did not accuse Mandeville of promoting vice at the expense of virtue (the familiar line of attack) but of failing to adequately distinguish between the two. “Every thing, according to him, is luxury which exceeds what is absolutely necessary for the support of human nature,” he said of Mandeville, “so that there is vice even in the use of a clean shirt, or of a convenient habitation.”

For Smith, this was nonsense. To the degree that having a clean shirt or a convenient home lies in our self-interest, the pursuit of them is not only legitimate, it’s fairly laudable. As Smith described it, Mandeville’s famous equation—private vices yield public benefits—was a piece of “ingenious sophistry” that ultimately relied on an “ambiguity of language.” Only by maintaining there is no distinction between self-interest and selfishness—indeed, that all self-interest is selfishness—could the equation hold.

Yet such sophistry can also work in reverse. If the brilliance of Smith’s reply was to distinguish activities that are self-interested from those that are merely selfish, thus providing a space for commendable commercial pursuits, the distinction is lost if we regard all self-serving pursuits as praiseworthy and just.

This is the danger I see in the way my students sometimes talk about the pursuit of self-interest. They are so convinced of the power of that pursuit that they have lost the ability to make moral distinctions among the types of interests they might pursue or, for that matter, how exactly they might go about pursuing them. A few even resist the idea that such distinctions should be made. The pursuit of self-interest is taken to be so obviously valuable that the notion it could be otherwise seems incredible and, in respect to the free markets, subversive to say the least.

It is neither. A philosophy that cannot distinguish between a pickpocket and Larry Page isn’t worthy of serious consideration, nor is one that says the only difference between the two is a matter of legality. True, those most apt to defend the efficacy of self-interest are quick to reply that the pursuits of the pickpocket don’t qualify, but either they are confused about the term they are using or they are merely making my point. Once you say that some pursuits are indecent or even impermissible, you have acknowledged there is a line between self-interest and selfishness. The rest is a matter for debate.

Such line drawing compels greater deliberation in the face of self-serving opportunities, yet it doesn’t resolve the greatest dilemma of the moral mandate of self-interest. That is, what should we make of the fact that private vices do yield public benefits? Or, to put it another way, that, sometimes, greed is good?

This was an inconvenient truth for Adam Smith, one he tried to downplay but which he couldn’t altogether escape. If you conclude that benevolence provides only a fraction of the benefit one typically receives from the by-products of envy, cupidity, and pride, you may be forced to concede that the common good depends in great part on giving these passions a wide berth, at least in the commercial sphere.

Maybe so, but I tell to my students that this is a claim that merits great skepticism, especially when it is made by those who stand to gain by it. Take, again, the case of Mathew Martoma. As a reward for a tip that provided SAC over a quarter-billion dollar benefit, the hedge fund paid him a $9.38 million bonus. It may be the case that his actions are defensible as a matter of “basic economics” and that the gains in efficiency that come from the estimated 25 percent of public-company deals that involve insider trading are so great that they outweigh the consequences of subverting a commonsense understanding of what fairness requires, but for those of us who will never gain from such practices in an immediate and outsized way, it doesn’t seem unreasonable to ask for proof. Hard proof. And even when that proof is forthcoming, we shouldn't be confused about the the dreary irony it demonstrates.

Reflecting on Mandeville’s infamous formula, the greatest philosopher of the age and Smith’s dearest friend, David Hume, observed that it is often the case that work employed to gratify “one man, would relieve the necessitous, and bestow satisfaction on hundreds,” a possibility that did nothing to change the fact that, without the opportunity for his indulgence, “the labor would not have been employed at all.” And yet, Hume continued, to say as much “is only to say that, there is some other defect in human nature, such as indolence, selfishness, inattention to others, for which luxury, in some measure, provides a remedy, as one poison may be an antidote to another.”

This is the moral paradox at the heart of capitalism, the one that Mandeville portended and Smith could not entirely escape. It proposes a hard bargain, and if we are willing to accept it, Hume is right: We should be clear about the terms of the agreement. “Let us, therefore, rest contented with asserting, that two opposite vices in a state may be more advantageous than either of them alone,” he said, “but let us never pronounce vice in itself advantageous.”

In other words, like so many of the minor crimes of capitalism, insider trading may be like the skunk that scares away the hungry bear. We may not necessarily be better off without out it, but that shouldn’t prevent us from saying it stinks.