Recently by Gary North: The Most World’s Important Unanswered Historical Question: ‘What Changed in 1800?’

“I seen my opportunities, and I took ’em.” ~ George Washington Plunkett (of Tammany Hall)

Oh, boy! A scandal among the rich – the very, very rich – and famous. Warren Buffett’s would-be replacement got his hand caught in the cookie jar. He is no longer in the running in the Buffett-replacement sweepstakes.

It seems that the fellow was on the fast track, along with three others, to replace Buffett. Buffett did not announce, “You’re fired!” He is not trying to replace Donald Trump on “The Apprentice.” He merely said the man has resigned. He did all this in a low-key way, unlike Mr. Trump’s style. Mr. Trump goes for the ratings. Mr. Buffett is a low-key fellow – kindly old Uncle Warren from Omaha, a man known for clever one-liners. “Your fired” is not clever.

As far as I can see, both Trump and Buffett know how to work the media, each with his own personal style. Whether their private lives match their carefully managed public personas, I neither know nor care.

What I do care about is the possibility that Congress will do something really destructive. That threat exists at all times, but especially when a scandal hits the media.

GAMING THE SYSTEM

It turns out that Buffett’s subordinate bought about $10 million worth of shares in some firm that the rest of us had never heard of, but whose customers are loyal to it. Then the guy pitched Buffett on buying it for Berkshire Hathaway. Buffett took the advice, the stock went up 30%, and the subordinate sold his shares for a tidy profit: maybe $3 million. Nice work if you can get it, and if you get it, tell me how.

The guy is dumb. Really, truly dumb. How do rich hot-shots survive when they are really, truly dumb? But they do.

This guy was not even street smart – not Easy Street smart, anyway. Here he was on the fast-track to stardom, backing up an 80-year-old geezer with an 87-year-old partner. The clock is ticking on both of them. All he had to do was outperform the other three hopefuls. He would then have become Omaha Sage II. He did not make it.

For about three million bucks before paying short-term capital gains taxes, the guy risked losing his shot. Hot-shots are not supposed to do this.

Why? Did he think he would not get caught? This is Buffett. This is the man who took Goldman Sachs to the cleaners in its time of need. Dumb. Really, truly dumb.

Buffett sent a letter to the media. He said that the hot-shot had resigned. In fact, he had resigned twice before, the letter said. Buffett assured the media, “Neither Dave nor I feel his purchases of Lubrizol were in any way illegal.” He also said that the hot-shot’s letter had said that his resignation had nothing to do with the share purchases. Wink, wink.

Buffett also assured everyone that he had known nothing about any of this. He also said that he had made the purchase on the man’s recommendation. He had been considering buying another firm’s shares.

In short, “You’re on your own, hot-shot. You deal with the Securities and Exchange Commission. I’m just an innocent bystander.”

The problem is, the poor schnook probably will deal with the SEC, which frowns on insider trading. If you doubt me, ask Martha Stewart.

I think he will beat the rap. He bought the shares before Berkshire Hathaway did. Buffett was not even considering buying the shares. So, legally, it was not insider trading. But even if it were, it would still be a bum rap.

INSIDER TRADING

The SEC prohibits insider trading. Insider trading is defined as making a profit based on information that is not available to all the owners of publicly traded shares. The inside trader buys or sells in advance of a public announcement regarding information that will affect the price of the shares. The assumption underlying this definition is simple:

Accurate information should be treated as if it were a free resource. Everyone with ownership, no matter how small, in a publicly traded firm must have access to the same information at the same time, if this information can measurably affect the price of the shares.

This assumption is nuts. I mean it is off-the-wall ridiculous. It assumes that a business, which operates in terms of privately purchased and privately monitored information, must share this information with the public as soon as it becomes available. Can you imagine running any organization this way? Does any civil government operate this way? Of course not. But the regulators insist that publicly traded firms must not allow any shareholder with inside information to profit personally from this information until they all can.

From the point of view of management, this official corporate prohibition is good policy. It is close to impossible to enforce, but it is good PR. The policy lets investors operate in terms of an assumption, however naive: senior managers will not profit personally at the expense of share owners. But this should not be a matter of civil legislation. It is a matter to be policed by the owners of the company.

If the owners think that senior management is ripping them off, they can sell the shares. This should be obvious. It is not obvious to politicians.

If outside investors think that senior management has made itself vulnerable to outraged shareholders, they can offer to buy the shares from these existing share owners. They can take control of the firm, toss out the senior managers, and replace them with managers who abide by the corporate rule against insider trading.

So, what do we see? We see the SEC impose rules against outside buyers who try to do just this. The SEC forces these “predator” investors to report on what they are planning if they plan to buy a controlling interest in the firm. This gives the targeted managers time to mount a defensive campaign. It raises the cost of any take-over. Existing senior managers like this.

The SEC imposes the terms of trade as its lawyers see fit. Congress authorizes this agency to enforce what does not need any enforcing. Congress thinks SEC lawyers are more alert of practices that are bad for investors than investors are.

Economists usually assume that the people with the greatest self-interest to monitor what senior managers do are investors. Investors are the people with “skin” – their own money – in the game. Investors, not SEC lawyers, are the people who should vote to elect the board members who set the rules, approve internal policies, and hire agents to enforce the rules. Investors can sell the shares if they think the rules are being violated at their expense.

Do we really want to reduce sharp practices that inflict needless losses on investors? Then we should let investors decide how to police the firms whose shares they own.

Do most of the investors not care? Then why should the government care?

Do most of the investors think that setting up such rules and enforcement arrangements is not worth the money? Then why should Congress care?

Congress passed a law against insider training. Fine, says senior management. But to be fair, senior management insists, the government needs to pass a similar law to restrict predatory speculators from buying control. Congress complies. Not only is this law seen as fair, it increases Control by the government.

Who wins? Existing corporate management. By consenting to rules against insider trading by individual members of senior management, they all get protection from corporate raiders who might swoop in and buy up control.

THE MOB AND ITS GOONS

If you think America’s corporate management is paying protection money to Congress, you do not understand economic cause and effect. Corporate management is the Mob. It operates in terms of a system in which Congress serves as the enforcer, along with the SEC. Congress is not cleaning up the financial system, ethically speaking. The financial system is cleaning up by means of Congress.

There is a tendency for American males to think of life as an extension of the Corleone family. They think in terms of the slogans that either Brando or Pacino announced as principles of rational administration.

The Godfather series is closer to the truth of the government-business partnership than college textbooks are. The politicians are on the take. They are compromised. They act as though they are in charge, but they aren’t. Brando or Pacino called the shots, not the Senator who got caught in the brothel.

It was not the big banks that rescued the Treasury in 2008. It was the Treasury and the Federal Reserve System – an official agency of the Federal government – that rescued the big banks. Today’s million-dollar big bank bonuses are not sent to Congressmen. They are sent to the survivors of the bailout by Congress. The voters saw this coming in October 2008. Congress didn’t care.

When the Mob in a gangster movie sends out low-salary goons to collect protection money from store owners, we get the correct picture. Think of Congress as the goons. Senior management is the Mob.

When we watch “The Untouchables,” we think of Eliot Ness as the enemy of the Mob. He was, too, if by Mob we mean private interlopers making a killing (in both senses) during Prohibition. Ness arrested Al Capone on income tax charges. That tells us something.

Ever since 1791, when Alexander Hamilton got the Federal government to take over state debts, which his cronies had bought for pennies, and then when he got the Federal government to authorize a monopoly for a privately owned central bank, the Bank of the United States, the real Mob has been plucking the feathers of the public.

The goons are Congress and the enforcers in the executive branch. The victims are taxpayers and investors who think the goons represent them. The Mob is the corporate system that consents to a law against insider trading in order to gain protection from investors: new investors who are ready to buy shares at a good price from existing investors, so they can replace existing senior management.

ACCURATE INFORMATION IS NOT FREE

Let us return to the assumptions undergirding laws against insider trading.

Accurate information should be treated as if it were a free resource. Everyone with ownership, no matter how small, in a publicly traded firm must have access to the same information at the same time, if this information can measurably affect the price of the shares.

Anything with a price is not a free good. It is a scarce good. That is the meaning of scarcity: “greater demand than supply at zero price.” There are few goods that are more valuable than accurate information.

In one of the most profound economics books ever published, Thomas Sowell demonstrated in 400 pages that knowledge is not a free good. Knowledge and Decisions (1980) is one of those rare books that you can re-read every few years and find new insights or old ones that you forgot.

Sowell began a profound question: “How does an ignorant world perform intricate functions requiring enormous knowledge?” Basically, the book is an extension of F. A. Hayek’s insights regarding the free market as an arrangement by which the most valuable knowledge that individuals possess is applied to the billions of problems that society faces each day. Hayek’s 1945 article is one of the most important articles ever written – in economics or any other social science. Congress ignores it at our peril.

Hayek spoke of the free market as a discovery process, and so it is. Sowell wrote about the production of a specific form of knowledge: knowledge that guides people’s decisions. It is not free.

The book is a detailed discussion of the implications of knowledge as a scarce resource. Sowell returns again and again to this theme: when civil government passes laws that assume that knowledge is either a free resource or ought to be, the result is inefficiency and a loss of liberty. He demonstrates his position with insightful analyses of how resources are misallocated because politicians treat knowledge as a free good. The section of the forcible restriction on competition (pp. 195-202) hones in on regulatory agencies.

He skipped the Securities and Exchange Commission – a pity, but not a great loss. It is not a great loss, because the SEC is covered magnificently by legal theorist, self-taught economist, and educational entrepreneur, Henry Manne [MANee]. He has launched several law and economics departments. But he made his academic reputation with his book, Insider Trading and the Stock Market (1966).

In that book, Manne showed that share pricing is affected only briefly by insider trading. Most information about a firm comes in a steady and seemingly random stream of news. As to how random this stream really is has become a matter of academic debate. If it is really random, how did Buffett get to be a multibillionaire? But for most investors most of the time, share price changes are random. So, any profit resulting from insider information is brief, and the same is true of losses.

As far as the general public is affected, insider trading is irrelevant. As far as the gains or losses to shareholders, only those few investors who buy or sell their shares on the day of the big move are winners or losers.

Manne hammered on this theme: share price movements precede the release of new information to the media. Inside information always gets out. In short, “buy on the rumor. Sell on the news.” This is true because inside information cannot be contained at a price that any free society should dare to impose.

Laws against insider trading create a black market for the distribution of this valuable information. The economic losses from the legislated restriction of insider trading were not considered in the decisions of Congress or the lawyers who wrote the administrative rules of the SEC.

The book is a masterpiece. It is long out of print. Manne told me that he once was told by one of the publishing company’s executives that the man planned to torpedo the book’s sales, so outraged was he over its defense of the free market.

CONCLUSION

I would like to think of the story of the schnook who forfeited his shot as the gold ring as one of those amusing stories that occasionally brighten our day, for stories of rich men who fall flat on their faces do greatly amuse us. It is nice to know that rich people are as subject to bad judgment as the rest of us are.

The schnook now insists that he had no idea that Buffett would act on his recommendation.

Does he expect us to believe this? If so, he is dumb. Really, truly dumb.

What bothers me is the possible aftermath of a story like this. It plays to the crowd. It is based on a falsehood, namely, that something the man did hurt anyone except short-term traders of shares of the most legendary buy-and-hold company in history.

I can see why Buffett would be upset. This guy made him look bad. He trusted a schemer – twice. The schemer betrayed his trust.

Why anyone else should care is beyond me.

April 2, 2011

Gary North [send him mail] is the author of Mises on Money. Visit http://www.garynorth.com. He is also the author of a free 20-volume series, An Economic Commentary on the Bible.

Copyright © 2011 Gary North