Bernie Madoff was sentenced to 150 years for “cheating” people. Two questions arise: Is the penalty appropriate for the crime? Is the crime he committed really a crime?

Raj Rajaratnam has been charged with insider trading (obviously he has watched the “Thomas Crown Affair” one too many times). If he is convicted, the same two questions will arise: Will the penalty be appropriate, and is insider trading really a crime?

I approach these two questions and cases from an economics perspective. Setting aside the second question for the time being, economists look at the penalties strictly as a means to deter future criminal activity. Fairness, equity and justice have nothing to do with the penalty! If either type of crime produces large losses for society as a whole, then severe penalties are needed. In the case of Madoff, we do not know the full extent of the losses. In the case of insider trading, we also do not know the full extent of the losses.

This then leads to the second question. People who invested with Madoff could have spent more time and money doing their due diligence. The large investors chould have retained S&P or Moody’s or a top line consulting firm to investigate Madoff. They chose not to, perhaps because they knew that there are laws that make cheating a crime and subject to penalties. As a result, they decided that there was no need to expend much on due diligence.

Collectively, we might all be better off when fewer resources are devoted to due diligence activities. But are we? If there were no laws against cheating and Ponzi schemes, investors would have to engage in extensive due diligence. The credit rating agencies might have a new line of business, or investors would stick with simple strategies such as buying a mix of market indexes and government bonds.

How much should be spent on due diligence? How much is spent on enforcing the existing laws? How effective is enforcement? When we answer these questions, we can decide whether the laws Madoff violated make any sense.

With regards to insider trading, the main argument is that this creates a tilted playing field. In the absence of any restrictions on insider trading, the average investor might feel as if the equity and other financial markets are rigged, with the big players having an advantage. This might lead to higher costs of capital for all companies, lower levels of investments in productive assets, and thus lower rates of productivity and economic griwth. The costs could be enormous.

On the other hand, if insider trading is legel, and insiders have to report their trades in real time, prices of financial assets might more quickly adjust to reflect this new information, and the prices might more accurately reflect the true values of these assets.

Insider trading and transparency might make the capital markets more efficient, reducing the costs of capital, and perhaps, even level the playing field relative to the current state of affairs. Again, unless we can determine whether insider trading imposes a cost on the economy, or a net benefit, we cannot conclude that outlawing insider trading is desirable.