“Don’t trickle down on me and tell me its raining” – Anonymous t-shirt

It really should not be surprising that we are currently seeing arguments in favor of the most dramatic implementation of “trickle down” economics in 20 years. What is surprising is that the arguments are coming from both democrats and republicans. Both presidential candidates are advocating a rescue plan for business and the wealthiest Americans that should “trickle down” into stability and cheap lending rates for the middle and lower income brackets.

The argument for trickle down economics goes something like this; if you create an efficient environment and incentives for the wealthy to invest then that will ultimately return as job stability and economic growth that the whole population can benefit from. This is the “in a rising tide all boats float” idea.

– The current version of an old idea

Specifically, Washington, Barak Obama, John McCain and most of Wall Street are currently implementing a plan that will essentially gift and/or invest several hundred billion dollars into the largest banks and insurance companies in the US. They will do this through direct investment, a myriad of loan plans, and by purchasing bad debt currently on the companies’ balance sheets. This should help save these companies and their shareholders from bankruptcy.

These benefits should then have a direct effect on stock price stability and economic growth. Most importantly this stimulus for the rich should reduce borrowing costs for middle and lower income home owners struggling with foreclosure. The cause-and-effect connection between these two independent issues is just an assumption and has never been shown to exist when similar policies were used in the past including during the buildup to the last asset bubble (2001-2007). In fact the census data this year showed poverty rates actually rising during the last two expansions when trickle down economics were popular in Washington. This seems to confound the basic ideas used to promote the rescue plans.

– What’s wrong with these ideas?

The fallacy with this argument is in assuming that there is a direct relationship between the money a corporation gets (earned or not) and their marketing and management policies. These two are not necessarily connected and therefore trying to govern corporate behavior indirectly through monetary and Treasury policy is logically very inefficient.

The only thing you can say with any certainty will result from giving money to the richest individuals and companies in the world is that they now have control of that money. What they do with it from there is uncertain. Make no mistake; I am not advocating that this money be given directly to the poor and middle class in some kind of attempt to push the “trickle” uphill to stabilize the banks. That is not likely to work either.

The ideas behind trickle down economics usually gain steam during periods of economic crisis. A version of the idea nicknamed “Reaganomics” swept republicans into power in the early 80’s and late it was applied through significant tax reform in the early 2000s as the markets were crashing again.

My premise may seem confusing to some readers familiar with the concepts behind supply-side or trickle down theory because typically trickle down advocates are pushing for tax cuts and there is very little talk about that right now. However, the flow of money to the government is a two-way valve. Lower taxes does increase the amount of capital available privately but so does cash injections from the government. In this way, the bailout proposals are a “contra-tax” achieving the same objective of lowering marginal tax rates but doing it at a much larger scale and without the messy process and public blow-back of actually cutting taxes.

The question we have to ask ourselves as investors is two-fold. First as a matter of being a concerned citizen we need to determine whether we really believe that most economists are wrong and that trickle down economics is a sound theory that really will work this time. Second we need to think about what this means to our portfolio. Political arguments are inherently illogical because they are almost always emotional but if we put some “money where our mouth is” we may find the clarity of thought that is currently eluding the candidates for US president.

– What can you DO about it?

I suggest that ultimately supply side or trickle down economics will be no more effective than at any other time and therefore risk will not be abated. That is not bad news. In fact, this is very good news for educated investors. Risk equals the potential for returns if you are willing to take advantage of it.

For example, if capital is fleeing equities because of instability it is not unreasonable to short the market and become a bear investor. Learn how to buy puts, short stocks and diversify your portfolio to reduce your unsystemic risk and market exposure. Think independently and make your own decisions rather than listening to the loudest voices, which are usually lobbyists, candidates and policy makers with powerful and rather obvious conflicts of interest.

If becoming educated sounds reasonable to you then you are at the right place. At learningmarkets.com we believe that surviving and thriving in the markets are two different things and only those willing to put in the effort to educate themselves will achieve the latter. It’s a great time to be in the market – we hope you come back soon.