Why I believe demand matters over the long run

It seems to be a common belief even among more liberal economists that, while recessions are frequently due to demand side constraints, over the long run supply side economics reigns supreme.  But when you apply supply side thinking to trade, the natural conclusions don't square with how beneficial trade surpluses really are.

Consider the case of China.  They have been purchasing American financial assets with the intent of deliberately manipulating demand -- that is, they are exchanging real goods for financial assets.  This has the effect of increasing demand for Chinese goods relative to American goods.  It also increases the financial capital of America at the expense of China.  This makes it easier than ever to get a loan in the U.S. while having the reverse effect in China.

What consequences should we expect from this from a supply-side perspective?  Because it is easy to get loans in the U.S., it is easier than it otherwise would be to start a business -- where there are opportunities for profit, entrepreneurs will be able to get the money for start-up costs, and, thanks to low interest rates, they will have an easier time paying back loans with those profits.  And as for the goods we import, the effect of that is to redirect China's productive capacity to our benefit.  We don't have to direct our scarce labor and resources to supplying those goods, so we should be able to direct them to providing the productive capital those businesses will need -- factories, technology, etc.  Indeed many economists find it obvious that financial capital and real capital go hand-in-hand.  Meanwhile the reverse should happen in China, so we should see our economy grow while theirs stagnates.  And what would they get out of it?  Well, the financial assets aren't nothing; some day when they decide they want the economy they have been forgoing all these years, those assets should make it easy for them to reverse the situation and take advantage of our productive capacity that they have made it easy for us to create.

Needless to say, nothing about this squares with the real world.  China has increased our supply of financial capital, and the result has been the de-capitalization of our economy and rapid growth in theirs.  In the real world nations like China and Germany that run trade surpluses over the long run see faster growth over the long run, not just in recessions, and they don't have to switch to running trade deficits to benefit from that growth.  This is because it is demand for the potential output of capital that drives private capital investment, not finance, not money circulating around Wall Street.  By driving investment, demand drives long term growth.

Putting the issue of trade aside, there are many other financial-capital-friendly policies we have that make sense only in the logic of supply side economics.  Take, for example, the reduced tax rate that day traders and hedge fund managers pay.  A lower rate on capital gains income means more money will be made available for capital, financial or otherwise.  By either raising income taxes or reducing government spending it similarly reduces demand for the output of our capital.  That is to say, it has exactly the same effect on our economy as running a trade deficit with China.  We should expect it to be exactly as beneficial.

It isn't that supply side economics is entirely wrong -- it is possible for an economy to be constrained by the factors supply-siders worry about -- it's just that given our actual economic situation supply side economics just doesn't matter, and it isn't clear that it has mattered at any point in the past three decades.  If long run trends of technology driven efficiency and automation continue, it seems reasonable to expect that supply side economics will matter even less in the future than it does today.