Tim Duy's Fed Watch

Slow and Steady

Looking at the spending component of this morning's Personal Income and Outlays report for February, it still pays to focus on the path of spending rather than to become terribly hopeful or despondent about the twists and turns along that path:

The 0.5% gain in February compensated for some earlier weakness in the numbers, while the overall trend holds - spending is rising about 0.18 percent per month compared to 0.24 percent prior to the recession.  Spending was supported by a drop in the saving rate, down to 3.7% from 4.3% the previous month.  This likely reflects borrowing for new auto purchases - note the stronger trend in durable goods spending:

The acceleration in auto sales is clearly supporting this trend since the middle of last year.  Apparently, what's good for Detroit is still good for America. The importance of autos in sustaining spending begs the question of what will occur when pent up demand is satisfied?  Obviously, auto sales will stop contributing positively to growth as sales level off at some point in what I would expect to be the not to distant future.   This is especially the case considering the anemic pace of personal income growth: 

Hopefully, income growth will accelerate as the labor market improves.  Otherwise, households will need to take on additional debt or running down saving rates to hold the current trend in place. 

Bottom Line:  Consumer spending continues to rise, although the sustainability is still called into question because of the reliance of pent-up demand and falling saving rates to support underlying trends.  That said, for all the ups and downs in the monthly data, the trend has generally been upward at a pace that is disappointing compared to pre-recession trends.  Slow and steady has been the best bet.

Inflation: Still Nothing to See Here

The Februrary Personal Income and Outlays report came out this morning, and with it a fresh read on the Federal Reserve's preferred inflation measure, the PCE price index.  On a year-over-year basis, headline inflation is trending down to the 2% target, while core is settling in just below that target.  

As a reminder, the Fed targets headline over the longer run, but watches core as a signal to where headline is headed.  Headline is trending down to core, as expected.  The Fed was right to dismiss last year's energy-induced headline increase as a temporary phenomenon. Is there any near term trends to be concerned about?  The three-month core trend edged down a notch to just above 2%:

Still less than the rise experienced in the first part of 2011.  What about the path of prices?  Still tracking along a trend below that of prior to the recession:

Opportunistic disinflation at work.

Bottom Line:  Inflation remains contained - by itself, price trends provide no reason for the Fed to turn hawkish.  Moreover, there is nothing here to stop Federal Reserve Chairman Ben Bernanke from easing policy should the US recovery falter.

Bernanke, Bullard, and QE3

This morning Federal Reserve Chairman Ben Bernanke gave a speech that apparently was identified as proof that QE3 is still in the cards.  He argues that while labor markets have shown improvement in recent months, conditions are far from normal.  Moreover, he sees the problem of long-term unemployment as largely structural, and delivers what many believed to be the money quote:

I will argue today that, while both cyclical and structural forces have doubtless contributed to the increase in long-term unemployment, the continued weakness in aggregate demand is likely the predominant factor.  Consequently, the Federal Reserve's accommodative monetary policies, by providing support for demand and for the recovery, should help, over time, to reduce long-term unemployment as well.

In my opinion, to interpret this as a call for additional quantitative easing is a bit of a stretch.  It sounds like simply a confirmation that Bernanke believes the current policy stance is appropriate and that the existence of long-term unemployment should not be viewed as a reason to believe that we are closing in on a resource constraint that would necessitate a tightening of the policy stance.  I was drawn to a much more nuanced section:

However, to the extent that the decline in the unemployment rate since last summer has brought unemployment back more into line with the level of aggregate demand, then further significant improvements in unemployment will likely require faster economic growth than we experienced during the past year.  It will be especially important to evaluate incoming information to assess whether the recovery is picking up as improvements in the labor market feed through to consumer and business confidence; or, conversely, whether the headwinds that have impeded the recovery to date continue to restrain the pace at which the labor market and economic activity normalize.

In essence, Bernanke suggests that the recent rapid improvements in unemployment reflect largely a reversal of out-sized deterioration experienced during the recession.  As such, we should not expect a slower pace of improvement given current growth forecasts.  Under such conditions, I believe, Bernanke would push for another round of QE - although it stills begs the question of why he doesn't push for more now given the existing forecasts.  But he hasn't, so we can only infer that he thinks the costs of additional easing outweigh the benefits.  

He leaves open the possibility, however, that labor markets will continue to improve at the recent pace, in which I think QE3 is off the table.  And that is where Federal Reserve President James Bullard steps in to the picture.  He said pretty much the same thing in a CNBC interview:

"I think QE3 would require the economy to deteriorate somewhat from where it is right now," Bullard said. "The basic story on the U.S. economy is that we've had good news over the last six months or so, especially compared to the recession scenario that was being painted in the August-September time period of last year."

That said, this is somewhat softer language than he used in a speech last week:

But now, with the Committee on pause, it may be a good time to take stock of whether we may be at a turning point. Many of the further policy actions the Committee might consider at this juncture would have effects extending out for several years. As the U.S. economy continues to rebound and repair, those policy actions may create an overcommitment to ultra-easy monetary policy. The ultra-easy policy has been appropriate until now, but it will not always be appropriate.

The FOMC has often been criticized historically for overstaying policy stances that might have made sense at one juncture but are no longer appropriate as macroeconomic conditions change. This occurs in part because of the lags in the effects of policy, the difficulty in interpreting real-time data, much of which is subsequently revised, and the sheer uncertainty of macroeconomic developments. With numerous monetary policy actions still on the table, and others still affecting the economy with a lag, it may be especially difficult to remove policy accommodation at the appropriate pace and at the appropriate time. One may want to approach such a situation with caution. 

This seems to suggest he is in fact entertaining the possibility that the turning point for policy will occur sooner than expected.  My view is that the crux of any disagreement between Bullard and Bernanke is the timing of any tightening.  Both would push for additional easing should conditions deteriorate.  But Bernanke is willing to leave existing policy in place for well into the future, whereas Bullard is looking forward to pulling the trigger on tighter policy sooner than later.

This, by the way, is a debate Bernanke would win in the absence of clear indications that tightening is necessary.

Incredibly, in his CNBC interview, Bullard strays into the world of Japanese monetary policy:

"I think one of the biggest mistakes is continue to throw us much more in the way of monetary injections into the economy and with that, you get a much higher increase in commodity prices and potentially produce less global consumption across the world, which slows economic activity down," Bullard said. "I'm afraid that's the real danger just now - that we've maintained too loose of a policy right across the global economy and what results is inflation and reduction in real spending power." (see update below)

I get this, I really do.  But I have come to the conclusion that the Federal Reserve should not consider the reaction functions of other central banks when setting policy.  Simply put, this is not the Fed's problem.  To the extent that other nations import the Fed's monetary policy, they do so by choice.  Bullard continues:

Bullard says he would like to see the Federal Reserve resume a "more normal monetary policy as soon as possible" because it has detrimental effects on the economy. 

"It (the policy) punishes savers, for instance, in the economy, it does send a pessimistic signal about the economy and I think that can hurt investment prospects in the U.S.," Bullard said. "But we need to provide the right amount of support for the recovery as we do that, and we need to keep an eye on inflation."

Concerns that like the commodity price issue seem to mimic those of Bank of Japan Governor Masaaki Shirakawa.  And we all know what about the wisdom of BoJ monetary policy.

Bottom Line:  I do not think Bernanke's speech is a signal that QE3 is guaranteed.  But it is a signal that QE3 is definitely not off the table.  It is entirely data dependent.  The current flow of data does not support additional action.  I don't think it would take much of a deterioration to prompt additional action, so if you have a bearish view of the US economy, expect QE3.  But if you have a bullish view, don't expect a rapid policy reversal.  Bernanke isn't ready to go there.

UPDATE/CORRECTION:

I have been notified by CNBC that the the struckout quote above originally attributed to Bullard was actually made by the show's host.  CNBC has also corrected their article.  So Bullard did not jump the Japanese shark.   

"Just a Little Walk in the Desert"

Not sure about this "vacation."  First, the truck incident.  Now, rattlesnakes:

Still waiting for desert to grow on me.  Everything here seems to have a spike or a fang.  Nothing nice and soft like the ferns and moss back home.

Lessons From Japan?

Via Mark Thoma, Robin Harding at the FT Money Supply blog reports on a speech given by Bank of Japan Governor Masaaki Shirakawa.  The speech reportedly details the problems that emerge from aggressive monetary policy.  I cannot find a link to the speech itself, but luckily the FT quotes key sections.  

The first concern is two-fold:

Mr Shirakawa’s first point is that loose monetary policy mitigates the pain as households repair their balance sheets, but reduces their incentive to do so quickly, not just for the private sector but for governments as well. However, he also suggests that the effectiveness of loose policy may fall over time as households that weren’t damaged by the crisis bring forward such spending as they want to.

The first sentence sounds like a rehashing of the "liquidationist" approach.  We should let the economy collapse rather than provide support during balance sheet adjustment.  The second part suggests that there is only so much spending that can be brought forward via low interest rates.  But I think this is not really a novel idea, as we pretty much know that the effectiveness of monetary policy fades at the zero bound:

 
In this case, I drew the LM curve as a (dotted) horizontal line at a positive zero interest rate, suggesting an economy at the zero nominal bound with deflation.  Yes, the effectiveness of low interest rates waned as the zero bound was a approached.  At this point, if the BoJ wanted to induce additional spending, they would need to make a credible commitment to a higher inflation target.  In other words, the effectiveness of monetary policy did not fade unexpectedly - it is exactly what you would expect given the zero bound problem.

The second concern is that a low interest rate environment is hurting potential growth.  This time, Shirakawa:

“If low interest rates induce investment projects that are only profitable at such interest rate levels, this could have an adverse impact on productivity and growth potential of the economy by making resource allocation inefficient. While central banks have typically conducted monetary policy by treating a potential growth rate as exogenously given, when the economy is under prolonged shocks arising from balance-sheet repair, we may have to take into account the risk that a continuation of low interest rates will affect the productivity of the overall economy and lower the potential growth rate endogenously.” 

I don't think this makes any sense at all (neither does Harding).  I could see a problem if low productivity projects are funded instead of high productivity projects, but presumably the latter would still be funded first in any event. In other words, I don't see that the low interest rate environment by itself would alter the composition of investment.  And if we cut off funding for the less productive investments, the capital stock would grow more slowly, and that would certainly reduce potential growth.  And note that this is separate from the worry that government investment is displacing private investment.  Government investment is compensating for the lack of private investment.  If anything, Japan needs lower real interest rates to support higher levels of private investment to lessen its dependence on fiscal deficits.  And that too is another result of the zero bound problem.

 The third concern is aptly handled by Harding:

Point three is the more standard argument that flattening the yield curve too far for too long will undermine the profitability of the financial sector.

Again, while I am sympathetic to the financial market consequences of low interest rate environments, the central bank is really just following the economy down.  In the absence of sufficient economic activity to pull longer term rates up, if the Bank of Japan raised rates they would simply be inverting the yield curve - and I don't see that as positive for the financial sector.

The final concern is almost laughable:

“Even though such a rise in commodity prices is affected by globally accommodative monetary conditions, individual central banks recognise that the fluctuation in commodity prices is an exogenous supply shock and focus on core inflation rates which exclude the prices of energy-related items and food. The resulting reluctance of individual central banks to counter rising commodity prices, when aggregated globally, could further boost these prices. From a global perspective, such a situation represents nothing more than a case where a hypothetical “World Central Bank” fails to satisfy the Taylor principle, which ensures the stability of global headline inflation. While it is understandable that the central banks would pursue the stability of their own economies in the conduct of monetary policy, it is increasingly important to take into account the international spillovers and feedback effects on their own economies.”

First, Shirakawa is making the error of thinking the Federal Reserve targets core inflation.  They do not, and they have made that clear.  They target headline inflation, but use core-inflation as a guide as to the direction of headline inflation.  Shirakawa implies that while core-inflation is tame, headline is running wild - and that simply is not true:

The path of headline inflation is actually on a lower trend compared to before the recession.  Moreover, please explain how headline inflation is causing such a problem for the Bank of Japan:

Finally, as Harding notes, if you don't like US monetary policy, don't import it.   

Bottom Line:  I would be cautious about taking lessons from Shirakawa.  The concerns about the low interest rate environment beg the still unanswered question:  What is the alternative for monetary policy?  To hike short term interest rates?  It sounds like Shirakawas "concerns" are more excuses for an ongoing monetary policy failure on the part of the Bank of Japan.

Spring Break Begins...

...with somebody hitting my truck on the way to the airport. I could barely hold in the tears, but my wife said I handled it as well as could be expected.

My 5 year old daughter looked at it and said "that doesn't look too bad."  Sure, they will probably just buff that right out.

 

 

Highway 395, Oregon

High desert rest stop.

Actually, I meant to post the view from home this morning (I awoke to the sound of trees limbs snapping all over the neighborhood), but the above picture was still stuck in what appears to be a faulty typepad iPhone ap:

 

On Straw Men

Arnold Kling claims I am using a straw man:

Recently, bloggers have been talking about potential output or potential GDP. I find the discussion to be frequently misleading. For example, Mark Thoma quotes Tim Duy:

If we claim the economic potential of the nation has declined - that in aggregate, we can not make as much stuff as we did a few years ago...

But nobody claims that. The pessimists on potential output only claim that it is growing below some previous trend. They never claim that it has declined in absolute terms.

 I refer Kling to St. Louis Federal Reserve President James Bullard:

The wealth shock view puts a different expectation in play. The negative wealth shock lowers consumption and output. But after the recession ends, the economy simply grows from that point at an ordinary rate, neither faster nor slower than in ordinary times. It is more like an earthquake which has left one part of the land higher than another part. There is no expectation of a “bounce back” to a higher level of output after the recession ends. This is closer to what has actually happened since mid-2009. Output has grown at a moderate rate, but not a rapid rate, since the recession ended. 

Read carefully: "...like an earthquake which has left one part of the land higher than another part."  (Side note: I kind of like that simile).  He is clearly saying that the 5% drop in output during the recession was a permanent shift.  Unless you really believe that potential GDP was overestimated by 5% - in which case we would expect inflation to have been much higher than actually experienced - the only reasonable conclusion is that at least one person believes that in fact potential GDP declined in absolute terms during the recession.

Also refer to Grep Ip:

You don’t need to be a supply sider to believe that potential has fallen; you could equally worry that actual output has been depressed for so long, that hysteresis has set  in and dragged potential down with it. 

He proceeds with charts of GDP for Sweden and Korea, both of which reveal what are interpreted as downward shocks to the absolute level of potential output.  And note, I don't ignore the possibility that Ip is in fact correct - the failure to respond with significant force to the recession may very well have allowed cyclical issues to fester into structural ones.  And this is even more likely if Bullard's position is widely adopted by policymakers such that they actively manage the economy along the new trend.  In such a case the hysteresis can be the result of a self-fulfilling prophesy.  If we deliberately keep people unemployed, they will eventually become structurally unemployed or exit the workforce.

I don't in any way disagree that the rate of potential output growth may be slower than prior to the recession, thus estimates of the output gap might be lower than those currently available.  But there is indeed another concern that there has been a negative shock to (long run) potential output in absolute terms.

Fed Still Lowering Potential Output Growth Estimates?

While financial market participants continued to sell Treasury bonds thinking that the Fed is out of the game, New York Federal Reserve President WIlliam Dudley gave no indication to suggest that either QE3 was off the table or just around the corner. Still, he was clearly concerned that the recovery is more fragile than the data would have us believe, suggesting that he would leap relatively quickly into additional easing if the economy faltered.

While Dudley certainly did not ignore the improved tenor of economic data in recent months,

The incoming data on the U.S. economy has been a bit more upbeat of late, suggesting that the recovery may be finally establishing a somewhat firmer footing.

he also suggested caution:

While these developments are certainly encouraging, it is far too soon to conclude that we are out of the woods. To begin with, the economic data looked brighter at this point in 2010 and again in 2011, only to fade as we got into the second and third quarters of those years.

In particular, he pointed to the moderate weather as a factor in the recent numbers:

Moreover, the United States has experienced unusually mild weather over the past few months, with the number of heating degree days in January and February about 17 percent below the average of the preceding five years. While this reduces the amount that households and businesses must spend for heating, I suspect that it temporarily boosts economic activity overall.

In the question and answer period (via the WSJ), Dudley commits to nothing but a data dependent policy:

Dudley was asked by an audience member what he expects will be the future path of interest rates. “We will continue to assess what’s appropriate” for monetary policy, he answered, saying “if the economy were to change in a meaningful way, obviously we’d change” the current plans for interest rates and other stimulus efforts.

Specifically on QE3, via Reuters:

"Nothing has been decided," he said of QE3, in which the Fed would make large-scale asset purchases in an attempt to lower rates and give the economy another controversial shot of adrenaline.

"It all depends on how the economy evolves," Dudley added. "It's about costs and benefits, and if we get to a point where we think the benefits of another program of QE outweigh the costs, then we'll certainly do so."

More interesting, in my view, were his comments on potential growth:

To put the recent pace of growth into perspective, we believe that the economy's long-run sustainable growth rate (what economists call the potential growth rate) is around a 2 1/4 percent annual rate. We need sustained growth above that rate to absorb the substantial amount of unused productive capacity. Thus, our recent growth rates are barely keeping up with our potential.

The 2.25% rate caught my eye, as it was slightly below the 2.3-2.6% range for longer term growth in the most recent Fed projections.  And that itself was a downgrade from the 2.4-2.7% November projection.

At this point, it becomes a little tricky:

Although the sharp decline in the unemployment from 9 percent last September to 8.3 percent in February suggests we are doing better than that, it is important to recognize that about half of that decline was due to a declining labor force participation rate. In fact, had the labor force participation rate not declined from around 66 percent in mid-2008 to under 64 percent in February, the unemployment rate would still be over 10 percent.

So half the decline in the unemployment rate since last September was due to falling labor force participation, while the other half was the result of growth slightly above potential.  GDP growth in the second half of last year averaged 2.4%, slightly above Dudley's estimate of potential GDP, and enough to bring down unemployment somewhat.

Looking back to what Dudley said last November:

After a very weak first half, when GDP growth was less than 1 percent, economic activity has strengthened somewhat and inflation pressures are starting to ease. Growth in the third quarter is currently estimated to be 2.5 percent, and recent indicators suggest growth in the fourth quarter could be somewhat higher...However, as we look toward 2012, the U.S. economy continues to face several obstacles to a robust recovery. Accordingly I expect growth of about 2.75 percent for 2012...One summary statistic says it all—the unemployment rate is unacceptably high at 9 percent. Given my outlook, the decline of unemployment over the next year is likely to be modest...To sum up, growth has picked up modestly in the second half of 2011, but not enough to bring unemployment down. 

Last fall, Dudley thought that growth somewhat above 2.5% would not bring unemployment down, while 2.75% would only have modest impacts.  That suggests an estimate of potential growth around 2.6-2.7%.  Now we only need to cross the 2.25% mark to bring unemployment down.  That is a fairly rapid adjustment, and not just due to slower labor force growth:

Also, it appears that productivity growth has slumped recently. Although that means that a given amount of growth translates into bigger employment gains, it certainly is not an unmitigated good development. 

This isn't sounding so good - growth is weak, but the hurdle is lower.  Does this mean that Dudley is less dovish than widely suspected?  I don't think so.  Another excerpt from Dudley's speech today:

More importantly, real economic activity has yet to be strong enough on a sustained basis to make a big dent in the overall amount of slack in the U.S. economy. While it is true that growth was stronger in the fourth quarter, most of that growth was due to inventory accumulation. Growth of final sales was actually quite weak. Historically, a quarter in which inventory investment makes a significant growth contribution is typically followed by a quarter in which that growth contribution is modest or even negative. That appears to be what is shaping up for the first quarter of this year.

This I find just plain irritating, as it sure sounds like he is saying that even though potential output growth has slowed, the existing gap remains unacceptably wide.  If so, why is a policy change dependent on incoming data as he says in the Q and A?  This is somewhat more amazing given his lack of faith in the quality of the recovery:

Based on available data, current expectations are that real GDP will expand at around a 2 percent annual rate during the first quarter of 2012. Despite the increase of light vehicle sales, overall consumer spending has been sluggish. While growth of retail sales in February was reasonably strong in nominal terms, it was considerably less impressive when the large increase of gasoline prices that occurred that month is taken into account. Based on data for the first half of March, gasoline prices are continuing to move higher which will further sap consumers' real purchasing power. And growth of business investment spending, which was quite strong in the second and third quarters of 2011, entered the new year with little forward momentum.

Not exactly a resounding endorsement of the economy.  Sounds like he views the downside risks as the greater concern.  But apparently not enough that the costs of additional easing (which I think amounts to the perception that QE is an inflationary nightmare waiting to happen) outweigh the benefits.

 Bottom Line:  Dudley presents a rather sober view of the US economy - signs of life are hopeful, but he isn't counting on their sustainability in any way, shape, or form.  His estimate of potential output growth is falling, but the existing gap remains wide.  The gap coupled with his obvious lack of enthusiasm for the quality of the recovery should point him in the direction of QE3 sooner than later.  But there is nothing to suggest that such a move is imminent barring a deterioration of the data - he seems to make this clear in the Q&A.  He seems ready to stick with the wait and see approach to policy, possibly because the declining potential growth rate makes him somewhat concerned the output gap could close faster than he would expect, but it sure doesn't sound like it would take too much disappointment in the days ahead to push him to support going back to the monetary well for another round of easing.

The Output Gap Debate Continues

The blogoshpere witnessed some additional contributions to the output gap debate this weekend.  Greg Ip offers up the possibility that potential output, both level and trend, are much lower than previously imagined.  Karl Smith responds with what I believe is an important point:

I’d, however, encourage everyone, as well, to think of the disaggregated story that we are telling here. If trend GDP is overstated, then we are arguing that one or more sectors of the US economy will is less capable of producing output over the next decade or so, than we would have otherwise thought.

Smith suggests we focus on the construction of housing, hospitals and medical facilities, public infrastructure, and transportation equipment.  He concludes:

So, if we think these things will repair themselves then we have an obvious path back to trend.

and then extends:

I don’t want to get too invested in this but a cursory look at the data suggests that GDP is likely to grow above trend in the coming years because two very high productivity export sectors are expanding – computers and gasoline and distillates.

What I like in Smith is the more careful consideration of the structural change story.  If we claim the economic potential of the nation has declined - that in aggregate, we can not make as much stuff as we did a few years ago - we need to identify what stuff isn't being made, why it isn't being made, why we don't think it should be made, and why no other sectors are growing to compensate for those in decline.  

Mark Thoma makes an important contribution to the debate by identifying a short-run path for potential output:

Even a standard business cycle type AD shock will temporarily depress capacity and produce similar effects. Suppose that interest rates go up, taxes go up, government spending goes down, investment falls --pick your story -- causing aggregate demand to fall. When, as a result, businesses lay people off, idle equipment, etc., productive capacity will fall. It can be cranked up again, and will be when the economy recovers, but rehiring labor and taking equipment out of mothballs takes time. In the interim the natural rate of output falls and, just as with a change in the preference for good A versus good B, a negative aggregate demand shock can cause "frictions" on the supply side that temporarily increase the natural rate of unemployment. And there are many other ways this can happen as well.

Mark notes, however, that policy makers should not focus too intensely on short-run potential output because capacity will grow as the economy recovers.  In other, don't confuse a temporary decline in potential with a permanent decline.  Mark extends this to an explanation for relatively stable inflation during the recession.  

That said, Ip does note that a permanent - or at least very persistent - drop in labor force participation rates could cause at least some downward shift in potential output, with a story that in aggregate we cannot make as much as before because we lack sufficient labor, although here too there should be sector specific impacts similar to Smith's critique (unless all sectors lost access to a more or less proportionate share of labor).  And Ip also raises the somewhat different issue of the path of potential output going forward - a decline in both productivity and labor force growth implies a lower path forward, although would not explain a sharp drop in the past.

Finally, I find Felix Salmon's explanation for fall in potential GDP less compelling:

In other words, in order to keep up a steady rate of GDP growth, we had to saddle ourselves with ever more cheap and dangerous debt.

Then, suddenly, the growth of the credit markets screeched to a halt, and we had a major recession. And since then, the size of the credit market has been roughly flat.

It makes sense that if we needed ever-increasing amounts of debt to keep up that long-term GDP growth rate, then when the growth of the debt market stops, our potential growth rate might fall significantly.

Salmon is telling a story about this chart (although he actually uses what I believe is a more difficult chart):

Smith responds by noting this is really a story about mortgage debt, with the first run-up being a natural consequence of the Volker Disinflation and the second being the housing bubble, which Smith views as largely an internal transfer of wealth.  

My additional criticisms of Salmon approach is that is seems primarily a demand side story to a supply-side question. Presumably, all of the productive resources (or nearly all of them, allowing for some hysteresis effects) still exist.  The debt is just plumbing in the background that helps support the demand for those resources.  So Salmon's story just collapses down to an aggregate demand shortfall that really has nothing to do with potential output.   

Moreover, Salmon ignores the assets on the other side of the debt.  We really need to look at some story about net worth:

Here again I think you are fundamentally telling a demand side story to explain the past two business cycles - both were dependent on asset price bubbles to hold output at potential (or even slightly above at the peaks).  Why did the US become dependent on these bubbles?  Here I tend to find the global saving glut story compelling.  A combination of aging developed economies combined with the high savings propensities of primarily Asian central banks has pushed the equilibrium real rate into negative territory, below that attainable given the zero bound and low inflation expectations.  Absent an asset bubble to compensate by adding wealth-effect induced aggregate demand, we are left with a savings-investment imbalance that becomes evident as a subpar equilibrium level of output.

I still believe that primarily we are looking at an aggregate demand shortfall rather than a collapse of potential output, but would agree that only one thing is for sure:  That we haven't seen the end of this debate.