Macro Man has thus far avoided the great "deflation versus inflation" debate, at least publicly, for a couple of reasons. The first is that he doesn't think the outcome will be as black and white as many of the debate's participants; he suspects the underlying dynamic is heavily dependent on the velocity of money, and so he prefers to focus his analytical energies in that direction. Moreover, the tone of the debate has taken on a quasi-religious tone, which is rarely conducive to the sort of open-minded give-and-take that yields substantive results.

However, it's probably worth touching on some small aspect of the debate, as behind the scenes it seems as if the same is happening at the Fed. Don Kohn's recent speech highlighted the large size of the output gap, a view largely echoed in last night's FOMC minutes. Yet at a recent St. Louis Fed conference, Bank president James Bullard offered a somewhat contrary view-namely that the collapse of the bubble has eradicated some of the productive capacity of the economy, thus rendering the output gap smaller than commonly believed.

This is an interesting and important issue, not least because the Greenspan Fed's belief in a large output gap was a major factor behind the policy mistake of leaving rates too low for too long in 2003-04.

Macro Man must confess that he has some sympathy for Bullard's view. A quick look at US manufacturing capacity, for example, shows that it has actually shrunk over the past year. Not as much as demand for that capacity has, of course, but still....it's quite a telling sign. While there is no accurate official measure of the total capital stock, Macro Man has to believe that it has been depleted as well.
Of course, a counter-argument to the notion of a smaller "national" output gap is the fact that consumer-driven Anglo-Saxon economies have essentially outsourced their manufacturing capacity, so you need to consider the notion of a "global" output gap. Well, perhaps....but even then there is no assurance that there is a limitless supply of foreign-made manufactured goods.