I'm missing something blindingly obvious, as Jim Bullard, David Andolfatto and Tyler Cowen (who also links to this argument) are very bright people. It's just that I don't see the argument. And the argument is stated in such a way that it seems like one of those "needs no explanation" points. As if the fall in wealth would obviously reduce consumption (I agree) and obviously that fall in consumption would reduce output. But why?
I am not sure I am comfortable with just tossing around a term "wealth effect."
Suppose that a foreign government confiscates some of our citizens' assets. Then domestic potential output is not affected. There may be less domestic consumption. But the that would make the output gap larger, not smaller.
Take a completely different example. Suppose that some of our capital becomes suddenly and unexpectedly unproductive. (I think this is closer to what Tyler has in mind.) Then we have lower potential output along with lower wealth. The effect on the output gap is ambiguous, but I could imagine consumers not adjusting so much right away, which would make the output gap smaller at first. Moreover, if macroeconomists fail to account for the reduced capital productivity on potential GDP, they will over-estimate potential GDP.
Of course, the PSST perspective finesses all this. The concept of potential GDP does not carry any weight. When we see unemployment, we do not see a shortfall in aggregate demand. Instead, we see an economy where some unsustainable patterns of specialization and trade have been shut down and entrepreneurs have yet to discover more sustainable patterns.
In the AS-AD paradigm, the unemployment of the Great Depression seems entirely unnecessary. The slump was a mistake, caused by bad luck and, above all, by incompetent macroeconomic management.
From a PSST perspective, one has to ask how full employment could have been maintained. Should the patterns of specialization and trade that were in place in 1929 been kept in place for ten or twenty years longer? This could not have been reconciled with the innovation in production methods that took place. On the other hand, could the patterns of specialization and trade in 1950 have been adopted sooner? That would have required incredible foresight and coordination on the part of entrepreneurs.
Or look at today's economy. If we were at so-called potential GDP, what would we be producing? As many mortgage originations and securities as in 2007? More manufactured goods, by returning to 2007 levels of employment and multiplying by 2012 levels of productivity? The set of goods and services that we will be producing in 2016?
Once you ask the question of what we should be producing, you realize that nobody knows the answer. The next logical step is to discard the concept of potential GDP.