The really key argument that hasn't been addressed here is why does such a behavior belong in psql, rather than elsewhere? Surely legibility problems aren't unique to psql users. Moreover, there are exactly parallel facilities for other datatypes on the server side: think DateStyle or bytea_output. So if you were trying to follow precedent rather than invent a kluge, you'd have submitted a patch to create a GUC that changes the output of boolout().
I find Tom's analogy to datestyle and bytea_output convincing.
+1 for a GUC that changes the behaviour of boolout.
-1 for changing boolout(). It will break anything that receives boolean values from the server. How a client is going to display values (of any type) is logic that should belong in the client, not in the protocol.
