Time for QE3, and Then Some

The global beating shares just took had many causes, no doubt. Still disgusted by the US debt-ceiling fiasco, I am apt to give that masterclass in malice and incompetence more of the blame than it really deserves: the talk in markets today was more about signs of stalling growth in the US and mounting anxieties over Europe than about US fiscal impotence. Still, it can't help to know at such a time that the US government is clueless and paralysed--or that any US fiscal policies one might recommend (extended payroll-tax relief and unemployment benefits) would have to be taken up by the US Congress. Once it gets back from vacation.

That leaves the Fed and quantitative easing. Weeks ago I said I thought the case for QE3 was strong. At that point, there seemed little chance of it: inflation hawks on the FOMC were asserting themselves. The bad growth numbers for the first half surely ought to be changing their minds. QE3 looks like necessary insurance against a second dip and possible deflation. Now, unlike then, you can accept most of the inflation hawks' way of thinking and still be in favour of QE3. The facts have changed, sir.

Apparently, not everybody thinks so. A signal that may have helped Wall Street to tank today was Jean-Claude Trichet's interview with Dow Jones. Inflation risks have not abated in Europe, he said. Yes, he is still worried mainly about inflation. He wouldn't rule out more rises in interest rates, even alongside new measures to provide emergency liquidity.

"I exclude nothing," Mr. Trichet said. "The separation principle is a very strong one... but we could pretty well go in various directions" in terms of standard policy measures and exceptional liquidity support.

Going in various directions, to no net effect, would seem to sum up a good deal of recent economic policy, on both sides of the Atlantic. It sounds better I suppose if you call this the separation principle.

Far from worrying about rising inflation, the Fed and the ECB need to see that the situation is deteriorating to the point where engineering a spell of higher inflation is actually the right goal. I understand the dangers. In ordinary times, I am an inflation hawk. But these are not ordinary times. Ken Rogoff puts the case well.

Some observers regard any suggestion of even modestly elevated inflation as a form of heresy. But Great Contractions, as opposed to recessions, are very infrequent events, occurring perhaps once every 70 or 80 years. These are times when central banks need to spend some of the credibility that they accumulate in normal times.

Rogoff first argued along these lines in 2008--presciently, it turns out, though back then it was less wrong to hope that a more normal recovery would ensue. The balance of risks has changed, and the central banks need to show the markets they have noticed.