We are experiencing financial panic. A downgrade of US debt has triggered a flight to liquidity towards the very assets downgraded. Ultimately, the cure for market paranoia is strong economic growth. Several commentators propose a sharp, contained bout of inflation as a way to re-energise growth in the US and the industrial world. Are they right?

To understand the prescription, we must understand the diagnosis. Recoveries from crises that result in over-leveraged balance sheets are slow, and are typically resistant to traditional macroeconomic stimulus. Over-leveraged, households cannot spend, banks cannot lend and governments cannot stimulate. So why not generate higher inflation for a while? This will surprise fixed income lenders who agreed to lend long term at low rates; bring down the real values of debt; eliminate debt “overhang”; and spur growth. Yet there are concerns. Can central banks with anti-inflation credibility generate sharply higher inflation in an environment of low rates? Will it work as intended? What could be the unintended consequences? And are there better alternatives?

Japan’s central bank tried and failed to generate higher inflation. Banks were too willing to hold the reserves that the central bank put out as it bought back bonds. Perhaps if a central bank announced a higher inflation target, and an asset purchase programme financed with unremunerated reserves, to continue until the target were met, it could have some effect. More likely though, any target would lose credibility once it became changeable. Market participants might conjecture that the programme would be abandoned once it reached an alarming size, and well before the target is reached.