Illustration by James Fryer

DEBT is out; cash is in. Financial institutions are finding it hard to borrow from anyone but the state—and they are reluctant to lend to anyone else. Firms, aware that credit is drying up, are striving to raise cash. They have already run down their inventories and are trimming investment and jobs. Householders whose homes are worth less than their mortgages must save hard to reduce their debts. Those that cannot service their mortgages will default, causing more trouble for banks and, via lower house prices, other homeowners.

Just a few months ago, the main worry of policymakers in many economies was whether, as the prices of oil and other commodities shot up, they could contain inflation. But the flight from debt and the dash for cash, inelegantly called “deleveraging”, means a bludgeoning for demand. Now central banks and governments are facing a new set of questions. First, can they stop deleveraging from gaining momentum and wrecking their economies? And second, will the tools of conventional macroeconomic policy—cutting interest rates, lowering taxes and increasing public spending—be enough?

The standard response to a demand shock is to use monetary policy: cut interest rates and increase the money supply. Lower interest rates spur spending by making saving less rewarding. Banks able to borrow more cash at lower cost from the central bank will usually offer more and cheaper loans to firms and households, to pay for new equipment, buildings and consumer goods, or to cover running costs.

Central banks are powerful because they control the “monetary base”. This comprises the notes and coins in wallets, purses, petty-cash trays and tills, plus the cash reserves that commercial banks hold with the central bank. When interest rates are cut, the cost of holding money goes down; and more money in circulation means more spending. A boost to bank reserves has a less direct, but usually larger effect. Just as individuals carry cash to cover incidental spending, banks hold reserves to cover cash withdrawals, cheque payments and bank transfers. So bank reserves matter because they are the foundation for other, “broader” kinds of money—current (checking) accounts, interest-bearing deposits and so on. Because most deposits lie fallow on any one day, banks are safe in holding only a fraction of them in reserve. The ratio of broad to base money is known as the “money multiplier”.

The banks are the conduit between central-bank policy and the wider economy. The trouble is, the conduit is blocked. Despite deep cuts in interest rates by the Federal Reserve, including one this week (see article), the cost of bank credit for American firms and households has not dropped by much. Investors are wary of lending to banks for even a few months, because of the risk that they may go bust or run out of cash. Banks are loth to lend to each other for the same reason (and fear of their own demise is leading them to hoard cash). The spread between what banks pay for overnight central-bank cash and what they pay to borrow for three months is therefore far above pre-crisis levels. The latter rate is the reference point for loans to customers.

Illustration by James Fryer

One route around this blockage is for central banks to lend directly to firms by purchasing their short-term debt at fixed rates, as the Fed started to do this week. A drawback, however, is that it essentially turns the central bank into a commercial bank, exposing the taxpayer to lending risk. And the fix helps only big firms.

The monetary base in big economies has been swollen by lots of liquidity from central banks. In the euro area, for instance, it has grown by one-third since the eve of the crisis in August 2007, even though interest rates are barely lower now than then. Most of the increase is accounted for by a doubling of bank reserves.

Some fear that such a rapid expansion of the monetary base will stoke inflation, which is still above 5% in America and Britain and 3.6% in the euro area. If the ratio of broad to base money were constant, such fears would be warranted. But because banks are using central-bank liquidity to plug holes in their short-term funding, the money multiplier is collapsing: even as reserves swell, broad-money and credit growth is wilting. In the year to September bank lending to British households rose by only 0.9%. Mortgage lending fell. If money is not circulating, but is stashed in reserves or under mattresses, it cannot boost spending or push up inflation.

Indeed, if scared banks, firms and households cling more tightly to cash rather than lend it or spend it, the downturn will deepen. The more confidence weakens and asset prices fall, the more eager is the rush into cash. At the extreme, the demand for cash is so strong than not even interest rates at zero can get the economy moving. When standard monetary-policy responses reach their limit, fiscal options, such as cutting taxes and increasing public spending, come into play.

To some extent, government budgets in rich countries stabilise the economy automatically in booms and busts. When the economy slows and jobs are shed, the state spends more on unemployment benefits, helping to support aggregate demand. At the same time, tax receipts shrink faster than GDP: this hurts public finances in recessions but helps ease the pain for firms and their employees. The power of these automatic stabilisers is greater in Europe, where state benefits are more generous and the tax take higher, than in America.

The use of fiscal policy to fine-tune the business cycle in any more than this passive way went out of fashion around 30 years ago. Policymakers have since preferred to tweak aggregate demand via interest rates rather than taxes. One reason is that although it may be easy to increase public spending in bad times it is hard to reduce it when the economy revives. Tax cuts might be saved, or spent on imports. And continued budget deficits harm private enterprise by soaking up savings, pushing up interest rates and “crowding out” private investment.

But when skittish banks and investors are turning away from funding private spending, there is a strong case for a more active fiscal policy to prop up demand. The dash into safe assets has cut the cost of public borrowing for most rich countries (see chart 1). Low bond yields may be a market signal to “crowd in” public spending. A well-judged budgetary stimulus would help fill the shortfall in demand while debt-laden firms and consumers get their finances in order. It may prevent a recession from turning into a rout. A good package would minimise the drawbacks of fiscal policy: a roadbuilding programme, for example, would cease on completion; tax cuts could be aimed at the poor, who would be more likely to spend the extra cash than the rich.

However, fiscal policy has its limits. A run of big budget deficits increases the risk that a government will default or repay its debts only by forcing its central banks to print money, creating inflation. If public debt spirals upwards as the economy stagnates, investors will worry that future taxpayers will be unable to shoulder the burden. Looser fiscal policy will stretch the public finances of countries that went into the downturn with big debts and budget deficits and have since had to fund bank bail-outs. Markets could choke on the extra bond sales required to finance huge deficits, driving interest rates up and worsening the downturn.

They are not choking yet. Financing government deficits is hard when investors are keen on rival uses for their money—such as companies' shares and bonds. In fact, investors are shying away from such assets. The omens for business investment from recent company reports and confidence surveys are poor. Job cuts, slumping asset prices and a worsening credit drought augur ill for consumer spending too. If firms fear that others will cut back their spending, it will make them still more cautious. The rot could easily feed on itself, leaving equipment and workers idle, and depressing tax revenues. A pre-emptive fiscal stimulus may help prevent that—and shore up the government's tax base.

If conventional monetary and fiscal policy fail, what then? Pessimists point to Japan's travails as a lesson in how a deflating asset-price bubble and a vast overhang of debt can defeat all that monetary and fiscal policy can throw at it. Since 1993 Japan's economy has been kept afloat by heavy government borrowing: the average annual budget deficit since then has been more than 5% of GDP. The economy flowered after 2003, thanks partly to a big intervention to weaken the exchange rate, but it is now close to recession again and threatened further by the rise of the yen. Japan's gross public debt has reached 180% of GDP, according to the OECD (see chart 2).

The sobering lesson is that conventional policy may not prevent a prolonged deflationary slump. This lesson has not been lost on policymakers. The nuclear option, conceived in America but untried in Japan, is to finance public spending or tax cuts by printing money. This requires the central bank to go along with the fiscal authorities (which may prove easier in America than in Europe). It could work like this: the government announces a tax rebate and issues bonds to finance it. But instead of selling them to private investors, it lodges them with the central bank in exchange for a deposit. It draws on this account to clear the cheques mailed to taxpayers. This scheme is essentially the same as the proverbial “helicopter drop” of money, but with neater accounting and a less erratic distribution of cash. It bypasses banks and money markets, and puts money directly into people's pockets.

Monetising a slug of public debt in this way is bound to be inflationary. But by this stage, inflation would be a blessing: an economy where conventional policy tools had failed would suffer from falling prices. A burst of inflation would lift asset prices, ease the weight on debtors (whose real burdens are increased by deflation) and improve public finances. Some central bankers will shudder at the thought. Some, but not all. Ben Bernanke, now the Fed chairman, recommended this course of action to Japan's policymakers in 2003 (when he was a Fed governor). Indeed, he went further. One way out of a slump, he argued, is for policymakers to commit themselves to a period of catch-up inflation, to break deflationary expectations and heal the wounds from past price falls.

If all else fails, it seems, the one sure way to secure solvency in the private and public sectors is to inflate away debts and buoy up asset prices. That nuclear option is the ultimate bail-out: rescuing the indebted by hurting those with savings. In essence, if not degree, it is not so different from conventional policy. Interest-rate cuts are a salve for debtors and a penalty on savers. Fiscal-stimulus schemes impose a cost on all taxpayers, even those well placed to endure a downturn. But the cost of a prolonged slump, in terms of idle resources, lost income, decaying skills and an erosion in the trust that keeps civil society going, would be far higher.