The idea is basically that if we could sustain a five or six percent inflation rate for a period of years, that would make it much easier to work off the debt overhangs—both in the public and private sectors—that otherwise threaten to hobble the economy for years. You would need, of course, to try to be sure that this doesn’t spiral into accelerating inflation. But the point is to move beyond the kind of anti-inflation hyper-vigilance that came into vogue after the Great Inflation of the 1970s. That mentality was an understandable reaction to what had happened, but the fact that an out-of-control wage-price cycle is a bad thing doesn’t mean that inflation should always be kept as low as possible. A moderate amount of inflation could do a great deal to help us.
There's only one problem: you can't inflate your way out of debt:
The bad news for central bankers is that creating currency isn't like, say, diluting shareholders in a company. You're always rolling your debt, and the market's response to an inflationary strategy is (not surprisingly) higher interest rates. It's a treadmill, and it's extremely hard to get ahead.
So why do we have this mythology, as Donovan calls it, of inflating our way out of debt? It's probably because on the surface there's some simple logic to it, though more importantly it's a myth borne out of necessity. The opposite idea, that we'd actually have to cut spending and raise taxes (which is to say, actually pay off our debts) is just too painful to contemplate.
Even worse, if a country tries to sneak out of debt by inflating it away not only will investors demand higher interest rates, investors may demand a risk premium on top of higher interest rates, or even refuse to lend at all. Even if that doesn't happen it's nearly impossible to stay ahead of lenders when you have to roll over the debt.
And of course, inflation also carries many significant downsides. In short, trying to inflate the debt away is a very bad idea.