**3. The legacy of past crises and current challenges**

#### **3.1 Lessons from Volcker's disinflation for the present**

During the GFC, the balance sheets (BSs) of Western CB expanded at rates never seen before. In particular, between 2008 and 2014, the BS of the Fed increased by a factor of 4.5. In 2016, the Fed made a modest effort at tapering but, as soon as the COVID-19 pandemic hit the globe at the beginning of 2020, substantial QE operations were resumed in order to help the Treasury finance huge aid packages to

<sup>7</sup> From a peak of over one trillion and a half in 2006, net new issues of MBS plus municipal bonds became negative in 2008, remained in negative or negligible territory every single year until 2013, and rose very modestly above zero through 2017 ([8], Section 2.3 and Figure 4).

<sup>8</sup> An illuminating discussion of the tortuous process that led to the adoption of the TARP legislation appears in Ref. [11].

individuals and corporations in the economy. As a consequence, between the end of 2019 and the end of 2021, the BS of the Fed doubled. This policy paid off for the US as it stimulated the economy and reduced unemployment in spite of the obstacles posed by the pandemic.9 However frequent lockouts in China and elsewhere along with the war in Ukraine revived inflation prompting CBs in many countries to increase policy rates. Initially, the Fed did not move the FFR away from the vicinity of the ZLB. But as U.S. inflation accelerated to around 8%, it finally engaged in a gradual process of rates lifting in March 2022.

The current situation is reminiscent of Volcker's disinflation at the beginning of the eighties. In both cases, an important portion of the inflation is due to aggregate supply factors; a dramatic increase in the price of oil by OPEC then and, currently, an increase in this price due to sanctions on Russia in response to the invasion of Ukraine. As Ukraine and Russia are major suppliers of cereals and wheat, the war also reduces world supplies of those staples causing a general increase in food prices. In both cases, CBs respond to rising inflation by raising policy rates. As recounted in Section 2.1, Volcker's disinflation was one of the factors contributing to the LA crisis in the early 1980s.

But there also are differences between those two episodes. Most importantly, due to fiscal and monetary policy measures deployed during the GFC and the COVID-19 pandemic, debt/GDP ratios, private debts, and CBs balance sheets of the U.S. and other Western economies are at historically high levels. By contrast, the levels of public and private debt in the early eighties were much lower. In addition, the current round of rate lifting comes after a decade of extremely low nominal and real interest rates along with subdued inflation. By raising the debt service of private and public borrowers and depressing the value of assets, overly quick lifting of rates, may create strains on business and public finances pushing marginal borrowers to the brink of default. The experience of the LA crisis in the 1980s suggests that this risk is relatively more important for emerging markets with limited access to international capital markets than for developed economies. For advanced economies, such risks are mitigated by the comprehensive regulatory reforms that have been implemented during the GFC.
