Oil, Fiscal Dominance, and the Return of Stagflation?

Why Today May Resemble the 1970s More Than the Pre-GFC Economy (Part 2)

In the first part of this series, we examined how oil shocks have historically interacted with monetary policy and inflation. The key lesson was that geopolitical energy disruptions alone do not determine economic outcomes. Instead, the policy response — especially monetary policy — determines whether inflation proves temporary or persistent.

But there is another critical dimension worth examining: how money enters the system in the first place.

The structure of money creation today may make the current macro environment more comparable to the 1970s than to the years preceding the Global Financial Crisis.

The 1970s: Inflation and Expanding Money Supply

During the 1970s, the United States experienced rapid inflation alongside two major oil shocks. But energy prices alone did not create the inflationary regime.

A crucial background factor was the expansion of the money supply, largely driven by commercial bank lending.

Banks created deposits through credit expansion:

Commercial bank lending
→ deposit creation
→ expanding money supply
→ rising nominal demand

At the same time, fiscal spending associated with the Vietnam War and Great Society programs increased government deficits. Monetary policy remained accommodative for much of the decade, allowing inflation to build before policymakers eventually responded with aggressive tightening in the early 1980s.

The combination of supply shocks, loose monetary policy, and expanding credit produced the stagflationary environment that defined the decade.

Today’s Monetary Expansion May Look Different

The potential inflation mechanism today may operate through a different channel.

In contrast to the 1970s, commercial bank lending has been relatively subdued in recent years. Credit growth is not the primary driver of monetary expansion.

Instead, the dominant force in the current macro environment may be fiscal policy.

The United States is running structural deficits of roughly 6–7% of GDP, even outside a recession. At the same time, federal debt levels have reached historically elevated levels, and interest costs on that debt are rising rapidly.

This raises the possibility of fiscal dominance — a situation in which monetary policy becomes constrained by the financing needs of the government.

In such an environment, monetary policy may be forced to accommodate fiscal expansion rather than strictly targeting inflation.

A Shift in the Source of Money Creation

The difference can be summarized simply.

1970s money creation

Commercial bank lending
→ credit expansion
→ deposits and money supply increase

Potential modern money creation

Government deficits
→ Treasury issuance
→ Federal Reserve balance sheet expansion or financial repression
→ liquidity injected into the system

If fiscal deficits remain structurally large, money supply growth could occur through the government sector rather than through private credit.

This shift matters because fiscal-driven liquidity can persist even during periods of weak private sector demand.

Declining Foreign Demand for Treasuries

Another structural change complicates the picture.

For decades, global demand for U.S. Treasury securities helped finance American deficits. Foreign central banks and sovereign investors accumulated large dollar reserves and recycled them into Treasury markets.

However, several developments may reduce this external demand:

• geopolitical fragmentation

• diversification of foreign reserves

• trade tensions and sanctions regimes

• shifts in global capital flows

If foreign buyers absorb a smaller share of Treasury issuance, two possibilities remain:

1. Treasury yields rise significantly
2. The Federal Reserve absorbs more government debt

Either outcome increases the likelihood of monetary accommodation of fiscal deficits.

Tariffs and Supply Fragmentation

The global economy is also becoming structurally less efficient.

During the decades before the Global Financial Crisis, globalization acted as a powerful disinflationary force. The integration of China into the global trading system lowered manufacturing costs and expanded supply chains.

Today, that trend has partially reversed.

Industrial policy, tariffs, and geopolitical competition are pushing economies toward strategic reshoring and supply chain redundancy. These developments may increase costs across a wide range of industries.

In that sense, the current environment again echoes aspects of the 1970s, when geopolitical tensions and trade disruptions contributed to persistent inflation pressures.

Policy Constraints and the Debt Burden

Another key difference between today and earlier decades lies in the level of debt.

When Federal Reserve Chairman Paul Volcker raised interest rates dramatically in the early 1980s to defeat inflation, total debt levels were far lower than they are today. The government could withstand extremely high interest rates without facing immediate fiscal stress.

Today, the situation is different.

With federal debt above 100% of GDP and interest payments rising rapidly, sustained high interest rates would significantly increase the government’s financing burden.

This may limit the ability of policymakers to repeat the kind of aggressive tightening that ended the inflation of the 1970s.

Why This Is Different From the Pre-GFC Economy

The years leading up to the Global Financial Crisis had a very different macro structure.

Inflation pressures during that period were largely driven by:

• strong global demand, particularly from China

• commodity supercycle dynamics

• rapid expansion of private credit

Money supply growth was closely tied to private sector borrowing, particularly through the housing market.

When the financial crisis struck, the credit system collapsed, demand fell sharply, and commodity prices dropped. Inflation pressures disappeared quickly.

Today’s economy may be more vulnerable to persistent inflation, because liquidity may be sustained by fiscal policy rather than private credit growth.

The Risk of a New Stagflationary Regime

A stagflationary outcome would require several conditions to align:

• sustained supply shocks (for example, energy or commodity disruptions)

• large fiscal deficits

• reduced external demand for government debt

• early monetary easing or financial repression

If these forces combine, inflation could remain elevated even while economic growth slows.

This is precisely the dynamic that defined the 1970s.