Resident Fellow David Frum

In this week of financial panic, we can already begin to see hope for economic recovery.

In trading Friday, the price of oil fell below US$65 a barrel, down from US$145 only four months ago. This dramatic price collapse will act like a massive global tax cut. Along with the huge monetary stimulus delivered by the U. S. Federal Reserve and other central banks over the past few weeks, it should jolt the world's major economies back to health over the coming months.

The only thing surprising about this price collapse is that anybody could be surprised. Some forecasters asserted that because oil had gone from $50 to $100, it must therefore double again to $200. These must be the same forecasters who predicted that because a detached house in suburban Las Vegas had doubled in price between 2003 and 2007, it must therefore double again between 2007 and 2011.

The price of oil is declining for the same reason it always does: Econ 101. If the price of something rises, consumers demand less and producers supply more. With falling demand and rising supply, price declines. When people use less, supplies increase. It happens so regularly, you might almost think it was a law or something!

Here's how the law operated in this case: The real-estate bubble of 2003-2007 enriched millions of Americans. Many borrowed against their homes and used the proceeds to buy goods imported from China. That spending spree triggered a giddy boom in China, growth of 10% and more a year. The richest Chinese bought cars. Car sales in China zoomed upward, peaking at almost nine million in 2007. Forecasters extrapolated from past results and predicted that China would buy more than 30 million more cars over the next four years. Cars of course run on gasoline. With 30 million more cars in China, the price of the oil from which gasoline is refined could only go up, up, up-- unless something happened.

Something happened.

The U. S. housing bubble popped. U. S. consumers stopped buying. Chinese economic growth decelerated. Those projections of Chinese car buying suddenly looked fanciful. Crash!

People got the oil market wrong because they assume oil is immune to market discipline. It's not.

Some history: U. S. demand for oil rose rapidly in the cheap-oil 1960s. It continued rising even after the oil shock of 1973. But the second oil shock of 1979 changed American behaviour. Consumers bought smaller cars. Utilities closed oil-fired generators. Industry invested in energy efficiency. Result: a sharp decline in oil consumption. Through the 1980s and 1990s--right up to 1996--Americans continued to use less oil per year than they had in 1978. (The same pattern applies in Canada and other developed countries as well.)

Oil got cheap again in the 1990s. Americans bought bigger cars and bigger houses, further away from work. Demand rose. By 2006, Americans were using 10% more oil than the previous peak of 1978.

The spike in oil prices in recent months has altered that behaviour. U. S. oil use has abated again as consumers change their buying practices.

But here's the risk. As oil prices decline, consumers could revert to old habits--and all that talk of "energy independence" will fade with the U. S. election campaign.

Politicians like to talk of reaching energy independence by inventing some sci-fisubstitute for the internal combustion engine. Much more likely, however, is that the world will move off oil gradually, by investing in step-by-step improvements in automobile efficiency: hybrid cars first, more futuristic developments later. There is only one stimulus that can drive this kind of change: price. Today's lower prices, welcome though they are, threaten to halt the progress away from oil.

The answer is to prevent the cost of oil to the consumer from declining any further. Let consumers pocket and benefit from the decline to US$65. Then impose a stand-by excise tax on any further declines. If oil goes to US$64, the government taxes $1. If the decline continues to $63, $2. And so on.

Consumers will continue to substitute away from oil. Manufacturers will be induced to continue investing in efficiency. Homebuilders will continue to shift to smaller, more centrally located development. Revenues to the governments of producing nations will be squeezed. Revenues to the governments of consuming nations will rise--and those governments should use the new tax to cut other taxes, especially taxes on work, saving and investment. I'd nominate the corporate income tax as the first tax to cut--and ideally eliminate.

There's no miracle cure for the Western world's dependence on oil. But there is good grounds for hope for a gradual emancipation from the stuff. The cure is not free. But it's worth paying for.

David Frum is a resident fellow at AEI.