Resident Fellow  David Frum

It's the first rule of Canadian economics: When the U.S. catches cold, Canada gets pneumonia. What if, this time, the rule does not apply?

Economists such as BMO's Douglas Porter have been raising this question for a year. Very soon we should know the answer.

The U.S. economy has been battered by unceasing bad news. Even adjusted for inflation, oil costs more than it did during the worst days of the 1979 oil shock. The housing market has collapsed, with prices down 20% from their 2006 peak--and still falling. Stock prices have dropped by 20% since the fall of 2007. My American Enterprise Institute colleague Desmond Lachman calculates that the drop in equities has wiped out US$2.5-trillion of household wealth in the United States. Credit markets and the mortgage market are in crisis, with the government bailing out--at an unknowable cost--the two giant government-sponsored mortgage lenders, Fannie Mae and Freddie Mac. And with each passing week, the news seems to get worse. Here, for example, are some of this week's leading stories:

Perhaps the gravest risk to Canada comes from Obama's endorsement of new higher taxes on the foreign operations of U.S. companies.

• Last Friday brought us the second-biggest bank failure in U.S. history. Reacting to that failure, bank stocks collapsed Monday, dropping to the lowest level since 1989.
• On Tuesday came warnings of accelerating inflation, when the U.S. Department of Labor reported that wholesale prices had risen 9.2% over the 12 months ending in June, the biggest annual wholesale price rise since 1981.
• Wednesday? More terrible news from the homebuilding industry: The National Association of Homebuilders announced that its monthly index of sales activity had dropped to 16 out of a possible 100, the lowest score ever recorded.
• On Thursday, America's largest stockbroker, Merrill Lynch, reported a disastrous quarterly loss of US$4.9-billion--bringing the brokerage's total losses over the past 12 months to almost US$20-billion.

Yet north of the border, conditions remain calm and bright.

Inflation remains low, house prices remain stable, Canadian banks show healthy balance sheets, the stock market is down only 3% for the year and the overall economy continues to grow--grow very slowly, yes, but still grow. It's not great news, but it's good enough: As they are saying on Wall Street these days: "Flat is the new up."

In the next months, we will learn whether decoupling is reality or just wishful thinking. The outcome will depend on these four factors:

1) Canada can "decouple" from the United States only if China has "decoupled" from the United States. China has become Canada's second-largest trading partner. Chinese demand for Canadian lumber, potash, grain and metals buoys the Canadian economy even as U.S. demand for Canadian manufactured products, especially cars, shrivels.

But can China keep buying from Canada if America ceases buying from China? China is heavily dependent on U.S. demand to sustain its wild growth: The WTO estimates that China trades 70% of its GDP. More than one-fifth of China's exports go to the United States.

2) Canadians profit from high natural resources prices. Higher natural resource prices drive up the value of the Canadian dollar, increasing the purchasing power of all Canadians.

Canadians also suffer from high natural resource prices. Even with their new 99-U.S.-cent dollars, it's expensive to fill a tank with US$130 oil. Much depends for Canada on which of those effects proves stronger.

3) Canada's banking sector may be less exposed to the US credit market--but is it less exposed enough? Bank of Montreal has $51-billion in U.S. loans; Toronto-Dominion, $46-billion. If those loans go bad, that will be a nasty shock.

4) U.S. economic troubles will likely produce substantial political change: bigger Democratic majorities in Congress and maybe a Democratic president as well. These changes threaten Canada with unwelcome policy changes. Barack Obama has mulled excluding "dirty oil," such as Canada's oil sands, from the U.S. market. While his aides acknowledge that his campaign attacks on NAFTA were insincere, Democrats in Congress genuinely wish to restrict international trade.

Perhaps the gravest risk to Canada comes from Obama's endorsement of new higher taxes on the foreign operations of U.S. companies. If enacted, these new taxes would discourage U.S. corporations from investing and operating abroad--squeezing the U.S. investment on which Canada has historically heavily relied.

There's a saying that the most dangerous words an investor can hear are: "This time it's different." Sometimes, these words are right. But not usually. Governments and individuals would do well to stock up on made-in-Canada medicine for a made-in-the-U.S.A. cold.

David Frum is a resident fellow at AEI.