What to do about the gas 'crisis': maybe nothing.

DESPITE what you may have heard, oil and gasoline prices have yet to reach record levels--once we adjust for inflation. Even so, the gasoline price spike that began in the fall of 2002 is the second most dramatic in American economic history--steeper than those in 1973, 1990, and 2000, and nearly as great as that experienced between 1979 and 1981. A back-of-the-envelope calculation finds that the average household today spends between $63 and $79 a month more for gasoline than it did just three years ago.

Perhaps the absence of an identifiable villain has dampened political outrage. Oil companies are making record profits, but there's no evidence that they're holding anything back from the market. Likewise, neither terrorists nor Iraqi insurgents have had any significant impact on OPEC production. Global oil production was 66.8 million barrels a day in 2002, 69.2 million in 2003, 72.5 million in 2004, and is at record levels in 2005.

Regardless, gasoline prices aren't particularly consequential in the grand scheme of things. Sure, we're approaching the record prices paid for gasoline in 1981--about $2.42 a gallon in today's dollars--but on average we're a bit more than half again as wealthy today as we were then. If we consider gasoline prices in relation to per capita disposable income, they are only 58 percent of what they were in 1981, 44 percent of what they were in 1955, and about 90 percent of what they were in 1972. That probably explains why gas-guzzlers are still selling as well as ever and politicians are hearing little outrage from constituents.

What's driving the oil market is demand--not primarily from American SUVs, mind you, but from the awakening economic giant that is China. U.S. consumption grew by about 700,000 barrels a day between 2002 and 2004, but Chinese consumption grew more than twice as fast: by 1.47 million barrels a day. But, even accounting for China, global oil consumption has increased by only 5.3 percent since 2002. How could that have resulted in a near doubling of world oil prices? There are two reasons.

First, the excess production capacity that characterized the world oil market since the price collapse of 1986 had finally all but disappeared by 2002. Accordingly, the recent surge in demand caught the market short. The only way to increase supply substantially is for producers to spend billions of dollars on new production capacity that won't come online for several years hence. Producers, however, fear another boom-and-bust cycle of over-investment followed by a price collapse. That explains why the recent surge in oil prices has not led to a corresponding surge of new supply for the market.

Second, consumers have been slow to adjust their behavior in response to rising prices. Trading in SUVs for Dodge Neons, moving closer to work, and rearranging commute routines to take advantage of mass transit and car-pooling can be costly in time and money. Motorists aren't about to pay those costs without evidence that the price hikes are here to stay. Even then, consumers may not respond as robustly as they have in the past, given that those increased gas prices are less of an annoyance thanks to higher incomes.

With both supply and demand relatively inelastic in the short run--meaning that neither responds very much to price signals--small changes in either will lead to very large price movements. That's because it takes a big price spike to get producers to cough up even a little more product and to get consumers to moderate their demand for oil.

How long will the current spike last? That depends on a couple of things. If the recent increase in demand is for consumption in the here-and-now, only two events will reverse the tide. The first is new supply--which could be several years into the future given the lag time between investment and production. The second is a break in demand, which could occur if China's economy cools off, if the global economy slides into a new recession, or if persistently high prices begin to encourage conservation and fuel switching.

However, if the oil demand we've witnessed is partially driven by inventory buildup, prices may fall when inventories are full or when investors become convinced that possible profits tomorrow are worse bets than sure profits today. Oil would then flow out of inventories, demand for oil would decline with speculators out of the market, and prices could come crashing down.

The majority view among market analysts is that the former story is more likely to be the case than the latter. Yet oil inventories have been growing steadily over the past year and storage capacity is dwindling. Accordingly, a price collapse cannot be ruled out--which further explains why producers are leery of spending billions for new production capacity.

Things could get worse before they get better. In a tight market with inelastic supply and demand, anything that interrupts supply--political unrest in Venezuela, Nigeria, or Iran, terrorist attacks in Saudi Arabia, increased insurgent activity in Iraq, hurricanes in the Caribbean, industrial accidents in refineries or along oil pipelines--could increase prices dramatically. Similarly, surges in demand from continued economic growth, unseasonable weather, or even currency revaluation in China could feed the spiral.

But things will get better--eventually. While both oil supply and demand are relatively inelastic in the short run, both have been shown to be quite elastic in the long run. The events of the 1979-1981 price spike caution against underestimating the ability of market actors to respond to high oil prices, given time.

The federal government can do little about high oil prices because it can do little about global oil supply or demand. Investment decisions by oil companies and OPEC nations determine the former, and global economic growth explains the latter.

The federal government could increase supply by opening up the Arctic National Wildlife Refuge (ANWR) to drilling along with other potentially lucrative fields off our coasts. Even so, it would likely take a decade before congressional action translated into significant quantities of new oil. Regardless, the effect on prices would not be as great as is sometimes advertised. Producing a million barrels of oil a day from ANWR, for example, would increase global oil supply by 1.4 percent, which would translate into a 14 percent reduction in world oil prices, all things being equal. Thus, were ANWR pumping today, we'd be paying about $47 a barrel for oil rather than $55.

Gasoline prices to a large extent track oil prices, so there's not much the government can do about prices at the pump beyond repealing state laws that mandate retail-price floors and ending regulations in some states that prohibit major oil companies from owning gas stations. Few people are aware of the extent to which state lawmakers have conspired to raise gasoline prices artificially in an ill-advised effort to protect "mom and pop" gas stations from competition.

Raising automobile fuel-efficiency standards is a bad idea. The Congressional Budget Office reports that tightening standards would increase the sticker price of new vehicles more than the savings in reduced fuel costs over the lifetime of the vehicle. It's also unclear whether it would reduce gasoline consumption. That's because the average fuel efficiency of new Japanese vehicles sold in the United States is well beyond today's regulatory requirement. Accordingly, Japanese companies could conceivably increase sales of SUVs, pickup trucks, and minivans without running afoul of new regulations.

Cutting gasoline taxes would work no better. Retailers who cut prices to reflect lower taxes would trigger an increase in gasoline demand. But because the supply of gasoline is relatively fixed in the short run, the only way to keep the pumps from running dry would be to raise prices back up to where they were prior to the tax cut. In short, cutting gasoline taxes now would simply redistribute revenues from the government to private companies without any effect on retail prices.

The perennial call to lessen regulation in order to increase the number of gasoline refineries misdiagnoses the problem. New refineries aren't being built for two reasons. First, investors have discovered that it's cheaper to increase the capacity of existing refineries than it is to build new ones. Second, competition in the refining sector is so ferocious that profits have traditionally been hard to come by. No profits, no investment. The only way for the federal government to increase refinery capacity beyond what the market provides is to subsidize refinery operators. Don't wait for the politicians or economists, however, to rally around that flag.

Finally, encouraging oil independence would worsen the problem. We buy oil from abroad because it's cheaper than producing that oil at home. Restricting imports would simply force reliance on more expensive fuels.

Happily enough, the lack of public outrage over fuel prices gives the market oxygen to solve its own problems. High prices will lead to increased conservation and greater incentives to produce both new supply and alternative fuels. Perhaps Americans are coming to realize that, however much they dislike high gasoline prices, governments have never demonstrated an ability to do anything positive about them.

Mr. Taylor is director of natural-resource studies at the Cato Institute, and Mr. Van Doren is editor of Cato's Regulation magazine.