Just as the credit crunch seems to be ending, the world faces a much more serious economic threat: the explosion of oil prices and the possibility of a return to 1970s-style inflation. Inflation is a more dangerous economic ill than deflation because it is so much harder to cure. Falling prices can be cured easily enough. All governments and central banks have to do is cut interest rates, cut taxes and boost public spending. These are popular steps that readily win political and business support.

The policies required to deal with inflation are, by contrast, always painful and unpopular - raising interest and taxes; cutting government spending and curbing public employees' pay. It is hardly surprising, therefore, that only one country in the world - Japan - has faced a serious deflation problem since the 1930s, while inflation crises have afflicted every market economy in the postwar era and have triggered almost every big recession since 1945. The question, now that the focus of attention is moving beyond the credit crunch, is whether this sad history is likely to repeat itself in the year or two ahead.

The answer depends largely on how governments and central banks worldwide respond to the oil shock. The challenge most discussed in recent weeks is the one facing central banks. If the surge in oil prices causes accelerating pay growth and then a second round of price rises in goods and services not directly exposed to oil, central banks will face stark alternatives: either deliberately to create recessions and mass unemployment by raising interest rates even amid the present property slump, or to accept 1970s-style wage-price spirals, which will have to be cured eventually with even deeper recessions, higher unemployment and greater financial grief.

The other, even bigger, challenge of the oil shock is the one presented to governments. This is the question of what can be done to reverse the rise in oil prices. This question is even more important than the central banks' inflation-deflation dilemma and yet is hardly discussed. Most politicians, economists and financiers simply assume that the trebling of oil prices in the past few years has been a natural phenomenon that must be accepted as an act of God - or at least an inexorable judgment by the markets. However, are there really no policy changes that could restore the more benign conditions in which oil prices of $40 or $50 were seen as normal?

The standard answer is “no” - oil at $100-plus must be accepted as inevitable and natural because growth in global oil production cannot keep up with growing demand, especially from China and the developing world. However, even if this were so - and statistical facts about the “peak-oil” limit to global production capacity are ambiguous, to put it mildly - it begs the question of whether oil consumers could soon take steps that would drastically reduce demand.

Specifically, there are four big steps that governments in oil-consuming regions could take once they recognise the existential economic threat of a $100 oil price.

The first and most urgent step is for developing countries, now responsible for all the growth in world oil demand, to reduce and ultimately eliminate energy subsidies. Once Asian consumers face global oil prices, they will change their behaviour - for example, buying smaller, more fuel-efficient cars - far more quickly than European and American consumers, since $100 oil is much more of a burden relative to total income for poorer consumers. Indonesia and several smaller Asian countries have begun this process and last week the Indian Prime Minister announced plans to reduce energy subsidies over time. China will surely follow. Once China and India made clear their aim to move towards global oil prices, the impact on oil prices would probably be very big and immediate, even if abolition of subsidies were spread over several years.

Today's high oil prices are largely sustained by expectations of huge Chinese demand growth. Mere announcement of a plan to align Chinese and global market prices could have a huge effect on long-term futures market prices, which have been driving up physical oil's price.

The second big step would be for financial regulators in the United States, Britain and Europe to reduce the artificial demand for long-term oil-hoarding created by pension funds, insurance companies, endowments and other long-term investors. These investment institutions have been piling into commodities recently in the same way they did into technology shares in the late 1990s and into mortgage-based credit derivatives from 2003 to 2006. Last week there were signs that US commodity market regulators may close loopholes whereby these long-term investors can accumulate immense positions far larger than those permitted to ordinary commodity speculators. Just like banking authorities in the sub-prime mortgage boom, US commodity regulators initially have been reluctant to interfere with market forces, but under political pressure from Congress a tightening of both regulations and tax rules seems to be on the cards.

Such a touch on the regulatory tiller might well, on its own, reverse the most recent spike in the oil price.

The third step to cut long-term oil demand is up to the US Government. A political consensus seems to be forming to end America's costly reliance on oil imports. This consensus could lead America towards European-style energy taxes, offset by lower taxes on income and employment. Any such shift would have a huge effect on global oil demand. If US oil usage could be reduced gradually to today's European level - perfectly plausible, given the similar populations and levels of development of these two continental economies - the cut in global oil demand would be almost equivalent to China's oil consumption.

The fourth big step in reducing global oil dependence would be for Europe and Britain, as well as the US, to create far greater financial incentives for renewable and nuclear electricity generation.

The ultimate aim should be a shift from oil-based to electricity-based technologies in all industries and throughout the global economy.

If such measures are adopted, there can be no doubt that the price mechanism will cut long-term oil demand drastically. So much so that the peak oil thesis about the inevitable dwindling of global oil production will almost certainly stay untested and unproven; for, in the end, a large part of the world's oil supplies will be abandoned for ever, virtually worthless, in the ground. The effect of price on demand was summarised during the last energy shock by Sheikh Yamani, then Saudi Arabia's Oil Minister, when he told greedier Opec colleagues that they would encourage replacement of oil by other energy sources. “Remember,” he said, “the Stone Age didn't end because the cavemen ran out of stone.”

If oil stays anywhere near $100 a barrel, the price mechanism and the political economy of national survival will ensure that the oil age ends long before the world runs out of oil.

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