- The Washington Times - Saturday, July 13, 2002

The fall this week of major stock indexes to five-year lows is raising concern that the deep pessimism on Wall Street will start to drag down the economy.

Some soft spots have emerged in the economic recovery in recent weeks, most notably a steep decline of consumer confidence, reflecting in part the stock market's drubbing amid numerous corporate scandals and a still-bleak job outlook. Consumer spending has pulled back from the solid pace that appeared to be leading the economy out of recession earlier this year.

While few believe the stock market on its own could overwhelm consumers and drive the economy back into recession, nearly everyone from Capitol Hill to Wall Street is nervous, if only because the market has been a reliable barometer of the economy's health.

The drops in the Nasdaq Composite and Standard & Poor's 500 indexes to levels not seen since 1997 despite some positive economic news and attempts by President Bush to stem the crisis in confidence on Wall Street are foreshadowing a fall back into recession, some analysts say.

"We cannot rule out a financial crisis and return to recession before year end," said David A. Levy of the Jerome Levy Economic Institute, citing "the rapid spread of the accounting scandal, the relentless bear stock market, currency instability, the alarming situation in the Middle East and the increasing corporate-credit crunch."

Mr. Levy said he expects that the economy will manage to muddle through this year but that it could be derailed by further big drops in the stock market, among other setbacks.

Dean Baker of the Center for Economic Policy Response notes that consumers are being weighed down not only by their stock losses, but also by a weak job market, with average wage growth falling to a 3 percent pace recently from 3.3 percent last year and 4 percent in 2000.

A major source of jobs during the recession robust state and local hiring of teachers and other government workers is drying up in many places as governments grapple with big deficits caused by the recession and stock market drop.

"In an economy with little forward momentum, state and local budget cutbacks and tax increases, coupled with more fallout from corporate scandals, could lay the basis for a double-dip recession," Mr. Baker said.

Frank A. Fernandez, chief economist with the Securities Industry Association, said most economists still see little risk of a double-dip recession, even though that has been the case with five of the last six recessions.

"They may be correct," he said, but "a more conservative view is warranted," given the likelihood that more shocks are in store for the economy, whether they are more massive corporate scandals such as Enron's and WorldCom's or another terrorist attack.

Besides putting a damper on confidence, the stock market losses are stifling business investment, a key ingredient of economic recovery, and slashing the wealth of consumers in a way that could hold back spending for years, analysts say.

In addition, consumers are in worse financial condition than they were last year because of the loss of 1.75 million jobs during the recession. Though job losses slowed in the first part of this year, more big bankruptcies could cause another rash of layoffs.

WorldCom Inc., for example, which recently laid off 17,000 workers, has not ruled out what would be the largest bankruptcy filing in history as it struggles to cope with massive debt.

Consumer debt also has soared to worrisome levels because of America's recent home- and auto-buying binge. And although interest rates and tax rates fell last year as the government moved to counteract the recession, consumers are not receiving much additional support from those sources this year.

The strong inflow of funds from abroad, which allowed consumers and businesses to splurge on debt in recent years, also has slowed sharply this year, causing a 10 percent decline in the dollar and raising concern about whether the United States can keep financing its large foreign debts and trade deficits.

The International Monetary Fund recently cited the possibility of a sharp reversal in the dollar as a result of years of record trade deficits as the principal threat to the U.S. recovery and to the world economy.

Despite the long list of things that could go wrong, most economists remain skeptical that the stock market's woes will infect the broader economy.

"So far, there is little indication that the setback in the stock market has significantly influenced the economy," said Sung Won Sohn, chief economist with Wells Fargo & Co., pointing to a recent revival of production and business spending, which had dropped during the recession.

"Historically, the disconnection between the economy and the stock market is short, and the economic fundamentals always win," he said.

The fall of the dollar actually boosts the economy in the short term by making U.S. exports more competitive, he noted. Also, consumers continue to benefit from a strong housing market.

Although about half of American adults own stocks, they represent a tiny portion of the average household's net worth, he said. Most consumer wealth is concentrated in homes, and home values have been rising sharply, offsetting losses in the stock market.

Recent studies have shown that consumers are more likely to spend the equity they build up in their homes than they are to spend their stock wealth, partly because most of their stock holdings are in retirement portfolios that cannot be accessed easily until retirement.

Home equity, by contrast, can be tapped through cash-out refinancings and home-equity loans, tactics that proved to be a hidden source of strength for consumers during the recession. Mr. Sohn said such financings contributed more than $70 billion to consumer spending last year.

Still, he worries that "each 100-point drop in the stock market casts an additional shadow over the fledgling economic recovery," particularly because the gloom on Wall Street causes corporate chieftains to hunker down, cut costs and postpone hiring and spending.

Richard Berner, chief economist with Morgan Stanley, sees a crossroads at which the economy will head south with the stock market or the market will start to pick up and reflect the rebound in the economy, as it traditionally has done.

"It's time to resolve the great 'double-dip' debate once and for all," he said, noting that the drops in stocks, bond yields and the dollar seem to be unanimously pointing to a "double-dip" recession.

But he also says the economy is strengthening and should eventually win the debate.

Consumers have grown cautious because they "sense that cautious businesses aren't rushing to hire," he said. But recent signs of life in manufacturing suggest that a return of jobs and income gains in that battered sector are not far down the road.

Other than in a few industries such as telecommunications, business profits are starting to rebound, he said, and that will help spur a recovery in investment and the stock market.

Temporary setbacks in the market have rarely deterred economic growth, he said, but the seeming inability of Wall Street to sustain a rally even on good economic news nevertheless gives him pause.

"A full-blown further slide in equity values would spell trouble for the economy," he said.

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