Wall Street plunge could worsen economy's troubles

The two-week plunge in stock prices is signaling economic anxiety, but it's also compounding the problem: Lower stock prices are shrinking Americans' wealth, rattling their confidence and making them less inclined to spend.

And employers may become even slower to hire.

The Dow Jones industrial average plummeted 513 points, or 4 percent, Thursday on fears about the U.S. economy and the debt crisis in Europe. The major stock indexes have sunk more than 10 percent from their previous highs.

Economists say sustained drops in stock prices tend to suppress consumer spending as people see their wealth shrink. And consumer spending accounts for about 70 percent of economic activity.

The drop in stock prices could especially slow spending by upper-income Americans. Eighty percent of stocks belong to the richest 10 percent of Americans. And the richest 20 percent of Americans account for about 40 percent of consumer spending, says Michael Niemira, chief economist at the International Council of Shopping Centers.

The drop in stocks "will have repercussions back on the economy," says Barry Bosworth, an economist at the Brookings Institution who has studied the link between stock market performance and consumer spending.

All this comes just as fears of another recession are rising. Many consumers, their wages devoured by high gasoline and food prices, are pinching pennies: In June, they reduced spending for the first time in 20 months, the government said this week.

Cato Corp., which sells budget-priced women's clothing, said Thursday that revenue at stores open at least a year fell 3 percent in July. CEO John Cato said the results "reflect the difficult economic conditions and uncertainty affecting our customers."

Luxury retailers like Tiffany & Co. and Saks Fifth Avenue have remained a bastion of strength. They benefited from a stock rally that started a year ago and made wealthy households even wealthier and willing to spend. MasterCard Advisors SpendingPulse says its index of luxury sales at restaurants, food boutiques, department stores and clothiers, surged 12 percent last month.

But the Dow's plunge could now threaten upscale retailers. The economy, Niemira notes, is "more dependent on spending at the high end so (a drop in luxury sales) could have a bigger effect.

But James Rushing, a vice president in the retail practice at the consultancy A.T. Kearney, expects high-end shoppers to keep spending. True, they slashed spending during the financial crisis a couple of years ago. But he says they've grown used to bad economic news and are unfazed by the stock market's short-term gyrations.

"The question is, how long of a funk do you have to have before those higher-end consumers" scale back spending? says Doug Hart, a partner in the retail practice of BDO USA.

The stock market still has plenty to worry about.

Cracks in the European financial system widened further Thursday as investors worried that Italy and Spain would be unable to pay their debts. Regulators have put banks there through a series of stress tests. The tests are designed to show whether the banks could withstand defaults by their weaker neighbors.

Fears of default by smaller, heavily indebted countries such as Greece and Portugal have been replaced by concerns about large Italian and Spanish banks. Some investors also worry that the banks are carrying too much of their home nations' debt and that the banks aren't reporting the true value of those bonds.

Investors fear that the European Union's bailout fund, set up last year to assist indebted countries like Greece, might not be big enough to aid all of the countries facing such problems.

Traders are losing faith in the creditworthiness of debt issued by a growing number of countries and in the banks that hold it. That's causing banks to charge each other more money for overnight borrowing. It's also making short-term credit harder to get, traders say.

One sign of jitters: The yield on the one-month Treasury bill fell into negative territory on Thursday. That meant that lenders would, in effect, pay the U.S. government to hold their cash. Market participants said the falling Treasury yields show that investors still regard U.S. debt as the safest place for their money.

There are other ways that Europe's problems could be felt across the Atlantic. European banks that can't get credit might stop lending to U.S. banks and hoard their money. U.S. banks' borrowing costs would rise.

A default by a major European bank would likely have similar effects, potentially sparking a credit crisis like the one caused when Lehman Brothers collapsed in September 2008.

"It's one of those unknowns that's big enough and scary enough to drag down the (U.S.) markets," said Kurt Karl, chief U.S. economist at Swiss Re.

Europe is also an important market for U.S. goods. Companies in the Standard & Poor's 500 stock index earn about 20 percent of their profits in Europe, according to Bank of America.

Investors have turned their attention this week to a string of data that shows the economy is much weaker than they thought, said Tom Porcelli, an economist at RBC Capital Markets.

"The recovery is going to be long and drawn out and is going to be more painful than many people appreciated," he said.


AP Business Writers Daniel Wagner in Washington and Christina Rexrode in New York contributed to this report.