Slumping stock market may crack consumer

The stock market may be the deciding factor in whether the U.S. economy tips into a consumer-driven recession this year.

Much of the hand-wringing about the big threat to household spending has focused on the slumping housing market, but history suggests consumers can withstand one serious blow to their wealth. A double-barreled assault can be disastrous, so if stocks keep sliding, spending may finally buckle.

Peter Ireland, an economics professor at Boston College and former researcher for the Federal Reserve Bank of Richmond, said that until recently, homeowners stung by falling property values could still take solace in the stock market, which managed to finish a tumultuous 2007 with gains, albeit slim.

With U.S. stock markets off to their worst start in history this year and a growing number of economists predicting a recession, households may begin worrying about their nest eggs and do something they haven't done much of for years -- spend less than they earn.

American consumers have been playing a game where they save, in a sense, without savings, relying on capital gains, Ireland said. The big question there is how will long will it last? If we get to the point where American consumers start to feel like the only way of saving is to actually do it the old fashioned way ... that could make 2008 a tougher year than we might have hoped for.

Investors and economists are keeping a close eye on consumer spending because it accounts for more than two-thirds of U.S. economic activity. If household spending dips, it would likely sink the economy into recession.

Ireland said that if the Dow Jones industrial average holds above the 12,000 mark, consumers will likely hang on, anticipating a bumpy but relatively brief ride. Below that level, he envisions household spending falling as investors gasp over double-digit declines in their stock portfolios.

The Dow was up 0.71 percent at 12,675 in mid-morning trade on Wednesday.

MEMORIES OF MILTON FRIEDMAN

To be sure, a bad week on Wall Street isn't enough to reverse a 25-year trend of households curbing savings to support spending. That track record gives Deutsche Bank senior economist Torsten Slok hope that consumers will pull through.

Betting against the consumer has long been a losing proposition. This decade alone, spending has survived the bursting of the technology bubble, the shock of the September 11, 2001, terror attacks, oil smashing through psychological thresholds of $60, $70, $80, $90 and now $100, and last year's housing misery.

Slok said many clients he speaks to think a consumer-led recession is inevitable because households simply cannot keep spending more than they earn. However, economic theory says they will sustain their spending as long as they remain confident in their long-term financial well-being.

If U.S. consumers want to keep consuming despite this temporary shock, they could just sell assets other than their house, Slok said. Housing is not the most significant part of the (household) balance sheet. In that sense, I'm still optimistic that we will not get a recession.

The reason for spending's resilience can be found in an economic theory that dates back some 50 years to renowned economist Milton Friedman. He found that people base their immediate spending decisions on long-term earnings expectations, not current income levels.

That means consumers don't stop spending just because the stock market goes down, as long as they perceive it to be a short-term move and not a permanent threat to their wealth.

Indeed, despite a barrage of bad economic news, November's spending was much stronger than anticipated, although consumers gobbled up their savings to accomplish that, pushing the saving rate into negative territory for the first time in 15 months.

Using Friedman's theory, the fact that consumers were willing to incur greater debt to sustain spending is a positive because it suggests they remained optimistic about the future.

That confidence may have been shattered in December.

Weak readings on employment and manufacturing heightened worries that the U.S. economy may already have slipped into recession. If upcoming reports bolster those fears, consumers may question their long-term economic health and cut back.

Deutsche Bank's Slok acknowledged that the employment report was distressing. If it translates into a consumer spending slowdown, that would make him rethink his premise.

If we do start seeing significant slowdowns in consumer spending, then we will be wrong because that means consumers will be much more nervous and worried than what we think, he said.