Steep market drop stokes fears of sustained economic downturn

The steep stock market drop that accelerated Thursday is being stoked by fears that the U.S. economy is headed into a sustained downturn at a time when policymakers are particularly ill-equipped to fight it.

The Dow Jones Industrial Average was down 513 points Thursday, closing at 11,383.68. The stock market has declined by more than 10 percent in the past two weeks. If those losses continue, they will severely undermine the efforts of government and individuals to dig out of the deep debt that many analysts say is at the root of the nation’s economic troubles.

The Federal Reserve has policies in place that have kept interest rates at near-record low levels, raising questions about what more it can do. Meanwhile, the federal government has not shown the political capacity to enact new stimulus efforts, given the large philosophical divide separating Democrats and Republicans.

“If we tie the hands of fiscal policy, and monetary policy has no new weapons and households are still cutting back . . . that is what the financial markets are reflecting now,” said Dan Seiver, a San Diego State University finance professor.

The debt-limit deal struck by Congress last weekend has been criticized by some budget experts as failing to address the nation’s long-term debt problems even as it staved off a federal default. About $1.1 trillion in stock market wealth has evaporated since the agreement was reached.

Analysts say that if the market losses continue, they will complicate efforts to fix the nation’s ailing housing market and make it more difficult for hard-pressed state and local governments to balance their books. Both of those sectors have been cited as major factors in the nation’s anemic economic growth.

Renewed economic troubles could also reshape the parameters of the high-pitched debate in Washington over the nation’s debt. Some lawmakers may feel less inclined to cut back federal programs during heightened economic trouble. But a decline in tax revenue may force the government to borrow even more money.

“If this economy were a bicycle, it would be about to topple over,” said Jared Bernstein, senior fellow at the Center for Budget and Policy Priorities and formerly the top economic adviser to Vice President Biden. “We need to put pressure on those pedals, but the political system is pushing in the other direction. The economy is crying out for help, and the political system is deaf to those cries.”

When the economy entered crisis in 2008, the government had many weapons in its arsenal to help the housing market. The Treasury Department and Fed started buying mortgage-backed securities, which helped push rates lower for homeowners. The government took over mortgage finance giants Fannie Mae and Freddie Mac, which helped stabilize the market. And the government tried to quell foreclosures.

If the housing market is hit hard again in a recession, the government would have fewer options. The Fed owns nearly a trillion dollars’ worth of mortgages. The Treasury has spent $130 billion on rescuing Fannie and Freddie, which are legally required to start shrinking this year. The government will still be able to try to use Fannie and Freddie — which aren’t counted as part of the budget — to help the housing market, but officials are unclear about what could be done to make a major difference.

Faced with declining revenue, states across the country have been changing their pension programs, cutting job, and trimming once sacrosanct programs such as education and health care to balance their books. Although revenue is improving, it remains below pre-recession levels and another downturn would deliver a severe blow.

“States have been making spending cuts to respond to their revenue levels and the end of federal stimulus,” said Brian Sigritz, director of state fiscal studies for the National Association of State Budget Officers. “They have had furloughs, layoffs, and, in some cases, raised taxes and fees. They have been making painful decisions, and any further decrease in revenues would force more tough decisions on the states.”

More than 40 state-run public employee pension plans have implemented changes since 2009 aimed at shrinking their huge unfunded liabilities, which some analysts say loom as a long-term problem. Among other things, states have raised retirement ages for new employees, increased employee contribution levels and, in a few cases, added defined contribution plans such as 401(k)s as an option for retirement saving.

They were also helped by the strong performance of the stock market, which in the fiscal year that ended June 30 delivered state pension funds median returns of more than 20 percent, said Keith Brainard, research director of the National Association of State Retirement Administrators.

That has helped pension funds accrue more than $1 trillion in assets since their nadir in March 2009, Brainard said. Although a strong market is important to pension funds, he added, “their focus tends to be on returns over decades, rather than individual days.”

The steep drop in the stock market also shakes the retirement security of many employees of private firms, the vast majority of whom rely on defined contribution plans for retirement savings.

“What that does is it shifts the market risks to the employees. The bigger the risk, the worse it looks,” said Judy Miller, chief of actuarial issues for the American Society of Pension Professionals and Actuaries.

During the last downturn, she added, many companies suspended matching contributions to retirement plans, a threat that lingers as long as the nation’s economy remains on shaky ground.

“If things don’t level out, and the down market is an indication of the general economic environment, I would expect to see some of them cutting back on the matching end,” Miller said.

Also, shrinking 401(k) balances make many ordinary Americans feel less wealthy and feel like they have to cut back — further compounding the nation’s problems because consumer spending is the biggest driver of economic activity.

“Investments go down, and they turn around and say, ‘Wait, I can’t spend that money,’ ” said Diane Oakley, executive director of the National Institute on Retirement Security. “They almost felt compelled to cut back on their spending because they weren’t sure how they were going to make up that income.”

Staff writers Zachary A. Goldfarb, Sarah Halzack and Cezary Podkul contributed to this report.

Michael A. Fletcher is a national economics correspondent, writing about unemployment, state and municipal debt, the evolving job market and the auto industry.
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