Is holiday spending hiding economy's flaws?

Even though holiday shoppers are whisking merchandise off shelves and overheating cash registers, it might not be the season to be jolly.

Instead of a boom, consumer spending today is a tinsel-wrapped binge headed for a bust, say a small but influential number of economists. Consumers are spending more than they earn and plunging the savings rate into the red for the first time since the Depression. Their excesses threaten stock market stability and, possibly, economic growth.

"We'll look back on the divergence between the [rising] stock market and the [falling] savings rate and say we should have recognized a disaster waiting to happen," says Stephen Roach, chief economist at Morgan Stanley Dean Witter in New York.

Many economists do not predict a big stumble in spending and stock prices. Normally, they note, overeager consumers eventually pocket their wallets rather than run down their savings. Spending falls more in line with income and, gradually, the savings rate revives.

Strange days

But these times are far from normal. Bankruptcy rates and debt levels are extremely high. Consumers have put a near-record portion of household assets into the stock market. And they spend with the assumption that equity prices - and their astounding stock profits - will continue to yield large returns, some economists say.

"People have not taken their income and squirreled it into savings," says Don Hilber, an economist with Wells Fargo Company in Minneapolis. "Instead," he says, "they are spending and letting the stock market do the saving for them."

The spendthrift optimism and high-flying stock market have spurred one another in a dizzying upward spiral: Consumer spending pumps up stock prices because it's the economy's No. 1 engine. A reverse, downward spiral could be swift.

Indeed, soaring spending and ethereal equities float together as a "double bubble," says Mr. Roach. They bob just above several thorns, including the threat of deflation, weakening corporate earnings growth, and a renewed bout of foreign financial turmoil.

"There are plenty of things that can go wrong - we are on very thin ice," says Mark Zandi, chief economist at Regional Financial Associates in West Chester, Pa.

Yet other economists are not so pessimistic. They note that a bank reform scheme in Japan, a financial bailout for Brazil, and congressional approval of funding for the International Monetary Fund (IMF) have calmed foreign markets.

Also, the threat of a recession next year appears to be receding, largely because of continued strong personal consumption. And Congress seems increasingly less likely to take the market-jarring step of impeaching President Clinton.

Most important, the Federal Reserve since September has averted a credit crunch by cutting interest rates three times. One gauge of the money supply - M2 - has expanded in the past two months at an annualized pace of more than 13 percent, or the fastest growth since just after the stock market "crashette" of 1987.

Correction ahead?

Still, some skeptics foresee a stiff correction in stock prices and consumer spending. First, they suspect the Federal Reserve might step back from its "fight." With credit markets calmer and stock markets rocketing, the Fed will probably not lower rates when it next gathers on Dec. 17.

Indeed, the Fed is concerned more rate reductions would spur the stock market from a recent record to an even more overvalued level. By postponing a rate cut, it might prompt a correction and skim froth from the market, say some economists. "The best response from the Fed would be no response," says Roach. "It should send a signal to investors that they cannot count on the Fed to nurture the market forever."

Second, projections of 18 percent average earnings growth for 1999 are far too sunny. The estimates ignore a dire "profit squeeze" for US companies because of competition from cheap imports and the pressure to raise wages in a period of low unemployment and scarce workers. Companies must also draw down abundant inventories. Slower earnings growth would badly undermine the price of many stocks.

Third, Japan and Brazil remain potential flash points for a renewed brush fire of market turmoil. Tokyo's reforms are too mild to shake down a banking sector reeling under an estimated $1 trillion in bad loans. Brazil's recalcitrant legislature might balk at the austerity necessary to secure full IMF funding and stabilize the economy.

Finally, many consumers apparently do not recognize that paper profits in the stock market are much more at risk than money in a bank. Their confidence in an ever-robust equity market could keep spending high and savings low. According to the Commerce Department, the personal savings rate - or savings as a percent of after-tax income - were negative in September and October for the first time since the 1930s.