The stock market is nothing if not a psychological barometer. The present signal is unmistakable: fear. It's not just that the market dropped by more than half; that decline parallels some previous post-World War II bear markets (48 percent in 1973-74 and 49 percent in 2000-2002).

More revealing are the day-to-day movements. From mid-September to Nov 21, there were 50 trading days; on 25, the market moved 4 percent or more (16 down, nine up), reports Wilshire Associates. In the previous 25 years, there were just 25 daily moves of 4 percent or more. We've gone from one a year to one every other day.

The wild stock swings confirm the palpable fear and uncertainty. On average, households expect to spend only $418 on holiday gifts this year, down 11 percent from last year's $471, reports the Conference Board. Unemployment remains well below the average peak of post-World War II recessions (7.6 percent). What terrifies Americans is the prospect that the slump will become much worse than average - and that government has lost control of events.

This last occurred in 1979 and 1980, when inflation reached 13 percent and government seemed incapable of suppressing it. No one knew what might happen. By 1980, interest rates on 30-year mortgages neared 13 percent. Would inflation go to 15 percent or 20 percent? (The brutal 1981-82 recession ended the high inflation.) There is a comparable foreboding today.

Perhaps Barack Obama will change that, but so far government officials, business leaders and economists seem overwhelmed. They are constantly playing catch-up and losing. Americans feel unprotected against accumulating misfortune.

The hyper-anxiety is not irrational pessimism, though it may prove unfounded. Every major episode of this crisis - from Bear Stearns' failure to General Motors' possible bankruptcy - has come as a surprise. Similarly, the crisis' three main causes have repeatedly been underestimated: the burst housing "bubble"; fragile financial institutions; and a reversal of the "wealth effect". Of these, the last is least recognized.

The "wealth effect" refers to the tendency of people to adjust their spending as their wealth - concentrated heavily in housing and stocks - changes. When wealth rises, spending strengthens; when wealth falls, spending weakens.

For the past quarter-century, higher stock prices and home values propelled the economy forward by inducing Americans to spend more of their incomes and to borrow more. In 1982, the personal saving rate was 11 percent of disposable income; by 2006, it was almost zero. The lowered saving rate added about $1 trillion annually to consumer spending - more shoes, laptops, books - out of total of about $10 trillion.

But now the wealth effect is reversing. As stock and home values drop, Americans are scrambling to increase savings and curb spending. The plausible math is daunting. Since September 2007, Americans' personal wealth has dropped about $9 trillion, says economist Nigel Gault of IHS Global Insight.

A common estimate is that every dollar's change in wealth causes people to change their spending by 5 cents. If so, the hit to consumer spending would be $450 billion. Gault thinks the effect would occur over several years.

Even this might be too optimistic. Everywhere, financial commentators urge "belt tightening" and more thrift. If the swing toward saving is too sharp, consumer spending wouldn't just weaken; it would collapse. Vehicle sales have already plunged.

In 2005, they totaled almost 17 million; Global Insight's 2009 projection is 12.2 million. And these problems feed on each other. Lower consumer spending depresses profits and stock prices, which corrodes confidence, further dampens spending, raises unemployment and increases loan defaults. Credit card losses could be the next big blow to financial institutions.

The case for a sizable economic "stimulus" package is that it would temporarily compensate for erosion of consumer spending. But if the positive "wealth effect" is now giving way to a lasting negative or neutral "wealth effect" - as people try to replenish savings and offset lost wealth - then even a recovery would be sluggish.

A new source of demand is needed to sustain faster growth. An obvious solution is for high-saving Asian countries, led by China, to consume and spend more so that their imports increase. Whether they have the capacity to reduce their dependence on export-led growth is unclear.

The scary words "depression" and "deflation" are bandied about because an economic free fall seems possible, even if it is unlikely. With time, economic slumps correct themselves as borrowers repay debts, surplus inventories are sold, industries consolidate and government policies promote recovery. They may now. But the mechanics of this cycle differ sufficiently from any since World War II as to raise doubts. Americans are less upset by hardships they've experienced than by those they imagine.

The Washington Post Writers Group

(China Daily 11/26/2008 page9)