Wall Street hates the debt deal: The details behind the stock market plunge

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Wall Street hates the debt deal: The details behind the stock market plunge

Wall Street, it appears, hates the debt deal.
Leading up to the debt-ceiling deadline, everyone was talking about how the stock market would crater if Washington didn't reach a deal. In fact, the opposite has happened. Just when it became clear last week that Washington was moving closer to a deal is exactly when Wall Street started to stumble. And now that we have a deal, the falls have been getting worse. Thursday was particularly bad. The Dow Jones industrial average plunged more than 500 point. Overall, the market has fallen 9 out of the last 10 trading days, one of the worst stretches of down days in recent years.

Of course, the economy in general and the economic problems overseas aren't helping things. This week we have gotten economic reports that show spending by consumers and manufacturing activity have both been falling. Around the world, overall inflation is falling as well, which could be a sign that global growth is on the rocks. Early indications are that the monthly jobs report, which comes out on Friday, will be disappointing too. On top of that, the European Central Bank said more may need to be done to mend the finances of Spain and other European countries if those strapped governments are to avoid default. All that has to be weighing on the market.

Some have said the fact that the debt deal was struck has allowed investors to focus more clearly on the economy, and what they see, now that they're looking again, is bad news. But it's more than just that. In the Aug. 15 issue of TIME, columnist Rana Foroohar argues that the debt deal will increase the level of inequality in the U.S. You can read her very good article here. I agree with Foroohar that it is bad news — and perhaps even worse than she makes it out. Inequality not only caused the financial crisis; it could make the recovery much slower. Here's why:I have written a few pieces about how the debt deal could slow the economy. A cut in spending, be it from consumers or the government, during a recession is sure to cost the economy jobs. Still, the direct drag from the debt deal on the economy is unlikely to be that big, mostly because the $2.1 trillion in cuts over the next decade won't really kick in for a few years. Thomas Lam, chief economist at Singapore-based financial firm OSK/DMG, calculates that the drag on the economy will lower economic growth by only 0.3 percentage points in each of the next two years, which is something but not disastrous. So why is Wall Street reacting so badly in the wake of the deal?

Because the big impact of the deal may not be the direct drag of a decrease in spending. At times in the debt-deal negotiations, it looked like we might get either an increase in taxes for the wealthiest Americans, an increase in unemployment benefits or both. In the end, we didn't get any of those things. Nor did we get a reduction in entitlement programs that benefit everyone. Instead, what was cut was largely discretionary funds, a large portion of which go to programs that help the poor.

That's why Foroohar says the deal will probably exacerbate income inequality in the U.S. And income inequality is one of the main factors that caused the financial crisis. But that's not the only way that inequality is haunting this economy. Inequality is probably slowing the recovery as well. So far most of the gains of the recovery have gone to wealthy Americans. Luxury spending is up. So that helps.

But as you put more and more wealth into the hands of fewer and fewer Americans, you get less of a bump from those gains for the overall economy. There's only so much money the rich can spend. Instead, they will take their extra wealth and put it into savings. And what we need right now to boost the economy is spending, not savings.

The debt deal seems to make clear that Washington, at least for now, has no plans to deal with the income gap. Not only that, it seems unlikely that after trying to claim victory in the debt deal, a politician would turn around and say, "O.K., now we need to spend money on programs to boost employment." Our best hope to boost the economy is for some deal to lower taxes, either for corporations or for middle-class Americans. But because there was no deal on raising taxes on the wealthy, it is likely that Obama and the rest of the Democrats will hold the line on the Bush tax cuts and let them expire completely. So taxes for everyone are going up. And that could be another drag on the economy. So why was the stock market down on Thursday? Why wouldn't it be?

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