(CORRECTS to show volume highest since day after "flash crash")
* World stocks hit by losses, Wall St down 6 pct
* Worst day for S&P 500 since December 2008
* Gold hits record above $1,700 an ounce
* Italian, Spanish bond yields drop on ECB buying (Adds details, quote)
By Leah Schnurr
NEW YORK, Aug 8 (Reuters) - U.S. stocks plunged on Monday, racking up their biggest losses in almost three years as investors fled to the safety of gold and bonds after the downgrade of the U.S. credit rating by Standard & Poor's stoked fears the country is powerless to stop another recession.
Wall Street ended down more than 6 percent while European stocks hit a two-year low as investors saw no solution to the twin debt crises on both sides of the Atlantic.
A favored gauge of investor anxiety spiked to its biggest one-day gain since February 2007, a sign investors are afraid of more declines to come. The CBOE Volatility Index <.VIX> surged 50 percent to end at 48.
The selling came in heavy trading, with volume of 17.5 billion shares on the New York Stock Exchange, NYSE Amex and Nasdaq, the busiest since the day after last year's "flash crash."
Ironically, investors took shelter in the one asset that was directly affected by the downgrade -- U.S. government bonds. Benchmark 10-year Treasury notes, held widely for their perceived high quality, rallied, the yield dropping to 2.32 percent.
Investors struggled to discern the effects of the U.S. credit rating downgrade to AA-plus from AAA, which could hit various components of the vast U.S. financial sector, from mortgage lenders to municipal issuers and insurers.
"It is a panic, and almost by definition it doesn't have an issue. It wouldn't matter what it was," said James Paulsen, chief investment strategist at Wells Capital Management, with over $340 billion in assets under management.
The downgrade -- and threats of subsequent moves by S&P or other rating agencies -- adds to concern about the credibility of the United States as the leader in the global economy, as well as the dollar's position as the world's reserve currency.
Central to S&P's argument was that political paralysis in Washington has reached a point where the government would be unable to deal with worsening deficits and sagging economic growth. This burdens a stock market already skittish after last week's outbreak of fear.
"In many ways this is not about the downgrade. I think it's about the underlying fundamentals and issues that are embodied in the downgrade itself," said Jonathan Golub, chief U.S. equity strategist at UBS in New York.
This was underlined when selling accelerated during comments from U.S. President Barack Obama, after he blamed the downgrade on political gridlock in Washington. He said he would offer more recommendations on how to reduce federal deficits, but detailed no new proposals.For details, see [ID:nN1E7771BR]
"Almost universally my clients are blaming this on the government, this lack of confidence -- and that is what this is," said William Suplee, a certified financial planner at Structured Asset Management in Paoli, Pennsylvania, who said he had received several calls from clients on Monday.
"This sell-off is uniformly blamed by my clients on the government's inability to act rationally."
MSCI's all-country world stock index dropped 5.1 percent to its lowest level since September 2010.
Monday's global stock market sell-off wiped out more than $1.35 trillion in investor wealth worldwide, according to the 5.2 percent drop in the MSCI World Index <.MIWD00000PUS>. The index entered the week with a value of $26.42 trillion.
Monday's rush for the exits extinguished any relief from news the European Central Bank was buying Italian and Spanish government bonds in the latest move to staunch the euro zone debt crisis.[ID:nLDE7770NM]
SEARCH FOR SAFETY
Several major brokerages have in recent days lowered their expectations for U.S. economic growth and share appreciation for 2011 and 2012.
Moody's repeated a warning it could downgrade the United States before 2013 if the fiscal or economic outlook weakened significantly. It said it saw the potential for a new deal in Washington to cut the budget deficit before then.
The Dow Jones industrial average <.DJI> dropped 634.76 points, or 5.55 percent, to 10,809.85. The Standard & Poor's 500 Index<.SPX> slumped 79.92 points, or 6.66 percent, to 1,119.46. The Nasdaq Composite Index<.IXIC> skidded 174.72 points, or 6.90 percent, to 2,357.69.
The S&P 500 lost $729.3 billion in value with its drop of 6.66 percent, the biggest since December 2008.
Investors looking for a place to park their money pushed into gold, U.S. Treasuries and some safe-haven currencies.
Gold
"Treasuries are still a comparatively low-risk asset. I think there's no doubt about that," said Michael Schumacher, a strategist at UBS in Stamford, Connecticut.
The euro slumped to a record low of 1.0640 Swiss francs
The dollar
European shares closed down 4 percent after registering gains on the ECB action. The FTSEurofirst 300 index <.FTEU3> has lost about 21 percent since a peak in mid-February, putting it in bear market territory. (Additional reporting by Daniel Bases, Lauren Young and Edward Krudy in New York and Atul Prakash and Jeremy Gaunt in London; Editing by Dan Grebler)