We were going to call this page "The Crumbling Economy" but didn't want to contribute to the alarmism that leads to a, well, crumbling economy. There's no doubt the US financial world is feeling fairly tumultuous these days - and there are increasingly few economists who think we can avoid a recession - but how long and deep of a recession the turmoil on Wall Street will cause is still an open question.

Still, the Federal Reserve (the US's lending arm which tries to keep the economy on an even keel) and Congress are not waiting to find out before intervening in ways they hope will cushion a hard crash. Through interest rate tweaks, stimulus plans, new regs and "bail-outs" they're hoping to give the economy enough bounce to avoid falling into a deep recession.

How'd this happen?

CitizenJoe wouldn't dare sum up the causes of the current financial mess in a few phrases, but the G20 "communique" world leaders produced in a November '08 meeting does dare: "weak underwriting standards, unsound risk-management practices, increasingly complex and opaque financial products and consequent excessive leverage." (WP)

What does that mean? Let us oversimplify: a few years back brokers and banks started offering more and more high-risk mortgages to people that had slim chance of making their payments; brokers could do so because they were able to chop up those mortgages and sell them off in bits (called "tranches" that then got packaged into "mortgage backed securities") and so pass along the risk to Wall Streeters (and pension funds and 401ks); those tranches became part of the web of securities traded on Wall Street that were increasingly complex and so hard to value; but because everyone kept making money, financial firms kept borrowing more (leveraging) so they could invest even more in the seemingly endless boom.

It all worked fine until those homeowners started defaulting on their mortgages, which set off a downward spiral of real-estate prices crashing, leading to yet more foreclosures as defaulting homeowners had a harder time refinancing their homes in a sinking market. At the same time, everyone holding on to mortgage backed securities started to realize they may be holding to, well, junk. Financial firms started to fall, making banks nervous about whether all their investments and loans were similarly locked up in bum securities. That made banks want to lend less, drying up credit all around. Few things clam up an economy more than dried up credit. (Also see cJ's housing crisis overview and this explainer from David Leonhardt at the NYTimes.)

What's a government to do?

When an economy slumps, there are a couple of things a national government can - and usually will - do to perk it up: lower interest rates and inject money into the economy (via "stimulus" packages). Because of the character of this particular slump, DC is also taking steps to grease the lending wheels of Wall Street and to stave off massive home foreclosures. Here's a running record of what DC's plans and actions:

Bailouts big and small. After stepping in to rescue progressively heftier Wall Street giants - Bear Stearns, Frannie Mae & Freddie Mac, and AIG - the Fed turned to Congress asking it to okay a bailout to - hopefully - end all bailouts. Congress complied in early October '08, greenlighting the Fed to give up to $700 billion (to be given in three installments) to ailing financial firms. The original idea was to buy up "toxic" debt that Wall Street firms have on their books (those mortgage backed securities mentioned above), but the Fed soon shifted gears and thought it wiser to directly buy stock in faltering financial institutions. (NYT, WP)

As part of the bail out package, the government is supposed to get some stock in the companies they help out (which means taxpayers could - in theory - end up making a profit if/when firms recover). CEO pay - and golden parachutes - in those companies will also be limited. Finally, the bill includes vague language about helping out more families who are at risk of going into foreclosure on their homes. (NYT, WP)

Congress also wrote in measures to insure oversight of how the Treasurer used his $700 billion check, but as of mid-November only one out of three oversight offices were up and really running. (WP)

Although the bill looks like it's a bailout for irresponsible financiers, the rationale behind injecting money into Wall Street is that it will ward off a credit freeze - which could push us all into a deep recession. With financial firms spooked by toxic securities, they are increasingly worried about extending credit to other firms; a credit freeze on Wall Street eventually translates to dried up credit for the rest of America. By cushioning the cash flow of weak firms, however, a bailout hopes to give Wall Street the confidence to start lending again.

Consumerism boost: Congress passed a "stimulus" plan in early '08, doling out $600 checks to most working Americans (low income taxpayers will get $300). With checks starting to arrive in May, economists hoped consumers would hit the mall (and not the savings bank) to shoot some energy into the economy. Another boost is in the works, but probably won't be okayed until early '09.

Earlier help from the Fed: The Federal Reserve at first played its usual economy-boosting game of lowering interest rates (which makes it more attractive to borrow and invest in the economy) to avoid a recession; it also started funneling money to investment houses (as short term loans) to prop up confidence among investors before moving to full-scale bailouts.

Propping up mortgages: Congress and DC regulators are also churning out ways to save homeowners from defaulting mortgages - by easing up and creating new federally backed loans - while protecting families from future risky loans. See our Housing Jitters page.

Regulating Wall Street: At least part of the current headache on Wall Street is blamed on newer, higher-risk and under-regulated ways of investing. Banks have the FDIC hanging over them to make sure they aren't going too far out on a limb (or at least making their work more transparent); many on the Hill would like to see DC also take a larger role in regulating all financial institutions. Congressional leaders and the administration have plans in the works, but no one expects any changes to be made this year - and only after many ideas are battled out. (NYT, NYT, WP, WP, WP)

How the US decides to regulate its markets may also depend on what the rest of the world does. In November, the G20 (made up of the world's wealthiest nations and major emerging powers) met to talk about possible global oversight of the financial markets. Discussions will resume in April '09. (WP)

Easing student loans: With the credit crunch putting the squeeze on student loans, Congress voted to open up federal lending, HR 5715, to make sure students can still pay their tuition without paying skyrocketing rates. (WP)

Updated November 15, 2008

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