Insurance and Economy and Government

EYE ON THE PIE: Economic crisis explained, at last

October 20, 2008

I was uncomfortably challenged when Faye of the Forest landed on my deck a few days ago wanting to know what all these economic goings-on meant.

"I'm responsible for teaching the elves," she said, "and I don't know what to tell them."

"I don't know what to tell you," I said. "But here's what seems to me has happened."

"Some people," I said, "are unable to make the payments on their mortgages. These mortgages are not held by the banks that made the initial loans. Investors bought packages of mortgages because American home mortgages are (were) considered safe. After all, the American home is (was) thought to be the sacred foundation of our ever-prosperous economy.

"But many investors are super-cautious people and they took out 'insurance' in case they were not able to collect the money they were due. That put the risk of default on the 'insurers.'

"When investors found out that some of their money was not likely to be repaid, they turned to the 'insurers' to get their money. But many times the 'insurers' were firms that did not have the reserves to pay their obligations to the investors."

"So," Faye said, "the problem is that some mortgage payments are not being made and the folks who were supposed to make good when there were defaults couldn't because they didn't put aside enough money to cover what they owed. That left investors holding the bag."

"That's a good part of the problem," I said. "It's not the whole story, but it gets to the core of the issue. When investors don't get their money either from the homeowners or the 'insurers' (the folks who issued those mysterious creditdefault swaps), then they cannot pay back the money they borrowed to finance their purchases of the mortgages.

"Thus we have people and institutions that lent money they had borrowed not being able to repay their debts. Ultimately, and that's where we are today, no one wants to lend to anyone because he doesn't know if he will be repaid. It's a Shakespearian world (we neither borrowers nor lenders be) and the economy stagnates."

"And we are going to punish the people who got us into this mess!" Faye proclaimed.

"In time," I said, "after appropriate investigation and consideration, but not now. Our current task is to get out of the swamp rather than trying to find those who gave us bad directions."

"So what does any of this have to do with Indiana?" Faye asked.

"Everything," I said. "Frightened people on Main Street everywhere see their retirement investments shrink as the stock market declines and they plan to buy less for Christmas. Retailers order fewer goods for Christmas. Manufacturers then cut back on production. This reduces employment and income.

"When people and businesses have less income, government revenue from sales and income taxes falls. The state has become more dependent on these taxes as it has moved away from the property tax. Local governments have become more dependent on the state for revenue.

"Now what?" Faye asked.

"Exactly," I said. "Can the state come through with the money it promised local governments from higher sales taxes? Or will local services have to be cut back? Or will local governments have to borrow money in a market where no one wants to lend except at very high rates?"

"The elves are getting nervous," Faye said. "Are we safe in the forest?"

"Sweet sprite," I said, "we are never safe anywhere. We have only illusions of safety that result from blocking out history and failing to prepare for the unexpected."



Marcus taught economics for more than 30 years at Indiana University and is the former director of IU's Business Research Center. His column appears weekly. He can be reached at mmarcus@ibj.com.
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