With America facing the worst financial meltdown since the Great Depression and markets worldwide reeling from the deepening crisis, it is time to ask faculty economists two questions:

What happened, and what happens next?

Steven M. Sheffrin, professor of economics, likens it to a giant financial belly ache.

"Our financial system ate a bad meal," he said. "Unsound mortgages are still working out the rather painful effects in our economic system. Unfortunately, we have digested and spread this bad meal" throughout the financial system.

'Draw a line'

Meanwhile, the U.S. government is in the extraordinary position of deciding which companies to support with emergency loans and takeover measures, he added.

Sheffrin: "The Federal Reserve and U.S. Treasury have tried to draw a line between those institutions whose failure would bring a major financial crisis to our entire system versus those whose effects would be confined primarily to the shareholders and stakeholders in the institution — the government was willing to bail out the former, but not the latter."

The government is concerned with the failure of institutions that would affect payment systems and the ability of financial institutions to extend credit to one another, he said. "This was the case, they believed, for Bear Stearns and American International Group (AIG), but not other institutions," such as Lehman Brothers, which declared bankruptcy.

Sheffrin, an expert in tax policy, believes the government can afford these loans and other means of support. Government action on crises is typically reassuring to the markets, which loathe uncertainty.

"The government in some cases will be providing funds to prop up some of these institutions, but in other cases there will be no net cost as a government guarantee can calm the markets," he said.

The Treasury Department last week announced a plan to extend a $700 billion bailout to beleaguered financial institutions. But the proposal is under fierce debate in Congress, where critics want protections for homeowners facing foreclosures and limits to sky-high CEO compensation.

'Moral hazard'

Ironically, in a financial world driven by numbers and data, whimsical human emotion often plays a role in investor behavior. "In a few cases, the institutions may have been sound, but overtaken by financial panic," Sheffrin said.

Brad Barber, a finance professor who has published widely on the psychology of investing, calls it "a slow train wreck" fueled by the "generous lending practices" and "inflated home prices of the past several years.

"This is the classic moral hazard problem," he said. "If we insulate these institutions from the full consequences of their actions, we may unwittingly provide incentives for them to take unwise risks."

A moral hazard occurs when an individual or a group behaves differently because they believe they are protected from risk and will not suffer the consequences, Barber says.

He says that if taxpayers are bailing out these companies, they should "insist on monitoring the practices of these companies." Often there is no other way to confront a dramatically worsening situation.

"The government has made the decision that the broader consequences of failure are sufficient to warrant some intervention," he said.

Every few years, Barber said, we receive "not-so-gentle reminders" that financial markets are risky.

"In the last decade we have witnessed a bubble in the valuation of Internet stocks, the dramatic failure of a hedge fund run by Nobel Laureates that nearly brought the world's financial markets to its knees, and the shocking bankruptcies of Enron and Worldcom," he said.

Is the worst yet to come?

Sheffrin believes the housing market is near the bottom and represents the ultimate source of the problems. Better regulations could lessen the impact of such meltdowns in the future.

"In the long run, we want to keep the financial innovations that have brought more flexibility to our system," he said. "But we do need to find a regulatory structure that provides more transparency in our financial institutions and corrects the incentives for making poor loans and attempting to pass the problems on to others."

To some, it may seem odd that the U.S. Congress is not more involved in straightening out the financial mess. After all, the institution represents the democratic will of the American people.

Sheffrin says Congress is not structured to respond quickly to economic crises that pose immediate threats.

"First, there is no consensus on what Congress really wants to do," he said. "There has been some discussion of a new entity being created that would buy and then eventually sell distressed debt from institutions. But designing such an institution would be difficult and there would be many concerns about whether it is needed."

Politics factors into these situations. "The political season has intervened and Congress wants to go home and use this as a political weapon during the campaign," he said.

In a democratic nation like America, some may see it as ironic that the government has assumed total management control of a major financial company like AIG. Sheffrin calls it an "exceptional case" that goes beyond a government bail out of an important company, which has occurred in the past 30 years, as in the 1979 case of Chrysler.

Sheffrin: "The Fed's loan to JP Morgan to take over Bear Stearns and its significant loans and equity position with AIG are novel. On the other hand, the reason we have a Federal Reserve system is to provide liquidity to the system and serve as a lender of last resort."

He noted that the lessons from the Great Depression are such that the country "cannot afford a breakdown of its payment and credit system."

As Barber put it, "In retrospect, it seems obvious that lending standards were too lax. The question is why were the standards lax, and what regulations might be appropriate."

It will take time for Congress and the government to sift through the issues, Barber added. Congress will have to approve the Treasury Department's $700 billion bailout plan to make it a reality.

Workers, jobs and fear

The world of high finance has great impact on regular people, said Vicki Smith, professor and chair of sociology.

"No one is exempt from feeling the effects of the situation," Smith said. "Highly-paid professional workers on Wall Street are losing their jobs in droves. Decently paid blue and white collar workers in many different occupations and industries watch as their retirement savings dwindle while the stock market loses its value."

Smith said that workers are suddenly finding themselves without a pension or retirement plan — "a double whammy for millions of American workers."

What type of thoughts and feeling are workers experiencing? Smith says fear and insecurity run rampant during economic downturns.

"Workers are less likely to think about looking for a different job when they can see that industry after industry is laying off workers because of declining business," said Smith, whose latest book, The Good Temp, discusses how some managers view all workers as expendable.

When individuals read about the dire economic news in the morning newspaper, she said, it often means they will buy one less item, make one less expenditure, forgo one more household item. All of this worsens the overall economy, of course.

"Multiply this thought process by millions of decision makers and you have a spiraling downturn of consumer behavior that further confounds the weak economy," she said.

Smith predicts a rise in temporary employment. "A New York Times business writer recently argued that American corporations are staging a hiring freeze and not creating new jobs — a strategy well underway before the severe crisis unfolded that we see today."

Bailouts and golden parachutes

Economic historian Peter Lindert says finance is "too important to left to the financiers alone, just as military affairs are too important to be left to the generals."

The sheer size and scope of the firms in jeopardy is an issue, Lindert says.

"If the government keeps telling firms that it will save giants, we are inviting firms to merge into giants and take big risks," said Lindert.

The business world's elite continue to thrive even while they are running their companies into the ground and threatening the U.S. economy, said Lindert, whose recent book, Growing Public: Social Spending and Economic Growth Since the Eighteenth Century, spells out the impacts of big social safety nets on the world's richest democracies.

"When will private companies and the government," Lindert said, "stop offering multi-million dollar golden parachutes to CEOs and board members that perform badly?"