Getting a Grasp On the Crisis

The $700 billion package approved by Congress still needs to be implemented, and any progress could take time. (By Mark Lennihan -- Associated Press)

All told, the government is on track to shell out more than $1 trillion to solve the credit crunch. And the price may keep going up. Yesterday, the Federal Reserve agreed to give American International Group a $38 billion loan, on top of an $85 billion loan given last month. These loans are backed by collateral. The $700 billion package is intended in part to buy securities that hold low value in the market but which officials hope will rise in value, allowing the government to make back its investment.

Where is the money coming from?

Three letters: Y-o-u. More precisely, the Federal Reserve and Treasury have assets, and Treasury will sell securities to investors to make up any shortfall. Treasury securities are backed by the full faith and credit of the U.S. government, making them the most secure investment possible. But if investors stop buying Treasury securities, then the United States will have to boost the interest paid on them to lure investors, raising the cost of debt financing to the American taxpayer.

How will this affect the budget deficit?

It depends. In the near run, it will increase the deficit as the government borrows money to meet these new obligations. But the government ultimately plans to sell the troubled assets it is buying from financial institutions; as in any sale, the government could make money. Or it could lose money.

The budget deficit hit a record $438 billion in the fiscal year that ended in September, according to the Congressional Budget Office, up from $162 billion last year. Eight years of war, tax cuts and now a faltering economy have doubled the national debt to $10 trillion. Running deficits in a time of economic distress is generally considered helpful, but over time chronic deficits are harmful.

Will China own everything?

China's economy is still going strong at 9 percent annual growth, and it has significant foreign reserves. China, in fact, holds about $1 trillion in U.S. debt, including about $400 billion in Fannie Mae and Freddie Mac debt. There are signs Chinese investors are diversifying, but at this point they appear unlikely to refuse to keep buying Treasury securities or dump much of what they have now. That's because such actions could reduce the value of the dollar and thus the value of their own U.S. holdings.

What does this mean for my retirement?

Perhaps the scariest statistic in the past week is this: The value of U.S. retirement accounts has declined $2 trillion in 15 months -- about $6,500 for every man, woman and child based on current population. For people nearing retirement or in retirement, their nest eggs have taken a real hit. Some of those gains were illusory in the first place, driven too high by the housing bubble. The increased debt load on the U.S. government will also make it more difficult to finance the Social Security deficits that will emerge as more baby boomers retire in the coming decade. That may require the government to cut benefits or raise the retirement age. Remember: It is important to diversify holdings beyond stocks before reaching retirement age so your portfolio will not be as affected by sudden market swings.

How long can this go on?

The market -- and the economy -- will improve only once investors have confidence in the political and business leadership again. Unfortunately, that may take months or even years. The United States has entered uncharted territory, and there are no easy answers or solutions.