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."

"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.

"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. "But it's not the whole story. When investors don't get their money either from the home owners or the 'insurers' (the folks who issued those mysterious credit default swaps), then they can not 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."

"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 revenues from sales and income taxes fall. 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 revenues.

"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."

Opinions expressed solely are those of the writer. Morton Marcus is an economist, author and speaker formerly at the Kelley School of Business, Indiana University. He can be reached at mortonjmarcus@yahoo.com.