The economic downturn
First, there was a fundamental malalignment between regulators and industry; rating agencies and the industry; and global capital. There has been a huge increase in the amount of world investment capital in the last 10 years. People needed places to put that money, and a lot of it was soaked up by the US real estate market - because it had historically only gone up in price, and was a safe bet. The market absorbed money both directly, in speculation, but also with mortgage bundles - collateralized debt obligations. The demand for CDOs was such that creation was streamlined and those pushing new mortgages weren't talking to those bundling them, who in turn weren't talking to investment banks, who in turn weren't talking to investors. The amount of risk was just lost in a big telephone game. Rating agencies didn't look very carefully at them either, since they were getting paid by the people trying to sell them, and they called practically anything with bond insurance AAA.
A lot of loans were made to non credit worthy people, but banks weren't afraid of defaults. According to their models, housing prices have always gone up (har), and the bank could just repo the house & sell at a higher price. Even now though, banks don't take a 100k loss when someone walks away from a 100k loan. Banks get the house. Banks are holding a lot of those now, which is limiting the assets they have to lend - since houses are very illiquid. That's the liquidity problem - assets which have value, but can't be sold quickly in the market for cash.
At the same time, banks invented credit default swaps, which on paper are a good idea. They're basically insurance on bonds. You pay ahead of time so that if a firm doesn't pay out on a bond, the bank swaps their assets with your worthless one. But then they were divorced of the bonds and they became insurance against another firm's default. The CDS market wasn't transparent or regulated, and banks backing these things couldn't accurately evaluate their risk. When Lehman went, there was a great fear that these credit default swaps would swamp everyone, and they might have.
So then housing prices leveled off, interest rates rose slightly, and a few other things led to an economic slowdown. Many of these CDOs started going belly up, and taking their investment banks with them. Lending dried up because investors freaked out about the disappearance of their assets. Money flowed into US treasury bonds because investors wanted safety. This buoyed the US dollar and gave the government all kinds of money to spend trying to save these banks. Ok so that's basically where we are.
For the last 30 years, we've used monetary policy to cushion busts and control booms - and fairly successfully. But it broke this time. The fed dropped interest rates below the rate of inflation, essentially to zero. The fed was handing out free money, they couldn't do any more. This is the end of our current economic model. The risk is deflation, and it is really scary. Japan lost a decade of economic growth to deflation, and there isn't really anything the federal government can do to get out of it.
Since our current economic model has no answers for us, Obama has fallen back to Keynesian economics. The only other good model we have - the classical model - says do nothing, and politicians are afraid of doing nothing. When we did nothing and let Lehman Brothers fail, it caused huge losses and problems. The classical model would say this is normal, and the pain is necessary. But since no one wants to put up with a radically decreased standard of living for a few years, it looks like we're going to give Keynes' theory its first real test. Economists basically figured out how much people would be spending if it was a normal year, subtracted how much we're actually spending, and came up with ~$800 billion dollars over 3 years. That's the simulus package.
As you know, Keynes' idea was this. Rather than to look at depressions as natural fluctuations which purged weak firms, bad debt, and reallocated people to more efficient employment (as classical economists had thought), Keynes thought of depressions has harmful negative downward cycles brought on by under consumption and oversavings. His theory was that if the government spent money when individuals weren't, the government spending, if it was an investment, would replace private spending and "kickstart" the economy.
We never really gave the theory a clean chance in the great depression, FDR did a lot of anti-keynsian things like try to balance the budget, and such. Keynes actually didn't like FDR very much, and died before FDR started spending real deficit money - but that was long into the depression, so the classical economists could just explain the upstart as the normal cycle out of the depression. For a while politicians thought of Keynes' theory as a license to spend all they liked - Keynes still believed government spending would crowd out private spending (which he recognized is better than government spending), so he would've been very against running up deficits in good years.
As you know, Keynsian econoics was the dominant theory until the 60s and 70s when some alternates came out - supply side (which was debunked during Reagan, and doubly so under Bush Jr), and the current top theory - the money policy theory. The current theory is that by regulating interest rates through money supply, the Fed can soften recessions if they've built up a cushion during the boom time. Raise interest rates during expansion, and lower them during recessions. Again, we've hit rock bottom there.
Keynes theory does seem logical if you consider depressions as "crises of confidence" where uncertainty causes people to spend less, which causes businesses to be less profitable, which causes layoffs, which causes more uncertainty, & it loops until jerked out by something else. Like a whirlpool. Keynesian economics makes no sense if you look at depressions as "bubbles" bursting, where bad debt, bad assets, weak firms, and unproductive employement is eliminated - and it takes a few years to clean out all the junk so the economy can be more healthy in the future. Like a deep spring cleaning.
Both stories are fairly compelling, I'm not sure which is right. I suspect it is some of both, but less like a whirlpool than most politicians are willing to admit because the cleaning entails enduring real human suffering. I think a lot of efforts to prop up home prices are misguided, housing prices were too high and propping them up will either cause inflation (and wipe out savings, and encourage reckless debt). Ditto with the efforts to prop up the reckless banks, when they go under, they'll be replaced by smaller more conservative banks. But at the same time, if we can spend a bit more now to avoid some of the real impact on actual people, even if that stunts growth later, it may be worth it.
As for how the money will be spent, I haven't looked at it directly, so I don't know. The right-wing sites are screaming about birth control for 3rd world countries (which is more about disease control - not birth control), and the left-wing sites are screaming about the 8-years of useless Bush spending the GOP was fine with but is now holding up over what amounts to a "mote". I doubt disease control in 3rd world countries is a signficant part, and I'm sure the holdouts have some legitimate concerns. Now that it has been finalized I'll probably take a look and decide.