Credit — lending between market players — is to the financial markets what motor oil is to car engines. The ability to raise cash on short notice, which is what people mean when they talk about “liquidity,” is an essential lubricant for the markets, and for the economy as a whole.
But liquidity has been drying up. Some credit markets have effectively closed up shop. Interest rates in other markets — like the London market, in which banks lend to each other — have risen even as interest rates on U.S. government debt, which is still considered safe, have plunged.
Many innocent players are going to get caught up in this. Banks which made stupid loans will panic and refuse to make good ones, or won't be in a position to. During the in the aftermath of the junk bond collapse in 1991 a business associate of mine had his line of credit cancelled. My friend was a VAR selling almost entirely to the federal government. His receivables were in the form of federal purchase orders, as safe as you can get short of currency. He could not bid on business without the ability to buy inventory on credit, so he had to turn away millions of dollars in business. There were many situations like this in 1991 and there will be even more in 2008.
What is truly sickening about this is that so many saw it coming and tried to raise the alarm. It does not speak well of our national discourse and political culture that we allowed it to happen.