It is not that the world economy faces a liquidity squeeze. Far from it: two-year United States Treasury notes with a face value of $1,000 will get you $998 in cash – the lowest liquidity price since the Great Depression and Japan in the 1990’s.
Yet the risk premia on non-Treasury assets have soared to barely believable heights: the annual interest-rate premium for holding a CD issued by a private bank now stands at five percentage points. And it is this rise in risk premia that threatens to send the global economy into a deep recession, and turn the financial markets from a spectacle of schadenfreude into a malign source of unemployment and idle factories worldwide.
We already know that there was enough available liquidity to inflate a housing bubble. So something went wrong in these markets that allowed the bubble to emerge and then pop, and this is causing us immense problems right now, but what was it?
I think the most important factors are agency problems, the mis-pricing of risk, and the failure of securitization to distribute risks across the financial system.