What’s going on with the economy?

Paul Krugman runs through some basic scenarios.  Remember when Philip Cagan asked why open market operations are performed in terms of money and T-Bills rather than other assets?

The final whammy may be this: the socialist calculation debate (remember that?) is now working against rather than for recovery.  Market prices communicate vital information but that assumes a critical mass of market participants is actually trading.  When trading dries up, prices go away.  When prices go away, the costs of trading rise and fewer people wish to trade.

Felix Salmon notes:

My feeling is that the credit markets are hysterical. They’re
not clearing, they’re not acting efficiently, and spreads, especially
on highly-rated debt, are much higher than credit risk alone could ever
account for.

Trading in junk bonds hasn’t been "right" since the fall.  Many of the markets for short-term debt securities are becoming illiquid as well.  Why markets are self-destructing in this way remains a puzzle; dump on markets all you want but why here and now?

Loyal MR readers will know that I am usually an economic optimist but at the moment I am worried.  I don’t see the so-called "real side" of the economy as intolerable by any means.  But a weird financial dynamic seems to be feeding on itself in an unusually violent fashion.  Steve Waldman has an insightful albeit overstated argument; consider this:

The distinction between debt and equity is much murkier than many
people like to believe. Arguably, debt whose timely repayment cannot be
enforced should be viewed as equity. (Financial statement analysts
perform this sort of reclassification all the time in order to try to
tease the true condition of firms out of accounting statements.) If you
think, as I do, that the Fed would not force repayment as long as doing
so would create hardship for important borrowers, then perhaps these
"term loans" are best viewed not as debt, but as very cheap preferred
equity.

Is/was the subprime crisis simply a mask for a more general revaluation of the meaning and extent of liquidity?  Are such revaluations always so bumpy and so lacking in locally stable iterative processes?  As the Chinese would say, we live in interesting times.