One popular activity on Wall Street at the moment is to question whether the current squeeze on credit markets will be long and shallow or short and deep. But looking at the financial system alone will give the wrong answer. It is the links and feedback loops with the real economy that will decide whether this is financial hell or just a financial hiccup.

Since the end of January there has been another round of broad-based turmoil in the credit markets. Subprime mortgage-backed bonds have fallen to new lows, but that is the least of it. Corporate credit spreads, municipal bonds and even bonds wrapped by the Freddie Mac and Fannie Mae agencies have lurched downwards. In contrast to last year, it is clear that this is not primarily a problem of bank liquidity. It is a widespread problem of solvency at leveraged institutions.