Right now sellers of credit won't sell to purchasers at the current price (interest rate). Were this any other market, economists would immediately say that, given the current supply and demand, the price is too low and prices (interest rates) should be allowed to go up. That was the recommendation for Soviet Russia grocery stores with their infamous lines. Increased prices reduce demand, increase supply and bring the market back into balance.
For over 70 years, however, the action of governments to credit crunches has been to increase the supply of credit by liquidity interventions. This was due to the fear of exacerbating the economic slowdown that inevitably accompanies a credit crunch. It has been so universal, and practiced so long (there is scarcely an economist alive who can remember any other way), that "increase liquidity" is a reflex response of all economists to a credit crunch. Economists have essentially forgotten that when supply is short and demand is set there are two possible actions; raise the price or increase the supply, and that normally economists recommend raising the price over increasing the supply directly.
Central banks, and the governments that back them, are mighty entities with great capacities. But like all human institutions, they have their limits. We have all become so used to the idea that governments can fill the credit supply shortfall created by low interest rates that we have forgotten they have limits and cannot supply infinite credit.
The current credit crunch has been caused by a truly massive worldwide destruction of financial capital. I have often read claims that the US housing bust, identified as the cause, isn't big enough to justify this. But there is much more than just a bust in US housing. There have also been massive real estate bubbles in many European economies, including England, Ireland, Spain, Poland, the Baltic states, and an old bubble in the Netherlands kept propped up for years. There is a major property bubble in China. There is a LBO bubble in most of the Western world, as well as extensive retail and hoteling bubbles. There is a large auto bubble in the US and large credit bubbles in the US and many other countries. Many have not yet gone bust, but the wise know at least most of them will, with vast additional losses.
I believe the losses simply exceed the ability of the current government to generate and reallocate capital. If so, no possible liquidity intervention will be able to hold credit prices to their current very low level (many real interest rates in the US are actually negative). Therefore, while governments should continue the current aggressive provision of liquidity, they should now raise interest rates until markets can once again clear given that additional (effectively subsidized) liquidity.
I say this is a return to the Old World Order because when currencies were meaningfully backed by gold and silver, governments were stringently limited in their ability to lower rates and create capital by the threat of specie flight. In those days, when a panic hit, interest rates had to go up. That Old World Order is now back; even with the considerable latitude provided by fiat currencies governments have hit their limits. Our credit is less than we might wish; we must choose which of our many competing targets will get it; and the most efficient way is by market allocation, which requires increased interest rates.
We can tolerate high real interest rates. Ask Paul Volcker. But we cannot tolerate failing credit markets. Our policymakers must accept their limits, encourge efficient allocation of limited capital, and restore public confidence by showing they understand this the realities of the credit markets.
(Hat tips to many people I've been discussing credit with, especially to evilhenrypaulson and AngrySaver. Anybody else who thinks they deserve a hat tip or link - tag me.)