Krugman quotes a prescient blog post about our current financial situation where he talks about foreclosures and people walking away from mortgages on houses that have declined in value:

Hal Varian (Berkeley prof and now chief economist at Google) puts it simply, and in somewhat exaggerated form, by saying that everyone will just default on their existing mortgage and move one house to the left, buying a new house for less than they save by walking away from the mortgage they have. Things don’t work that smoothly, but that gets the principle right.

And what that means is that a substantial portion of the decline in housing values that’s now in progress will eventually show up as losses, not to homeowners, but to investors. We’re talking about some significant fraction of, say, $6 trillion (a 30% decline in home values from their peak). A trillion dollars in investor losses sounds quite reasonable to me.

Wonks Anonymous calls the reader's attention to previous posts on the sudden increases in the demand for currency, also illustrated by Professor Krugman here.

Catastrophic losses in asset values have created a large demand for secure assets by both consumers and banks. The interest rate is effectively zero so the security of holding cash costs nothing. People want cash, banks want cash. People keep their savings in secured bank deposits. Banks suck service fees off this pool of money. Almost no loans are made.

And it gets worse. If we expect prices to fall by 2% over the next year then our money has earned 2% no risk taken.

Meanwhile dropping prices will further lower the value of homes and other real estate and this will increase the magnitude of the losses that investors are trying to make good.

Government debt in this situation is not crowding out loans to investors. It is crowding out hoards of cash in investor portfolios.