Since the onset of the liquidity and credit crunch last summer this column has been arguing that monetary policy would be impotent to address such a crunch because, in part, of the existence of a non-bank “shadow financial system”. This system is composed of conduits, SIVs, investment banks/broker dealers, money market funds, hedge funds and other non bank financial institutions. (…)

(…) This is the worst US financial crisis since the Great Depression and the Fed is treating it as if it was only a liquidity crisis. But this is not just a liquidity crisis; it is rather a credit and insolvency crisis. And it is not the job of the Fed to bail out insolvent non bank financial institutions. If a bail out should occur this is a fiscal policy action that should be decided by Congress after the relevant equity holders have been wiped out and senior management fired without golden parachutes and huge severance packages.

RGE - A Generalized Run on the Shadow Financial System

This banking crisis of the 1930s showed that unregulated, unsupervised financial markets can all too easily suffer catastrophic failure.

As the decades passed, however, that lesson was forgotten — and now we’re relearning it, the hard way.

Paul Krugman