Don’t ask me. I don’t have a clue. But Larry Kudlow does:

An extraordinary money-market development has occurred in recent days. The safest liquid credit instrument — the gilt-edged 91-day Treasury bill — has seen its yield plunge.

Here’s the story: Last Wednesday, August 8, T-bills traded at 4.49 percent. On Monday they dropped to 4.74. On Tuesday, 4.63. And yesterday they fell to 4 percent. This morning they dropped another 50 basis points to 3.52 percent. What’s this mean? It means the entire banking system has turned completely risk averse and is fleeing into the safest haven possible.

It is fear. It is hording cash. It is a mountainous tremor that has seized financial markets.

In terms of funding requirements — for big mortgage banks like Countrywide, or perhaps the major money-center banks and various hedge funds — it shows financial dysfunction.

Um…okay. I sorta understand that. What should we do about it?

The Federal Reserve must lower its target rate and pour new cash into the banking system. It should float the federal funds rate and let reserve and money-market forces determine the right rate level as it injects new liquidity into the system. A T-bill rate around 3.5 percent suggests a fed funds target rate of perhaps 3.75 percent, or somewhere thereabouts.

Right now, because of the fear and hording, cash demands inside the banking system are rising faster than cash reserve supplies injected by the Fed. So the central bank should keep adding new money until the fed funds rate stabilizes in the open market. In other words, the key target variable right now should not be the Fed’s interest-rate target, but the large amount of new cash it is injecting into these markets.

Put simply, Ben Bernanke & Co. should let the money market set the new target rate. Their job is to create enough new cash to stabilize and accommodate the fear-based rush of liquidity demands.

I’m no Milton Friedman, but won’t that goose inflation?

So far, the economy looks fine. This is good. But the Fed must be the lender of last resort for the banking system. For my inflation-worrying friends out there, I say we can deal with that issue if it remerges sometime in the future. After financial stabilization, the new cash can be withdrawn and the fed funds target can be readjusted.

All I’m saying is first things first. That means stabilizing the banking system and accommodating the huge cash demands that have arisen. Right now, the system is virtually frozen.

Whenever the stock market plunges as it has in recent days, Americans get very nervous. Especially these days when more than half of us either invest directly in individual stocks or have shares in mutual funds. Our pensions are heavily invested in the market as well.

And most of us are like me; almost completely ignorant about the forces at work that make stocks rise or fall. This crisis, as I’m sure you’ve heard, is all about the sub-prime mortgage outfits who took advantage of the market when housing was booming by offering loans to marginal (“sub prime”) credit risks. Most of those people will work out fine, paying on time and staying current. But a large enough percentage of those mortgages will be a lost cause, thus precipitating a credit crunch as sub prime lender after lender goes belly up.

With the credit crunch, cash dries up. Even I know that much. Now Kudlow wants the Fed to intervene by dumping massive amounts of dollars in the banking system hoping it will reduce the panic and get everyone’s feet under them.

Whatever Chairman of the Fed Ben Bernanke does, I sure hope he acts quickly and that whatever his prescription is, works.