Throwing Lehman to the wolves will not clear US financial mess

London: We will find out soon enough whether the decision to throw Lehman Brothers to the wolves was a wise one.

Princeton economist Paul Krugman has accused the US Treasury and the Federal Reserve of playing "Russian roulette" with the financial system, warning that the shadow banking system could disintegrate within days.

The hunting packs switched instantly to AIG on Monday, driving down its shares by 70 per cent in early trading. The world's biggest insurer is suddenly on the brink of collapse as well. The killer virus is striking deep into a whole new sector of the financial system.

"This is a potentially very dangerous situation," said Professor Tim Congdon from the London School of Economics.

"Banking system capital is being wiped out. The risk is that this could lead to a contraction of credit and set off a self-reinforcing downward spiral, leading to the sort of debt-deflation we saw in the 1930s.

"It is already clear that money growth has ground to a halt over the past three months. We must prevent it from actually contracting. If the Fed and European Central Bank don't cut interest rates soon, it is going to be a problem," he said.

Nobody was ready for a derivatives shock during the Bear Stearns bailout. This time, hopefully, they are. The Bear Stearns bail-out gave the banks an extra six months to clean up their positions and lower exposure.

With the tail risk of a derivatives Chernobyl out of the way, the Fed and the Treasury at last feel safe enough to strike a blow against moral hazard. The line has to be drawn somewhere.

Unlike Fannie Mae and Freddie Mac, broker dealers are not crucial pillars of the US housing market. Lehman is an optimal candidate for ritual sacrifice. While the appearances of free market discipline have been upheld, the reality of the weekend events is a further lurch towards socialism, or state capitalism.