We are all on the roulette wheel now. As names such as Halifax, Merrill Lynch and Lehman spin into oblivion, and the City shrinks, British job prospects and pension values are stakes in a game that is moving at internet speed.

Investors who gambled so exuberantly on the way up in the good times are now gambling just as recklessly on the way down, seized by an equally irrational doom-loop.

This is not just short-selling by “spivs”. There are two much bigger problems. The first is paralysis in the credit markets, which threatens every business. The second is that longer-term investors who had even last week been prepared to bet on recovery in the financial sector are now dumping their holdings in panic. Thus we end the week with Goldman Sachs and Morgan Stanley, the last two investment banks left standing on Wall Street, each seeking a buyer, despite having just posted billion-dollar profits.

When fear trumps fact on this scale, only government and central banks can quell the hysteria. Until last week, the US authorities had played an astute hand. The Treasury orchestrated the takeover of some companies, such as Bear Stearns, and the Federal Reserve advanced credit to keep banks solvent, making it clear to the world that it would stand behind any institution whose failure could topple too many dominoes.

Unfortunately, America's bailout of its mortgage giants Fannie Mae and Freddie Mac had the perverse effect of spooking precisely the long-term “value” investors that the system desperately needs. Sovereign wealth funds are wary. Pzena, a big investment management company, was heavily vested in Fannie, Freddie and - oops - Lehman Brothers. So its bet on red for recovery is now worth a big fat zero, while a black for apocalypse would have raked in the chips. Ironically the principled desire to let the market have its way with shareholders has made it more likely that the US will eventually have to create a version of the Resolution Trust Corporation, the giant pawn shop that operated from 1989 to 1995 to buy the toxic assets of the 800 banks that failed in the US Savings & Loan crisis.

The horrifying costs of creating such an entity are beginning to look affordable compared with the risk of a prolonged recession. The Fed slowed the roulette wheel yesterday by co-ordinating the injection of £100billion into the credit markets by the world's central banks. Stock markets rallied. But we are in a firestorm where the flames keep spreading. Reactive policy - bailing out Fannie Mae or getting JP Morgan to buy Bear Stearns - has not provided a sufficient firebreak.

Consolidation of banks is a good thing. A correction is long overdue. And fear of failure is an efficient regulator. But the speed of “deleveraging” poses real risks to the economy. The average securities firm was leveraged 27 to 1 - that is, had borrowed 27 times its capital - in 2007. That unbelievable recklessness is unwinding too fast. This is paralysing the credit markets, which means that businesses cannot grow and jobs cannot be created.

The UK economy is particularly vulnerable. First, our banks were more over-borrowed at the height of the boom than in any other country, holding about £600 billion more in loans than deposits - because British capital adequacy requirements were even weaker than America's. Secondly, our economy is more dependent on financial services than any other. Thirdly, we have built up more personal debt than any other of the G7 nations.

Fourthly, our Government's woefully wasteful spending spree in the good times has left the fiscal coffers empty. The Institute for Fiscal Studies predicts that borrowing will be at least £65billion higher in 2010 than the Chancellor predicted in March. As the City shrinks, tax receipts will plummet. The Government urgently needs to rethink its figures and spending.

Yesterday, Comrade Gordon announced that he had long wanted unspecified “reforms” to “clean up” after greedy bankers. This struck me as a bit rich. Who was Chancellor for ten years? Who decided to hive off banking supervision from the Bank of England and put it in the hands of people who feel asleep at the wheel? Who has left us with a rigid economy much more vulnerable to inflation than America's, because it is riddled with debt, public sector inefficiencies and employment law regulation?

The Government did the right thing this week in facilitating the takeover of HBOS by Lloyds TSB. It ripped up the rule book on competition law to make the deal happen. This is the time to be ripping up rule books, not writing new ones that could weigh down British business for a decade out of a desire to score a few populist points. Any new regulation that is written now, in the fog of war, risks fighting the previous battle.

What is striking is that the Treasury and the Bank of England are still at odds with each other. If Alistair Darling is right that this is the worst financial crisis for 60 years - and it now looks as though he may be - then Mervyn King is wrong to remain so grudging about advancing liquidity. There is simply no place for academic concerns about moral hazard during a crisis of this scale. Yet until yesterday, the Bank of England was still planning to close its credit lifeline for banks on October 21, fanning the flames of uncertainty just when it should be doing the opposite.

On financial matters, the Government must be pragmatic, not populist. On the economy, it cannot tax and spend as usual. The shrinking of the City will expose the lack of productivity in other parts of the economy, and the unsustainable burden of a giant public sector and its pensions. Much of this was foreseen. But like the bankers, the last Chancellor was enjoying the ride on the way up too much to look down. It is too late to score points: what is needed is calm pragmatism.

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