When the United States investment bank Bear Stearns was bailed out from collapse by the Bush government this past March 14, the Financial Times' chief neoliberal commentator Martin Wolf lamented this as "the day that the dream of global free-market capitalism died." The Western world's self-regulating financial system indeed broke down. The cause was what economist Paul Krugman described as "an epic crisis" in the global financial markets. Many others admitted the crisis might be "the most wrenching" since World War II.

Six months on, the US government undertook much larger rescue operations. It seized America's two largest housing mortgage companies, Fannie May and Freddie Mac, committing $100 billion to each. Then, the US's fourth largest investment bank, Lehman Brothers, filed for bankruptcy; and the redoubtable financial management company, Merrill Lynch - with the famous logo, "We are bullish on the future" - was sold at bargain basement prices. With what metaphors beyond dead dreams and nightmares would Wolf describe today's meltdown?

• US financial crisis: Complete coverage

Since the Lehman-Lynch fiasco, Washington Mutual and Wachovia, two of America's top commercial banks, have gone under. Goldman Sachs and Morgan Stanley have given up their investment bank status. The Federal Reserve has sunk a $85 billion loan into insurance giant AIG. Countless other banks and investment firms are failing. Stock markets are plumbing new lows in the US, and now, Western Europe too.

Last week, the US government prepared a $700 billion bailout package for its failing banks. This is the largest in American history, and equivalent to 3.4 times Hong Kong's GDP, about 3 multiples of South Africa's or Thailand's national income, and about 70 per cent of the GDP of two of the world's most populous countries, India and Brazil. The package was rejected by the US House of Representatives 228 to 205. But economists are agreed that it wouldn't have been enough to stem the meltdown.

The crisis hasn't run its course. It's likely to snowball. A recent study by International Monetary Fund economists, who have analysed 124 banking crises over 27 years, says the average fiscal cost of managing a crisis is 13.3 per cent of GDP. The $700 billion only represents 5 per cent of US GDP. That apart, the absence of liquidity in the system has affected other sectors, knocked the bottom out of the realty market and destroyed people's savings. So the bill is likely to be over $1,000 billion!

The meltdown and proposed rescue measures have triggered a three-way debate in the US, which is partly reflected in Congress's anti-bailout vote. On one side are bankers with their obscenely fat salaries and bonuses, who are delighted at the prospect of their junk assets and toxic mortgages being bought at a premium.

On another side is a minuscule minority of market fundamentalists, mainly right-wing economists, who oppose any state intervention; the markets would get everything "right" again. They're supremely unconcerned about the enormous losses that ordinary savers and home-buyers will suffer - for no fault of theirs.

The third side consists of politically conscious working people who are livid that their money should be wasted on making huge donations to corporations - without these being punished for causing the crisis in the first place. Many US Congressmen had to defer to this sentiment.

Filmmaker Michael Moore voices this sentiment eloquently. He describes the bailout as "the biggest robbery in the history of this country... Though no guns are being used, 300 million hostages are being taken... After stealing a half trillion dollars to line the pockets of their war-profiteering backers..., after lining the pockets of their fellow oilmen to the tune of over a hundred billion dollars..., Bush and his cronies... are looting the U.S. Treasury of every dollar they can grab. They are swiping as much of the silverware as they can on their way out..."

Moore cites The New York Times: "Even as policymakers worked on details of a $700 billion bailout�Wall Street began looking for ways to profit from it.

Financial firms were lobbying to have all manner of troubled investments covered, not just those related to mortgages�Nobody wants to be left out of Treasury's proposal to buy up bad assets..." Wall Street firms are salivating at the prospect of consultancy fees to evaluate assets - although nobody knows how much they're worth.

As Nobel Prize winner and former World Bank chief economist Joseph Stiglitz puts it: "(Even) Wall Street's best and brightest do not exactly have a credible record in asset valuation; if they had done better, we wouldn't be where we are... Even if they do use some fancy mathematical model to value different mortgages, those in Wall Street have long made money by gaming against these models. We will then wind up not with the absolutely lousiest mortgages, but with those in which Treasury's models most underpriced risk. Either way, we the taxpayers lose, and Wall Street gains."

The present crisis was precipitated by reckless lending by banks to "sub-prime" (or unsecured and high-risk) borrowers, particularly in real estate markets. It has now become a full-blown market failure related to the incalculable risks of mortgages and other loans which banks concealed in the hope that hiding and distributing the risks would somehow minimise them.

Instead of reducing risks by exercising prudence, bankers - driven by blind faith in the "free market" - developed fantasy-driven models of evaluation based on "mark-to-market" accounting. This is logically absurd and becomes extremely dangerous when markets fail. It makes no sense to rely on market prices if a bank wants to protect itself from a failure of market signals or prices!

Yet, bankers did exactly that. They lent to borrowers that everybody else was lending to. This was celebrated as a shift from "bank finance" to fanciful "market finance". That resulted in further enlarging risks to a point where they became too heavy to bear, and banks became insolvent. Then, in shameless inconsistency with their own professed commitment to markets, bankers pleaded, lobbied and begged for multibillion-dollar bailouts with taxpayers' money.

However, the bankers' main error didn't lie in violating the rules that govern global banking. In fact, these rules are themselves flawed and promote what has been called Casino Capitalism, the title of a book by Susan Strange. The rules are set by the Basle Committee of Bank Supervisors, representing only 11 OECD countries.

The "Basle Consensus" has increasingly disfavoured banking regulation by public authorities and placed "market prices" at the heart of self-regulation. But given business cycles and periodic market failures, solely market-based norms can be a recipe for disaster.

That's what we're witnessing. The severity of the crisis is all the greater because the strict separation made after the Great Depression under the Glass-Steagall Act between commercial banks and securities firms/investment banks stands abolished. Indeed, the meltdown has led tightly amalgamated the two. But the crisis isn't confined to the financial markets. It's hurting the real economy. There's an economic slowdown in the US and European Union, aggravated by food shortages and a sharp rise in primary commodity prices. The question is no longer if there will be a recession, but how severe it will be.

Two conclusions follow. First, even zealous free-market advocates can't deny we're seeing an unprecedented crisis and delegitimation of the Anglo-Saxon neoliberal model, dominated by finance capital, which has ruled the most powerful economies since the 1980s. The meltdown proves the market isn't infallible. This calls for a real fight against neoliberal policies and a search for humane and egalitarian "social economy" alternatives based on prudent state intervention.

Second, the gravity of the present crisis will inevitably provoke a policy debate and state action. Governments have to act. The question is how. Conservative politicians, markets-obsessed regulators, and of course, bankers, will want generous bailouts followed by tinkering at the regulatory margins, but no change in then neoliberal paradigms that dominate thinking on finance. This would only perpetuate Casino Capitalism and the cycle of destruction, restructuring, concentration and destruction.

A radical solution would demand structural changes in the global financial system, including strict public regulation, controls on capital mobility, coordinated monetary policies, and a plan to restructure banking along equitable and accountable lines as part of an economic reconstruction programme.

An excellent example of such a programme is President Franklin Delano Roosevelt's New Deal, launched in 1933 with the Emergency Banking Act, in response to the Great Depression and the worst banking crisis in US history - until now.

FDR went way beyond straightening out the "bad banking situation" caused by "incompetent or dishonest handling ... of people's funds...". Under the New Deal, the government undertook public-works projects, building about 8,000 parks, 40,000 public buildings, 72,000 schools and 80,000 bridges.

The entire cost of these programmes (in today's dollars) was about $500 billion. They produced dramatic results in reducing poverty, putting purchasing power into the people's hands, promoting equity, and energising growth. It's ludicrous to spend twice as much money just to temporarily stabilise the financial system.

Not just the US, the whole world, including South Asia, today need a new New Deal.

• US financial crisis: Complete coverage