AP

BARRY RITHOLTZ, a prominent financial pundit, writes with tongue not entirely in cheek that the first lesson from the government's bail-out of Bear Stearns in March was to “Go Big”. “Don't just risk your company, risk the entire world of finance. Modest incompetence is insufficient—if you merely destroy your own company, you won't get rescued. You have to threaten to bring down the entire global financial system.”

On Tuesday September 16th, a day after America's Treasury boldly let Lehman Brothers go bust, again the “Go Big” theory is being tested. This time, the focus is on American International Group (AIG), one of the world's biggest insurers. As well as writing general-insurance policies all over the world, the firm has plunged disastrously into the market for derivatives linked to housing and credit. Its exposure to the murky credit-default swaps market alone is a notional $441 billion, enormous by anyone's standards. Do such exposures make it too big to fail, especially given the possible risk, however small, to ordinary folk around the world who insure with AIG?

Hopes that this question would be met with a tentative “yes” helped New York stocks erase some of their earlier losses on Tuesday—though AIG's shares were still down sharply. There were reported rumours that Treasury support for AIG would be forthcoming. But the Federal Reserve, whose policymakers were meeting on Tuesday, resisted pressure to give a boost to markets and chose not to cut rates.

These rumours were not confirmed, but it has already become painfully clear how hard it is for America's financial authorities to steer a straight course through a crisis that is piling one systemic threat onto another. On Monday, Hank Paulson, America's treasury secretary, was hailed for bringing back moral hazard, or the risk of failure, to the banking system by letting Lehman fall into Chapter 11. Faced with the collapse of the much bigger and more entangled AIG, can he afford to defend that line in the sand?

Even those battling to find a solution for AIG admit that time is running out. On Monday the Fed asked two banks, Goldman Sachs and JPMorgan Chase, to find up to $120 billion in new funds for AIG. The firm also won a concession from New York state, which supervises it, to raise $20 billion by borrowing against the insurance assets of its subsidiaries. On Tuesday markets around the world tumbled after two ratings agencies, Moody's and Standards & Poor's, cut AIG's credit rating. That decision forced the insurer to seek at least $13 billion in extra collateral to back its credit derivatives.

But cash is not easy to come by for big institutions with concerns about their solvency, as Lehman's collapse showed. As of Tuesday, there appeared to be no private-sector solution for AIG, and the matter was in the hands of the government.

Meanwhile, fears that a collapse of AIG could paralyse the financial system were reflected in the interbank market, where banks tap each other for cash. Dollar rates of the London Interbank-Offered Rate, known as LIBOR, doubled overnight. Central banks, including the Fed, pumped in liquidity.

Not all the news was bad. Goldman reported a 70% slump in third-quarter profits, which may have looked ghastly, but it beat analysts' estimates. There had been fears that it and Morgan Stanley, the other Wall Street bank left standing, were at risk from a possible collapse of AIG. But a Goldman spokesman said its exposure was “not material”, according to reports. Washington Mutual, America's largest savings-and-loan bank, helped its share price by declaring it would be able to withstand the latest cut in its credit rating.

Meanwhile, August saw the first drop in America's consumer-price index in almost two years. The 0.1% fall was helped by the decline in fuel prices, and the oil market remained in retreat on Tuesday, with prices hovering above $91 a barrel. The dollar remained firm.

But in this crisis, the only things that have given Wall Street real fillips have been the chances of government intervention, and easier monetary policy. Now almost all the markets' hopes are pinned on the authorities. If AIG goes, it is hard to think what else would be considered as too big to fail.