This is a fundamental misunderstanding of economics that politicians tend to have. You can't spend money and change history, all you can do is let the errors f the past be worked out via natural processes, like bankruptcy. If we had liquidated all those fraudulent securities we would have a stronger economy than we do by damaging the rest of the economy in order to perpetuate the fiction that those securities were not fraudulent.
The money used to support these bog use housing securities was taken out of the economy, and that act damaged it more than letting banks fail.
It, notably, also did not free up the credit markets which remain seized. In this case the market was not tricked by a political action that did not address the fundamental issues.
I agree 100% that deleveraging is what's required, the liquidation of all these bad investments (and for that matter that's what the Austrians recommend).
Here I'm talking about timing and secondary effects. There's a big difference between this effectively happening all at once as banks and other institutions refuse to do business with each other due to the fear of counterparty risk vs. working through this inevitably very painful process over a period of years (traditionally I gather it tends to be about a decade, which is way too slow and painful, but better than the first option).
When you allow the first to happen a bunch of viable companies go out of business quickly because they can't do their day to day financial work. E.g. one of the FDICs actions has been to guarantee non-interest bearing business accounts so that e.g. you can be sure your payroll will happen (even if the bank collapses and a bit of a delay is incurred at worst case).
My point, which may have gotten away as well, is that there will always be a rationalization for the claim that "if we don't act now, the whole system will seize up and it will be a catastrophe!"
I believe this is a perspective that is popular among politicians because it gives them a chance to take Bold Swift Action in the Face of Danger.
But it fails to understand what markets are. Markets, if allowed to operate, will reprice correctly, and pretty quickly, things that are mis-priced.
Thus we can have a huge change in the market price of some particular asset due to new information--- and here's the point-- but we then have a new price.
Politicians think that achieving this new price, eg, the price drop, is the calamity. But it is actually the aversion of the calamity because it brings clarity to all the players and they can start dealing with the new price.
The alternative, to "prevent the crisis" involves regulation which inherently makes prices more opaque and makes it harder for the operators to know what things are really worth.
I am not presuming perfectly efficient markets, they can over react, but it is the ability for prices to move freely based on new information that is the mechanism by which things get worked out.
Seizing control over the market inevitably does more damage, because it prevents transparency about real prices.
It also creates moral hazard because it incentivizes bad activity-- you just have to be "too big to fail" and then your actions have no consequences, or perceived consequences.
The mental image I think people have is that the economy is an engine and it can sieze up if there's not enough liduidity like oil, in it.
But that's not really right. If allowed, it will react fairly quickly and seek the least painful solution to the problem by letting actors price based on how efficiently they can solve the problem.
It is important for institutions that act poorly to fail, so that the following institutions can learn from their mistakes, or institute controls to reign in their excesses.
It is all the external solutions, like TARP and Stimulus, that are the sand in the oil, so to speak.
I've broadened my response, more to make my core point, and realize you may not be disagreeing with me.
BTW, the FDIC increases bank failures by having a government monopoly on deposit insurance. The rates are not priced actuarially and thus bad banks are not incentivized to be good banks less likely to fail. This is an example of the moral hazard. (not to mention the inherent risk of fractional reserve banking in the first place.)
I agree that discovering the new price is not a calamity, my argument is narrowly limited to keeping the financial system going so that process can happen in a orderly fashion. The Great Depression in the US was immeasurably worse due to all the bank failures triggered by this sort of thing (and I've read this seems to be a mostly US phenomena due to regulations which kept banks small and limited to one state (heck, when I arrived in Massachusetts in 1979 a bank couldn't cross county lines; my bank (BayBank) had a holding company on top of their individual county banks)).
The vast, near total majority of "bailouts", like the multiple efforts to prop up residential real estate prices in the US or Cash for Clunkers (which at best moved purchases forward in time and in the latter case amply demonstrate the Broken Window thesis) are not called for.
An edge case of possibly justified intervention might be keeping GM and Chrysler alive so that the failure of the suppliers wouldn't put Ford out of business; that would be another example of a cascading failure, but a hopefully limited one and obviously spending less money by only keeping Ford's supply line intact would have been a lot better.
ADDED: Here's Andy Kessler in the WSJ on "TARP and the Continuing Problem of Toxic Assets", due to the bait and switch (I supported the bait...): http://www.google.com/search?q=%22but+no+one+could+decide+wh...
(And, yeah, I've grown rather fond of "misapprehension"; it's great for situations where someone has gotten part of the point but the rest is succeeding for the moment in getting away.)