The probability of a policy error in an emergency is high and once again the $700 billion bail-out plan is likely to leave behind a legacy of poor judgment and government folly much like the "New Deal" did. Clearly, the distrust that people had of financial institutions and the possibility of running out of cash was keeping banks away from lending. Surely, this cannot be solved by either monetary expansion or measures such as cash infusion by the Government. A much more direct way is suggested by the Levy Economics Institute of Bard College. In one of their papers, they recommend that the Fed could be temporarily turned into a clearinghouse and use its financial clout to support it. Banks then deal with a counterparty which is credible.
The commercial paper market froze after the demise of Lehman Brothers which had in the past acted as the market-maker in short-term borrowing and lending. In addition, the inter-bank lending market froze because it raised the specter of other banks being allowed to fail. Before letting Lehman go, the Fed could have announced that it will be a make-shift clearinghouse for ensuring the flow of commercial paper. The cisis had been underway for a year so the Fed had enough time to prepare for it. If it had, the $700 billion bail-out plan would not have been necessary.
Several possibilities are conceivable to directly address the confidence issues. Some people such as Warren Buffett continue to enjoy the confidence of the public. It should be possible to set-up a non-profit organization, headed by Warren Buffett, which administers funds from the public and other non-profits to extend loans to banks and businesses during the course of the emergency. One simple way could be to have individual banks park their funds with the non-profit and borrowing banks could be in touch with the non-profit. The Government could have simply provided a temporary gaurantee to support the non-profit.
The $700 rescue plan may well recover the costs incurred to buy bad debts when the markets recover. They do have housing assets backing them. The one thing that the taxpayer is not going to be able to recover are all the goodies, amounting to another $150 billion, that were attached to the bill or simply put the spoils of office. The alternatives would have saved these extra costs and the attendant corruption.