Looking at this announcement the wrong way is a mistake, because this is the first smart thing to come out of the Obama administration.  Now Obama may be throwing a hissy-fit, but I really don't care about his motivations.  To date, he's been a huge enabler of Too Big to Fail, moral hazard, and the taxpayer bailouts that ensue.  This would be a big step towards fixing these and other economic issues that have resulted in the FIRE (Financial, Insurance, Real Estate) bubble economy of the past 15 years.

As for the stock market, its current valuations are insane -- just as bad as at the 2007 peak.  This is partly due to the market assuming an endless flow of taxpayer money into any corporation able to buy off a handful of politicians.  The stock market being down on sensible economic reform is a given, as reform means forcing corporations to eat their own mistakes rather than go to Uncle Sugar for a handout on the taxpayer dime.

Don't forget, when Reagan brought in Volcker at the Fed to clean up in the early 80s, we went through a painful two year recession getting things un-fucked before starting in on huge growth.  The current underlying economic situation is far worse than the late 70s, due to a much higher national (government plus private) debt to GDP ratio (there are other issues, but that's the big one).

Of course, the biggest part of the mess is the government itself.  If the GOP is smart, it will take Obama's proposals and say, "Great idea, now if we could have Geithner's and Summer's resignations, Bernacke denied confirmation, and Barney Frank taken out back and shot, we might have a good start!"  Obama, with his love of government, is bound to fuck up proper financial reform, but the GOP needs to do more than just root on Wall Street.

Oh, and this kind of thing is the exact reason why I stopped reading Ace for the most part.  The amount of economic ignorance and rank partisanship over there is pathetic.  I did appreciate his recent mea-culpa on being in the bag for the GOP since mid-2008, however.  Not surprisingly, that's exactly when I stopped reading/commenting there.

Would we be worse of if those banks that were "too big to fail" had failed?

In short, we'd be better off if we had let them go down, and I said as much at the time.  As things stand, all the major banks (with the possible exception of Goldman Sachs) are still technically bankrupt, and are surviving on the largess of the taxpayer and Fed expansion of the base money supply (which eventually come down to the same thing, just through a different mechanism).

The US simply has far too much debt to GDP, and as a nation (government, corporate, and household combined) are unable to service that debt.  Instead of taking an ever-increasing amount of private debt onto the Government's balance sheet (which is what has been happening), those who took too much risk should have been made to eat their own losses.  Instead, we've seen a huge transfer of wealth from the taxpayer to the financial industry and other politically connected groups (such as the auto makers).

Not that we're alone in this mess.  England and Japan are clearly worse off than us, while the Eurozone is a mixed bag (France is amazingly one of the financially healthier nations at the moment, while Greece could face a sovereign default at any time).  However, unless we get our financial and economic house in order, we could easily go the way of Japan, and 20 years from the peak be even more in debt with an economy in the trash, and nothing to show for our 'efforts'.

I have no issue whatsoever with the Friedman-based quote above.  It addresses how to deal with a financial panic, when the balance sheets of institutions are sound and the problem is lack of liquidity.  Unfortunately, unlike in 1987, when Greenspan applied the same principle appropriately, the bank's balance sheets are an utter disaster.

Also, Bernacke's Fed has been doing far far more than repo and Govt.-debt-based monetization operations.  He's been (illegally, according to a strict reading of the Fed charter) outright purchasing paper other than US Government Securities, such as MBS paper.  Bernacke claims to be a student of the Great Depression and Friedman, but he's either the worst student ever or an outright crook using that as cover for his actions (I believe the latter).

I'm quite certain that Friedman never intended his theories to become a huge moral-hazard bailout excuse that would effectively crush the taxpayer.  Also, I seriously doubt he would have approved of a long-term zero-interest rate policy, which screws savers at the expense of the failed risk-takers.

What should have been done?  Appropriate liquidity operations to maintain the health of depositors, while forcing all the failed institutions into bankruptcy (over time, as there are simply too many to deal with at once), and leaving the risk where it belonged -- with the shareholders, bondholders, and management of the failed institutions.