Cash expenditure targeting does not prevent the stockholders of banks that made bad loans from taking losses. If the losses are severe enough, it doesn't protect bank creditors, including uninsured depositors, from loss either. While insured depositors are protected, the deposit insurer may also take losses. And that means that taxpayers are subject to loss one way or another. (I oppose the existence of deposit insurance, though I do not favor getting rid of it "cold turkey" ever, and certainly not when many, if not all, banks are in danger of insolvency. )
If the banking system is full of bad loans because banks have lent heavily into a speculative bubble, and that bubble had implications for the allocation of resources, then cash expenditure targeting doesn't avoid the need to reallocate resources. For example, if single family houses were overbuilt, then fewer single family houses should be produced, and instead, other goods and services should be produced. The result will almost certainly be structural unemployment for an extended period of time. Carpenters are laid off and must become waiters--or something. Similarly, capital goods specific to housing, like saw mills, will lose value. Equity investors in housing related industries must certainly take losses. If the losses are severe enough, firms may fail, and those holding debt may take losses too.
The shift in the composition of demand, away from overbuilt housing to whatever it is people really want, has reduced the productive capacity of the economy. The relevant productive capacity is a capacity to produce what people actually want to buy. Real output and employment will grow more slowly, and if the shift was severe enough, it may fall. With cash expenditure targeting, the result of this will be higher inflation for a time, an increase in the price level, slower growth in real incomes, and perhaps even lower real incomes. Nominal incomes, on the other hand, will continue to grow.
While there are surpluses of those particular goods that were overproduced, there are shortages of other things. In those areas of the economy, there are higher prices, higher profits, and both a signal and incentive to expand hiring and purchase appropriate capital goods. As workers are hired and appropriate capital goods are produced, real output will grow more rapidly. The unemployment rate will fall back to its previous level (more or less.) With cash expenditure targeting, this results in deflation. The price level falls back towards its pre-crisis level. Real incomes grow more rapidly, though nominal incomes continue to grow at an unchanged rate.
In the end, real output will return to growing as it did, the unemployment rate will fall back to where it was. The inflation rate will be zero (at least with a 3% target for cash expenditure growth.) However, it is likely that real output will be on a somewhat lower growth path and the price level slightly higher than it would have been if resources had never been misallocated by the speculative bubble.
A second type of problem can result from disruption in credit markets due to bank insolvency. Even if cash expenditures continues to grow on target, it is possible that firms that have buyers and can make profitable sales will be unable to obtain credit to finance production or delivery. This is a "supply-shock." A lack of credit forms a bottleneck for production. The result is reduced real output and employment. With cash expenditure targeting, this results in shortages of goods and services, and higher prices. The profitability of the production that can be continued, both using whatever remaining credit is provided as well as by self finance, is enhanced.
If secondary effects of disrupted credit markets are considered, the pattern of demand resulting from self-finance will likely be different than what would exists with credit markets that operate. Households consume what they earn, and firms fund production and investment with retained earnings. The movement of funds between and among households and firms through credit is disrupted. Would be lenders consume and invest more. Would be borrowers consume and invest less. Assuming that the productive capacity of the economy, both labor and capital, is appropriate to a composition of demand reflecting well-functioning credit markets, then the shift in the composition of demand reflecting more self-finance allows for less production and employment, and a higher price level.
What cash expenditure targeting does is provide that the sectors of the economy with growing demand, rising prices, and rising nominal and real profits from expanded economic activity will overbalance any shrinking sectors. It is into that environment that a new bank, or an reorganized bank, will find itself. And if there has been a disruption of credit, so that a shortage of credit is creating production bottlenecks, it is an environment where the extension of credit will be profitable.
In my view, the first best solution to a financial crisis is free banking combined with index futures targeting to keep cash expenditures on target, and then rapid bankruptcy and reorganization of insolvent banks to avoid "supply-side" disruption in credit markets. Given the status quo, the Fed should have committed to keeping cash expenditures on target, and if and when that failed, returning them to target one year in the future. And then FDIC should have reorganized insolvent commercial banks and encouraged those newly solvent banks to rapidly expand enough to replace the shrinking shadow bank sector. Allowing shareholders and uninsured debtors who funded the credit bubble to take losses, while allowing a reallocation of resources, including labor, away from housing, are necessary evils.