by Andrew Clark in New York

A sweeping package of measures by the US government to bail out struggling banks sparked hasty cross-party negotiations in Congress and sent financial markets rocketing on hopes of a long-term resolution to the credit crunch yesterday.

Proposing a state-sponsored corporation to sweep up toxic debts held by teetering financial institutions, President Bush called for bipartisan action to restore confidence in the US economy.

"America's economy is facing unprecedented challenges and we are responding with unprecedented action," he said. "There will be ample opportunities to debate the origins of this problem. Now is the time to solve it."

Alarmed at the prospect of this week's banking crisis sparking a domino-style fall of further banks, the US treasury put forward a three-pronged plan which amounts to the biggest intervention in the markets since the Depression of the 1930s.

Its proposed body to clean up the banking industry will require hundreds of billions of dollars. Alongside this, there will be federal insurance to protect money held in usually ultra-safe money market funds which have been faltering this week due to their exposure to troubled banks.

The treasury secretary, Henry Paulson, admitted that it would be expensive to tidy up banks' bad debts, but he said doing nothing would be far more costly.

"This bold approach will cost American families far less than the alternative - a continuing series of financial institution failures and frozen credit markets unable to fund economic expansion," Paulson told a press conference in Washington.

Referring bluntly to the week's events as a "crisis", Paulson said it was no longer viable to treat each financial blow-up on a case by case basis: "We must now take further, decisive action to fundamentally and comprehensively address the root cause of our financial system's stresses."

The planned body to hold banks' liabilities is loosely modelled on the Resolution Trust Corporation, a body which tidied up assets held by crumbling savings and loans associations between 1989 and 1995.

Democrats said they would work with the Bush administration on the plan. Barack Obama backed it in principle, saying it was "critical" the markets and the public have confidence that action will be "unimpeded by partisan wrangling".

Democratic senator Charles Schumer said treasury officials had left no doubt about the alternatives: "Their description of what would happen if we didn't act was startling, astounding and a little worrisome."

Although lawmakers promised measures in "hours rather than days", there is likely to be a tough round of horse-trading. Democrats are expected to use the opportunity to demand more public money to aid homeowners facing foreclosure.

The proposals had a euphoric impact on Wall Street, where the Dow Jones Industrial Average leapt 368 points to close at 11,388. After a remarkable week, the surge meant the market was only down a few points for the week, despite Monday's biggest one-day plunge since 2001.

The rise provided relief for Wall Street banks trying to halt a collapse in investor confidence as sceptics questioned the viability of standalone "broker dealer" institutions on Wall Street in the wake of Lehman Brothers' bankruptcy.

The fragility of banks has caused repercussions for millions of savers with their cash in money market funds, which only hold securities with good credit ratings, and which hold a total of $2trillion. Earlier this week, one fund dropped in core value for only the second time in the industry's history, and others have been shutting down, prompting the Bush administration to step in with a guarantee yesterday.

"The financial fever has broken," said Mark Vitner, an economist at Wachovia Securities. "The government's actions have broken down the fear that was so widespread and pervasive."

As in London, the US Securities and Exchange Commission has ruled that some 800 financial stocks are to be protected from short-sellers. A criminal investigation is under way into whether speculators deliberately spread misinformation about banks' finances.

"Now the shorts are really going to be squeezed - until the pips squeak," said Mike Lenhoff, chief strategist at stockbroker Brewin Dolphin in London.

But Adam Sussman, director of research at the hedge fund consultancy Tabb Group, said it made no sense to punish speculators when shares go down, yet allow them free reign when stocks rise. "If we're going to be against speculation, maybe the government should force people to stop buying Google when its price jumps 500%," said Sussman.