His comments came as the prospect of an all-out court battle moved closer, a development internal sources said would lead to a "bloodbath the like of which the party has not seen before".
The former Holyrood Presiding Officer, warned that the LibDems, already wallowing in the polls were getting themselves in "the most awful mess" and members across Britain would be very angry this had not been grappled with from the start.
"The first rule in politics is: if you're in a hole, stop digging," he declared. "The fact is they have been digging on both sides for the past two days and it's disastrous."
The 75-year-old Scottish peer suggested the party drop its suspension of Lord Rennard and he withdraw his threat of legal action. Asked what Mr Clegg should do, Lord Steel replied: "It's a bit hard to say: it should be the party leader. But, collectively, the party leadership should get a grip on this and say it's got to be reversed. There should not be a threat of expulsion. Chris Rennard should withdraw his threat of legal action and we should get this sorted out once and for all."
But he was swiftly rebuffed by a senior LibDem source, who said "obviously we disagree" and that reinstating Lord Rennard was "not going to sort it out".
The former election strategist who helped treble the number of LibDem MPs has instructed a QC to see whether or not the decision to instigate a disciplinary inquiry against him is lawful.
The 53-year-old peer was suspended from the party and faces a disciplinary hearing for not apologising following an internal inquiry into the claims of sexual harassment.
He has refused to do so because he denies the claims.
While the inquiry found there was no proof beyond a reasonable doubt to the allegations, it said the claims were "broadly credible" and that the peer should apologise for any distress caused.
Yesterday evening at Westminster, Mr Clegg addressed LibDem MPs and peers at their weekly parliamentary meeting and emerged half an hour later stony-faced.
His spokesman said the party leader had thanked his colleagues for their calm co-operation and resilience during a difficult period.
He explained that when all the rhetoric was stripped away, Mr Clegg continued to stand by his decision to abide by the inquiry's recommendation that Lord Rennard apologise.
The spokesman insisted the party had followed due process throughout but said he would not comment on whether or not the leadership was confident it could win any court battle against Lord Rennard, who, if the disciplinary process continues, could ultimately face expulsion from the LibDems. Asked why Mr Clegg could not seek a one-to-one meeting with his colleague, the spokesman replied that in the early days - they have not spoken for almost a year - such offers were rejected.