Digest authentication is not supported for WebDAV folders, as far as I can tell. The directory is not accessible via the shell once WebDAV is activated in the panel. Any existing .htaccess file is deleted, as well. So trying to plant one with Digest auth before activating in the panel won't work. Likewise, you can't turn "DAV on" in an .htaccess file and just bypass the panel.
I'm stumped at this point. I'd really like to be able to use WebDAV with Digest passwords. But I can't. Any help, Dreamhost?
A broader question: can we just do away permanently and across the board with passwords in the clear as the default option? Passwords in the clear should be a selectable option to support broken clients. But they should never be the default option.