Nick Bloom has a good description of the most plausible transmission mechanism to medium term economic activity and growth over at VoxE:
So why is this banking collapse and rise in uncertainty likely to be so damaging for the economy? First, the lack of credit is strangling firm’s abilities to make investments, hire workers and start R&D projects. Since these typically take several months to initiate the full force of this will only be fully felt by the beginning of 2009. Second, for the lucky few firms with access to credit the heightened uncertainty will lead them to postpone making investment and hiring decisions. It is expensive to make a hiring or investment mistake, so if conditions are unpredictable the best course of action is often to wait. Of course if every firm in the economy waits then economic activity slows down. This directly cuts back on investment and employment, two of the main drivers of economic growth. But this also has knock-on effects in depressing productivity growth. Most productivity growth comes from creative destruction – productive firms expanding and unproductive firms shrinking. Of course if every firm in the economy pauses this creative destruction temporarily freezes – productive firms do not grow and unproductive firms do not contract. This leads to a stalling productivity growth.
I disagree strongly with Nick on his conclusion about the impact of change of policy towards an anti-market stance. The financial markets have imposed not only the huge direct costs of crisis on the economy, but also a huge opportunity cost in taking talent away from other honest, productive activities.
