In hindsight, we readily see that at least one of the purported pathways to depression was never followed.

Here's something Casey Mulligan should get right, since he understands that the financial sector is not exactly wedded to the rest of the economy, but doesn't:

"October Hysteria in Hindsight

Copyright, The New York Times Company

After Lehman failed and “credit markets froze” in the second half of September 2008, many people proclaimed that a second Great Depression( I DIDN'T ) would unfold. In hindsight, we readily see that at least one of the purported pathways to depression was never followed.

During the first days of October 2008, it was claimed that businesses would not be able to borrow from banks even for basic operational expenses, such as making their payrolls. As employees had to work without pay (so the story goes), the businesses patronized by those employees would suffer, and the downward spiral would continue. Then presidential-candidate Barack Obama said that “the credit market is seized up and businesses, for instance, can't get loans to meet payroll.” It was even suggested that “recession proof” employers such as colleges and municipalities would not be able to pay their employees.

Now that a couple of months have passed, let’s look at payroll spending measured by the Bureau of Economic Analysis. The chart below shows payroll spending (measured in billions of dollars) for each of the months of second half of 2008 (December data not yet available), including contributions to pension and health funds for employees. Aggregate payroll spending was highest in August, and has remained within 0.1 percent of the August high ever since.



The Lehman Brothers investment bank failed on September 15. The bank was deeply intertwined with other financial institutions – its failure to pay its obligations put its creditors at risk – and brought the credit crisis to its crescendo. By the end of the month, the intense financial chaos motivated Mr. Obama and others to warn that banks needed lots of money from taxpayers, or else the banks’ business customers would not be able to pay their employees.

Because the bailout bill took time to pass, and then additional time for the Treasury to design and execute its $700 billion Capital Purchase Program (CPP), no bank received any money from the Treasury pursuant to the CPP until the last couple of days of October. Thus, if the warnings were right, payroll spending should have been precipitously lower in October than in the previous months. Instead, payroll spending was almost $1 billion dollars higher in October than in September – not exactly the collapse that we feared.

Some of the details of the CPP became known earlier in October. Anticipation of the CPP expenditures cannot explain why payroll spending did not collapse in October, because the purported pathway to depression was about the day-to-day cash needs of otherwise strong businesses. Even the United States Treasury admitted last week that “capital [from its CPP] needs to get into the system before it can have the desired effect.”

Even when some (but by no means all) of the CPP funds finally got “into the system” in the last days of October and the full month of November, Congress was dismayed to see that banks were not using the funds to lend. Nevertheless, payroll spending did not collapse in November, either.

It is true that payroll employment fell by about 850,000 in October and November – and that’s serious as compared to the last couple of recessions – but the payroll spending data show that the employment loss was small compared to the spending collapse forecasted in early October. The fact is that more than 136,000,000 workers received their paychecks – more than $1.3 trillion worth in October and November combined – essentially the same aggregate payroll that was paid out in the two months prior to Obama’s warning.

None of the above denies or confirms that our economy is headed for economic depression, because there are multiple pathways for getting there. Nor does it deny that the Treasury CPP might help in some way. But it does refute one of the scariest pathways to Depression – a collapse of payroll spending – that politicians from both parties alarmingly described to the American public in order to justify spending $700 billion of taxpayer funds on a bailout of United States banks."

Now, we have been dealing with two distinct events:
1) A Calling Run, followed by:
2) A Proactivity Run.

The Calling Run involved a panicked scramble to get out of declining assets and into cash, or guaranteed investments. The reason that this could effect lending was because many of the assets and investments that were being fled were loans, or other financial assets and investments held by banks. Quite naturally, if your lending practices and loans are leading you to a mad scramble to unload and untangle them, losing you an unknown sum of money, it is only natural that your lending would be curtailed. The fact that Mulligan doubts this defies belief. He only has to ask himself whether he would keep lending normally if his normal lending had led to enormous losses. Apparently he would. One explanation of the lending going on is the fact that many people had preexisting lines of credit and they accessed them. That's what these lines of credit were there for. As well, the government did intervene enough to keep some lending going on. Finally, there are small banks, for instance, who have been able to keep lending through this crisis. In any case, this run does not automatically lead to a Proactivity Run, because the financial sector is somewhat separate from the general economy. In any event, employment would certainly lag the Calling Run, at least until the extent of the Calling Run becomes clear.

In this crisis, the Proactivity Run, as opposed to simply some prudent downsizing, quite obviously began in the second half of November. It wouldn't be dramatic even here immediately, because some workers would be kept on until after the end of the holidays. By now it is obvious in both employment and consumption. In my opinion, the dithering about these bailouts, including the Automotive Bailout, have led to an Uncertainty Shock as to the level of government support. Now that the government has guaranteed more and more businesses, leading to the belief that the government will do whatever it takes to stop these runs, we are beginning to see a diminution in the fear and aversion to risk, as evidenced by the TED and VIX. My evidence for my position is the actual flow of investments.

One final thing. I don't know what is included in that compensation figure above, but, having run a business, I can tell you that if you let people off, you pay UI for them for a while. As well, if business stays higher than the employer estimates, he might have to pay more wages than he anticipates to the remaining workers. I have often found, after trimming my staff, that my payroll expenses remained the same for some time. A very annoying occurrence, but a real world one.

Finally, let me state the following: The Calling Run was not inevitable, and, even after it hit, the Proactivity Run was not inevitable. A system based on Bagehot's Principle's, I contend, would have stopped both. The handling of this crisis by the government, while better than nothing, has been a mess. That's how I see it.