Why are we in the mess we are in? There are lots of proximate causes: overleverage, global imbalances, bad financial technology that lead to widespread underestimation of risk. Readers can no doubt improve on that list.

But these still are all symptoms. Until we isolate and tackle fundamental causes, we will fail to extirpate the disease.

I will confess to not having addressed this particular line of thought directly, even thought it has crossed my mind plenty of times. Many readers have noted, and I agree completely, that the financial sector has become too large relative to the real economy. But many commentators, your humble blogger included, have failed to probe deeply how such a distorted economy came to be seen as a good policy outcome.

In 1980, financial firms accounted for 8% of S&P earnings. During the peak of our last stock market cycle, their profits were over 40% of the total.

Now consider: finance is a necessary function, but is represents a tax, a drain on the productive economy, just as defense and lawyers do (aside: I had a lawyer from an entrepreneurial family who was refreshingly aware of that issue, and would write off hours before sending bills to clients, recognizing that the amount of time her firm had spent on certain matters simply wasn’t worth it from an economic standpoint to the client). It is ironic that free market fundamentalists have so vociferously argued for unfettered markets, without understanding (or perhaps understanding all too well) that the house always wins.

When I was a kid and had my first serious jobs on Wall Street, there was no explicit formulation of that conundrum, but the firms understood their place. You could make a very very nice living on Wall Street. The barriers to entry were high enough to allow for oligopoly pricing, but that meant for rich pay packages rather than an easy life. You do not know how hard you can work, short of slavery, unless you have been an investment banking analyst or associate. It is not merely the hours, but the extreme time pressure. Priorities are revised every day, numerous times during the day, as markets move. You have numerous bosses, each with independent demands and deadlines, and none cares what the others want done when. You are not allowed to say no to unreasonable demands. The time pressure is so great that waiting for an elevator is typically agonizing. If you manage to get your bills paid and your laundry done, you are managing your personal life well. Exhaustion is normal. One buddy stepped into his shower fully clothed.

And exhaustion and loss of personal boundaries is an ideal setting for brainwashing, which is why people who have spent much of their career in finance have such difficulty understanding why their firm and their world view might not be the center of the universe, and why they might not be deserving of their outsized pay.

But I digress. There is a remarkable failure to acknowledge a key element of the task before us, that is, that the financial system HAS to shrink. Its current size is based on an unsustainable level of debt, a big chunk of which will go bust or be renegotiated. Yet rather than trying to figure out what a new, slimmed down version of banking ought to look like, to ascertain which pieces should be preserved and which jettisoned, the authorities are instead reacting in a completely ad hoc fashion, rushing to put out the latest fire. And in the process, they keep trying to validate overly inflated asset values (a measure straight out of the failed Japan playbook) rather than try to ascertain what their real value might be so as to determine how much recapitalization might ultimately be needed (if you doubt me, Exhibit One is the pending Citi bailout, in which lousy assets will be guaranteed at phony values). Is this denial? Do the authorities fear that if they work up this analysis, it will leak out and the markets will panic? This seems to be the first, most important order of business, yet here we are more than a year into the crisis, still tip-toeing around one of the very biggest issues.

And why is that? Back to the cult issue. Willem Buiter has chastised the Fed for what he calls “cognitive regulatory capture,” that is, that they identify far too strongly with the values and world view of their charges. But it isn’t just the Fed. The media. and to a lesser degree, society at large has bought into the construct of the importance, value, and virtue of the financial sector, even as it is coming violently apart before our eyes. Why, for instance, the vituperative reaction against a GM bailout, while we assume Citi has to be rescued? A GM bankruptcy would be at least as catastrophic as a Citi failure. but GM elicits attacks for the incompetence of its management and the supposedly unreasonable posture of the UAW (the same free market advocates recoil at a deal struck by consenting adults). The particular target for ire is the autoworker pensions and health plans, as well as their work rules. But the pension plans being underwater is the fault of GM management for not providing for them in the fat years; I personally have trouble with the idea that health care should vary by class; and for the work rules, German and Swedish automakers have strong unions and yet can compete. I see the UAW as having correctly seen GM management feeding at the trough and doing a good job at extracting their share.

And yet the specter of incompetent, and worse, DISHONEST management elicits far less anger. GM may not make the best cars, but Citi and other banks sold products that were terrible, destructive, that resulted in huge losses and are wrecking economies, damage crappy cars could never inflict (environmentalists might quibble, but never has so much seeming wealth evaporated in so little time, and with the main culprits readily identified). They paid huge bonuses, yet their 2004-mid 2007 earnings have been wiped out by subsequent losses. But while UAW workers will have to give up on deals cut earlier, in terms of health care and pension promises (entered into, by the way, to bridge difference over wage levels), I guarantee no Wall Street denizen of the peak years will have to cough up one penny of his bonus from those days.

I don’t know how to convey a sense of how deeply indoctrinated we all have been. This Independent story may give a sense of how banks have completely lost sense of their place.:

High-street banks are continuing to hit businesses with punitive interest rates for loans and overdrafts and are resorting to more severe measures to ensure they are paid. Some are demanding that owners of small businesses put up personal assets as collateral in return for a business loan. Others are changing conditions of loans by sending emails rather than meeting in person, and giving borrowers just 48 hours to comply with unilaterally-rearranged overdraft and lending agreements. The Business Secretary, Lord Mandelson, said he was alarmed by the banks’ behaviour: “That is not the sort of constructive relationship that is sustainable between banks and businesses… Paul Cox, from Surrey, was also asked for his personal property to be put up as collateral against a business loan by the Royal Bank of Scotland just last month – despite an excellent record with the bank. “I’m fortunate – I could walk away,” said Mr Cox. “Others have to accept punitive terms.” RBS received the biggest slice of the Government’s bailout deal – up to £20bn. The Federation of Small Businesses (FSB) said that when some members approached banks to discuss loan agreements, their accounts were reissued under harsher lending terms. Chief executives of Britain’s big banks, who have been regularly meeting with the Government and small business groups, have all made positive noises about ensuring viable small businesses have the access to finance that they need. But branch managers are often reluctant to return to relaxed lending policies which may put their branches in a perilous position.

There are several issues conflated in this story that need to be picked apart. One is that there were a lot of loan made in the frothy years that were not sound. Some people who had access to a lot of credit will correctly have a lot less, and that on dearer terms. But there are also perfectly worthwhile businesses and individuals who are also caught in the meat grinder of indiscriminate reduction of loan balances. And because government support has been extended with the explicit understanding that banks would make loans, the punitive treatment of high quality borrowers is indefensible.

But those are not my main focus. What stuck we was the subtext of the piece: times are bad, and any efforts to extract more revenues from customers, even if it is blood from a turnip, or worse, even if it puts a viable business under, is warranted. The idea that the needs of the financial sector can trump those of the productive sector are dangerous and destructive to our collective well being, and need to be combatted frontally.