Allowing insolvent banks to fail is critical, and would be the first step in a badly-needed restructuring of our economy. Too many talented people are lured into the financial industry by outsized pay-packages. We need to shrink the industry and get these people in productive industries. The rise of “financial innovation” has only slowed real growth and led to rampant moral hazards.

Shrinking the sector, if done responsibly, would not lead to breadlines and a depression. Experts like William K. Black have outlined the strategy for removing these SDIs (systemically dangerous institutions). Recovery (in a sustainable fashion) would take place quicker than most people think. The alternative is 20 years of Japan-style malaise, and that’s a best case scenario in my opinion. Stagflation and other nasty outcomes are real possibilities.

Our financial sector remains a disproportionately large drain on the economy, and impedes recovery efforts. Profits from financial firms peaked at 41% of total corporate earnings in 2006, and they’re heading back to pre-crisis levels. That is wildly unsustainable, as noted by Simon Johnson in his must-read The Quiet Coup.

Bank activity is currently a net-negative on US growth. Responsible lending makes up an increasingly small part of the finance sector. The vast majority of their activity has a parasitic effect on the economy: derivatives, selling swaps to naive investors, flash-trading, usury-level CC interest rates, front-running, bonus-madness, etc. [Read Don’t Fear the Brain Drain for more.]

See these charts from The Quiet Coup:

Simon Johnson comments:

From 1973 to 1985, the financial sector never earned more than 16 percent of domestic corporate profits. In 1986, that figure reached 19 percent. In the 1990s, it oscillated between 21 percent and 30 percent, higher than it had ever been in the postwar period. This decade, it reached 41 percent. Pay rose just as dramatically. From 1948 to 1982, average compensation in the financial sector ranged between 99 percent and 108 percent of the average for all domestic private industries. From 1983, it shot upward, reaching 181 percent in 2007.

Mr. Johnson’s writes at BaselineScenario.com. He is among the few mainstream economists who acknowledges Wall Street’s corrupting influence on government. We need more people like him in government. While his pro-stimulus policies aren’t ideal (artificial stimulus is inefficient, in my view), he would be an immeasurable improvement over existing appointees. Getting someone like him in a top government post would be a first step towards meaningful curbing of Wall Street’s ponzi game.

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Updated 9/22/09