In a previous post, I noted that one alternative to asking the question of whether the manufacturing sector in the US was now too small was to ask whether other sectors have grown too large. The financial sector is one obvious candidate — over the last thirty years, the US financial sector has grown some six times faster than US nominal output.

Before the onset of the global financial crisis, many would have found the suggestion that finance was too big an implausible one. After all, the level of a country's financial development seems to be positively correlated with its growth prospects, and there is a large empirical literature investigating the workings of the finance-growth nexus. Then there are all those lovely high-pay, high-skill jobs on offer, which governments both national and local are extremely keen to attract and retain.

In the aftermath of the crisis, however, there has been a greater willingness to ask whether the financial sector may have grown too large in the US and some other developed economies. Certainly, the sheer scale of the financial pollution suffered by the world economy over the past couple of years suggests that our assessment of the relative costs and benefits of the sector merits a rethink, something which would also require that we do a better job of measuring both of these things.

It also requires thinking about whether the large public subsidies implied by government backing for the sector have distorted the structure of at least some developed economies. Indeed, there is now widespread agreement on the proposition that, not only did implicit government support lead to the creation of 'too important to fail' institutions in the run-up to the crisis, with destabilising consequences for risk-taking behaviour, but also that the problem has since grown worse. What is true for individual institutions may also apply to the sector as a whole.

One result of the crisis is going to be a tougher regulatory environment, including requirements for more capital and more liquidity. All else being equal, this will imply some reduction in the size of the financial sector relative to its post-crisis high in countries like the US. Mind you, given uncertainties about some of the trade-offs involved, not to mention the past success of financial lobbyists in shaping the industry's regulatory environment, just how big any reduction will turn out be remains an open question.

Photo courtesy of TaxBrackets.