Financial Sector Proves Too Big To Shrink-$15 Tillion Economy Carrying $50 Trillion Debt

Financial
Sector Proves Too Big to Shrink

Can't live
with it; can't live without it. That is the trouble with the financial system.

The
relationship between markets and the "real" economy has gotten out of
whack. The amount of debt outstanding in the U.S. -- from home mortgages to corporate
bonds to municipal securities to U.S. Treasurys -- stood at roughly $50
trillion, or more than triple the size of gross domestic product, as of June.
On Thursday, the Federal Reserve's third-quarter "flow of funds"
report will offer updated figures through September.

The total
amount of debt actually peaked in the first quarter of 2009 at about $51
trillion. That it has only fallen a bit since is owed to the leap in government
borrowing to fund various stimulus programs. This occurred precisely to cushion
the economy from the effects of debt-shedding in the private sector, and to
wrench the U.S. out of recession. In turn, government debt now accounts for 24%
of the total, up from 15% in 2008.

This goes
to illustrate the nation's current conundrum: how to reduce the total debt
burden without triggering another recession. If the current 335% ratio of
household, business and government debt-to-GDP sounds bad now, just imagine if
GDP were to contract. A 3% drop in nominal GDP from current levels would push
that ratio up by more than seven percentage points to 342%. This is the trouble
with austerity measures, and is why Greece's debt-to-GDP has soared, not
declined, over the past 18 months.

The surest
way out of this trap is through economic growth, which is why the Federal
Reserve has been pursuing such aggressive easing measures. But again, its
methods conflict with its goals. Namely, the Fed relies on credit creation via
the financial sector to get the money it creates flowing into the real economy
-- and yet this credit creation was part of the problem in the first place.
Indeed, Princeton University economist Hyun Song Shin argues a global
"banking glut" precipitated the financial crisis, not a global
"savings glut," as Fed Chairman Ben Bernanke has said.

The
trouble is, urgency to shrink the financial system conflicts with the urgency
to boost growth. Call it the paradox of heft: The financial sector has become
so large it is damaging, and yet shrinking it is painful.

Credit: By
Kelly Evans