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We need government and we need banks, but we don't need government to be as big as it's grown and we don't need banks which are too big to fail. When sectors like government or banking grow out of proportion to the benefits they bring, the economy as a whole suffers from a misallocation of resources.

So headlines like these from The Wall Street Journal this morning are good news:

BofA Ponders Retreat

Bank of America has told U.S. regulators that it is willing to retreat from some parts of the country if its financial problems deepen.

Banks Overhaul for Leaner Era

The investment-banking industry, notoriously prone to cyclical hiring and firing during booms and busts, is in the midst of a retrenchment that may be more far-reaching.

RBS Bids to Shrink to Glory

The needed contraction in the financial industry would have happened sooner if there hadn't been the bipartisan bailout known as TARP; it would also have been more abrupt. IMHO the economy would've recovered quicker if we hadn't cushioned the way down for investment bankers. Others argue that that an abrupt banking contraction would have tanked the economy worse. We'll never know who is right.

The fight now is to make sure that banks don't get further bailouts and that too-big-to-fail banks get smaller. The prognosis is not great. The European Central Bank is continuing to print money to "lend" to its member banks at concessionary rates (1%) in hopes that these banks will turn around and lend some of it to their feckless governments, thereby keeping the governments afloat and earning high profits for the banks so that they can repair their damaged balanced sheets. Note that this is a scheme which protects employment in BOTH the banking and the government sectors.

Here in the U.S. the government sector shrinks slowly from one employment report to the next. Meanwhile the private sector creates more jobs than are lost in government, although not enough to bring the unemployment rate down as fast as we'd all like to see. Particularly good news is that manufacturing employment here is growing.

Government employment also would have contracted much more abruptly without the local government bailout contained in the Stimulus Bill. One can make a better argument, again IMHO, for cushioning the downsizing of government during a time when the need for government services increased than for bailing out banks. But the states and local governments by and large didn't take advantage of the reprieve to make the structural changes that were needed or even to get control over the cost of public sector retirement benefits.

Those who benefit from megagovernment – including those in the private sector serving government or exploiting grants, preferences and mandates – will fight to regrow government. As tax revenues recover along with the economy, the temptation to let government grow again will grow. That'd be a mistake. Just like bailing out banks.

Source: A Decline In Financial And Government Sectors Is Good For The Economy