Should the Financial Sector Shrink?

The financial services industry seems to be x times larger than it needs to be to effectively service and lubricate the real economy that produces useful goods and services. (Arnold Kling is one of many that agree with me.)

This suggests that the market is misallocating resources (both capital and human). It is also failing to price in the very real negative externalities of that oversized sector (i.e. global financial collapse).

But: the financial services industry does, quite literally, create lots of *money* — not only via leverage, but via the profits from fees and commissions. (It accounted for 40% of corporate profits just before the crash.)

If that sector shrank significantly,* would real gross prosperity decline or increase? Short term? Long term?

* How would this happen? As Pigovians say quite aptly, “if you want less of something, tax it.”