Last year, Berkshire Hathaway (NYS: BRK.B) Vice Chairman Charlie Munger said, "We would be better off if we downsized the whole financial sector by about 80%." That may have been an exaggeration, but not by much.

We often hear that one of America's great strengths is the depth of its financial markets. That's true to a point, but there are limits. A new study by the International Monetary Fund shows that rich countries hit a point "at which financial depth no longer contributes to increasing the efficiency of investment."

That point, they showed (link opens PDF file) this week, tends to hit when a country's private sector debt totals 80%-100% of gross domestic product. The United States hit that threshold two decades ago, and now chugs along at about double the level:


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Source: World Bank.

What happens when credit levels spike above 100% of GDP? The IMF paper shows that rising private-sector credit helps fuel growth when it's at a fairly low level of GDP -- say, when private-sector credit rises from 20% of GDP to 30% of GDP. But after the 100% threshold, the boost to growth vanishes. And worse, countries past the threshold tend to face more frequent, deeper, and longer financial crises (this should sound familiar).

Then there's the impact a large financial sector has on misallocating talent. Fifty years ago, 4% of Harvard's undergraduate class went into finance. Today it's about a quarter. At Princeton's School of Engineering, financial engineering is the most popular undergraduate major. What other types of productive work could these brilliant minds be doing instead? Munger himself worried: "A big percentage of Cal-Tech grads are going into finance. I regard this as a regretfully bad outcome. They'll make a lot of money by clobbering customers who aren't as smart as them."

But there's something more important here to think about, and that's who has caused the big boom in private-sector credit. A predictable villain to blame is the Federal Reserve, which controls the money supply and pumps credit into the economy. But the Fed doesn't make private-sector loans. It doesn't take out mortgages, run up a credit card, or engage in leveraged buyouts. That's all done by the will of private borrowers. Even when loans are cheap and artificially attractive, the decision to go into debt is entirely up to the consumer or the business. I don't think you can even lay blame on the big banks like Bank of America (NYS: BAC) or Citigroup (NYS: C) . A banker offers you a loan? Say no. He points out that it's a low interest rate? Say no. See how easy that was?

The credit boom of the last two decades is mostly indicative of people's yearning to live a life they can't afford. It's keeping up with the Joneses, or the fake-it-till-you-make-it effect. There are all kinds of explanations for it. Some say income inequality caused the material aspirations of common folks to be inflated by the legitimately rich, and the only way they could afford it was through debt. Others say an increasing level of short-termism in business caused managers to boost near-term profits with leverage at the expense of long-term sustainability.

The reason doesn't really matter. We've gone into a lot of debt. We've done it voluntarily. It's now backfiring, and the effects will probably linger for years to come. "There is no faster way to feel rich than to spend lots of money on really nice things," Motley Fool's Bill Mann wrote four years ago. "But the way to be rich is to spend money you have, and to not spend money you don't have. It's really that simple." Timeless advice.

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The article A Finance Sector Too Big for Its Britches originally appeared on Fool.com.

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