Simon Johnson's Blog, page 37

Three More Governance Questions For The New York Fed

By Simon Johnson.  This is a long post, about 2500 words.

Over the last several weeks on this blog, I have expressed a broad set of concerns about governance arrangements at the Federal Reserve Bank of New York. I have made the specific case for Jamie Dimon, the chief executive of JPMorgan Chase, to step down from the New York Fed’s board because of the large, unexpected losses in his bank’s London proprietary trading operation – and the fact that these activities and their disclosure are now under investigation by the Fed.

On Monday I met with senior staff members of the Federal Reserve System to deliver and discuss a petition I created, signed by 38,000 people, requesting that Mr. Dimon resign or be removed from the New York Fed board. They were gracious in the time they afforded me.

More broadly, I see no grounds for optimism that Mr. Dimon will relinquish his Fed position any time soon. In addition, as a result of recent interactions with former officials and others who know the Fed intimately, I now have three additional substantive governance concerns for the New York Fed that merit further discussion. Let me pose them as straightforward questions that I hope the Fed – at the Board of Governors or New York Fed level – will answer publicly, and soon.

First and most important, why didn’t Mr. Dimon step down from the board of the New York Fed in March 2008, when JPMorgan Chase bought Bear Stearns with financial support provided, in part, by the Fed?

This transaction fundamentally transformed the relationship of Mr. Dimon and the New York Fed. It is very awkward for any director to enter into a significant commercial transaction with an organization that he or she is charged with overseeing.

This was a significant transaction for Mr. Dimon – representing a big expansion of his business. It was also a significant transaction for the Federal Reserve – both as a measure to stabilize the economy and in terms of the specific provisions of the financing it provided.

The authorities worked closely with JPMorgan Chase during this phase of the crisis. As the Fed chairman, Ben Bernanke, testified to the Joint Economic Committee of Congress on April 2, 2008:

“To prevent a disorderly failure of Bear Stearns and the unpredictable but likely severe consequences of such a failure for market functioning and the broader economy, the Federal Reserve, in close consultation with the Treasury Department, agreed to provide funding to Bear Stearns through JPMorgan Chase. Over the following weekend, JPMorgan Chase agreed to purchase Bear Stearns and assumed Bear’s financial obligations.”

JPMorgan’s downside risk in the latter arrangement was limited. On March 16, 2008, invoking Section 13(3) of the Federal Reserve Act, the Federal Reserve Board of Governors authorized the New York Fed to form a limited liability company “to facilitate lending in support of specific institutions.” As expressed on the New York Fed’s Web site:

“In March 2008, Maiden Lane L.L.C. (ML L.L.C.) was formed to facilitate JPMorgan Chase & Company’s (JPMC) merger with Bear Stearns Companies Inc. (Bear Stearns) and prevent the contagion effects of Bear Stearns’s disorderly collapse to the broader U.S. economy. ML L.L.C. borrowed $28.82 billion from the Federal Reserve Bank of New York (New York Fed) in the form of a senior loan, which, together with funding from JPMC of approximately $1.15 billion in the form of a subordinate loan, was used to purchase a portfolio of mortgage-related securities, residential and commercial mortgage whole loans and associated hedges (derivatives) from Bear Stearns.”

The precise terms of this arrangement were, appropriately, subject to detailed negotiation after the initial announcement (see this news release). Valuation of the relevant securities was presumably a hot and complex topic in this conversation, which ran from March to late June 2008. (JPMorgan Chase also acquired other Bear Stearns assets, in addition to what was covered by Maiden Lane.)

How was it appropriate for Mr. Dimon to remain on the board of the New York Fed while this negotiation was going on?

Keep in mind that before passage of the Dodd-Frank Act of 2010, Class A directors – such as Mr. Dimon – were involved in appointing the president of the New York Fed. In other words, Mr. Dimon (and his employees) were negotiating a multibillion-dollar deal with Timothy F. Geithner, then the president of the New York Fed and now the Treasury secretary (and his staff) – even as Mr. Geithner reported to Mr. Dimon in his board role.

Mr. Dimon, of course, does not run the New York Fed – in any well-run organization, management runs the show and the board is responsible for oversight, including the hiring and performance evaluation of the chief executive. In the case of the New York Fed, the Board of Governors is also involved. But any notion that the New York Fed’s own board of directors is “purely advisory” is completely at odds with the legal and practical reality. (By removing Class A directors from the selection of regional bank presidents, the Dodd-Frank legislation recognized this point, at least in part.)

As for the terms of Fed support, this was obviously more generous that what would have been provided by the market – in part because the Fed had become convinced that such action was needed to stabilize the broader market. From the Fed’s Maiden Lane page:

“The New York Fed lent ML L.L.C. approximately $28.82 billion. The loan has a 10-year term and accrues interest at the primary credit rate. JPMC lent ML L.L.C. approximately $1.15 billion. The JPMC loan has a 10-year term and accrues interest at the primary credit rate plus 450 basis points.”

(The primary credit rate was 2.5 percent when this deal was announced on March 24, 2008; this rate had previously been lowered on March 16, 2008, to 3.25 percent from 3.5 percent, at the express request of the New York Fed. I am not implying that the cut in the primary credit rate was related to the Maiden Lane transaction.)

To be clear, this loan has been repaid in full – in fact, just two weeks ago, the New York Fed was able to announce (on its Maiden Lane page): “The successful repayment of the loans marks the retirement of the last remaining debts owed to the New York Fed from the crisis-era interventions with Bear Stearns and A.I.G.” (This included repayment of loans made to Maiden Lane III, which was one of the financing vehicles created when A.I.G. was rescued.)

The full results of the Maiden Lane intervention are not yet known – and there may be some upside for the taxpayer: “Proceeds from future sales of ML L.L.C. assets will be used to repay the subordinated loan extended by JPMorgan Chase & Company, after which the New York Fed will receive all residual profits.”

At the same time, this kind of central bank support should make us all feel queasy. Adjusted for risk, will the Fed end up making an adequate return? Putting that thought differently – if the Fed did this 20 separate times, would it (and the American public) end up ahead or behind, taking into account the effects on broader financial stability?

Partly for this reason, the Dodd-Frank financial reforms modified the Section 13(3) powers of the Fed, so it can in principle no longer provide the kind of specific support manifest in the Maiden Lane support.

What exactly will happen in the next financial crisis, of course, remains open to question. In any case, any banker who receives extraordinary support from the Fed – beyond regular use of the discount window – should immediately resign from being on the board of a Federal Reserve Bank. I say this although the Government Accountability Office did not find specific wrongdoing or conflicts of interest in how crisis funding was handled; it did, however, make a number of suggestions (see Pages 143-4) for strengthening governance at the regional Feds. I am proposing to go even further.

(I would also point out that last October, Senator Sanders’ staff questioned GAO if they had requested from the Fed any e-mails, phone calls, letters or other documents from CEOs of institutions that received emergency Fed lending while serving as directors at the Fed banks.  Such documentation could prove if they used their influence as board directors to receive loans for their firms.  GAO staff said that they did not ask for any of that information.  The depth of the GAO investigation remains controversial.)

We should apply to ourselves the same principles that would be applied by the United States Treasury if it were involved in lending to any other country in financial distress, either directly or through the International Monetary Fund. There is no way that the United States government would countenance a prominent banker’s continued involvement in the governance of a central bank while that central bank is providing financial support to that banker’s company.

I also do not know of any other of the 12 regional Reserve Banks in the Federal Reserve System where a banker has or would remain on the board of directors while negotiating a deal of this scale and nature. Mr. Dimon’s arrangement seems to be unique to New York. But this is still a first-order concern; Mr. Dimon runs the largest bank in the country. If any company is too big to fail today, it is JPMorgan Chase.

Second, I would like to raise the following question about Stephen Friedman, who was previously a Class C director of the New York Fed – and chairman of its board during the intense financial crisis period, from January 2008 through early 2009. (Class C directors are appointed by the Board of Governors, not by bankers, and are subject to different rules.)

According to the rules established by the Federal Reserve Board (see Pages 4-5 of this currently available guide on the Fed’s “Directors—Eligibility, Qualifications, and Rotation,” for this quotation and the one that follows):

“By statute, no Class C director may be a stockholder of any bank. In addition, to give effect to this prohibition, it is the board’s policy that no Class C director may own stock in a bank holding company, foreign bank, Edge Act or agreement corporation, subsidiary of a bank holding company, operating subsidiary of a bank, D.F.M.U., or S.I.F.I. (collectively, together with banks, referred to as “financial stock issuers”).”

(A D.F.M.U. is a designated financial market utility and a S.I.F.I. is a systemically important financial institution; both are categories introduced by the Dodd-Frank legislation, to extend the reach of federal regulators in general and the Fed in particular.)

This looks like a fairly comprehensive ban on holding financial stock, and the same requirements were in effect in 2008, although there are reasonable exceptions for stocks as held typically by diversified mutual funds:

“Class C directors are not disqualified by virtue of indirect ownership interests in financial stock issuers through limited types of widely held, diversified investment vehicles. In particular, Class C directors may hold interests in financial stock issuers through ownership of shares of a mutual fund so long as the mutual fund is registered under the Investment Company Act of 1940 and does not have a stated policy of concentrating in the financial services sector. Class C directors also may own shares of financial stock issuers through other diversified investment funds. For these purposes, an “investment fund” means a mutual fund, common trust fund of a bank, pension or deferred compensation plan, or any other investment fund which is widely held (i.e., more than 100 participants) and where the director has no ability to exercise control over the fund’s investment decisions. “Diversified” means that the fund holds no more than 5 percent of the value of its portfolio in the stock of any one financial stock issuer, and no more than 20 percent in the financial sector.”

But Mr. Friedman at that time was – and still is – a senior executive at Stone Point Capital, where, as a member of the six-person investment committee, he is involved in the fund’s investment decisions. Stone Point Capital specializes in financial-sector investments. For example, its portfolio in 2007 included Atlantic Capital Bank – a commercial bank situated in Georgia, owned by a Dallas-based bank holding company – as well as other financial services companies.

How was Mr. Friedman allowed to own these shares while being a Class C director? Was this a decision of the Federal Reserve Board of Governors or the New York Fed? (I’m not accusing Mr. Friedman of any wrongdoing; I’m confident he had permission to own bank stock. I’m asking who gave him permission and on what basis.)

Mr. Friedman bought Goldman Sachs stock after the moment when that company was effectively rescued by the Federal Reserve – by being allowed to become a bank holding company in September 2008. Mr. Friedman is a former chairman of Goldman Sachs and was a director of Goldman at the time.

A great deal of concern has been expressed about the timing of Mr. Friedman’s stock purchase, for example relative to Goldman falling under the supervision authority of the Fed, and he subsequently resigned before the expiration of his term. I am not implying that these events were related.

My concern is more fundamental. I don’t understand how a Class C director could have thought it was acceptable to buy any financial services company stock – the prohibition is on owning stock directly in any financial services company, not just for banks that belong to the Federal Reserve System.

Third, I have a further question about the role of Lee C. Bollinger, the president of Columbia University, who is a Class C director and current chairman of the board of the Federal Reserve Bank of New York. (I discussed his position more broadly in my June 14 review of Federal Reserve governance.)

According to the Federal Reserve Act (Section 4.20): the chairman of the board of directors of a Federal Reserve Act “shall be a person of tested banking experience.”

Mr. Bollinger is a distinguished First Amendment lawyer and an experienced university administrator. However, he does not have banking experience of any kind. He has not written or spoken publicly about banking or finance matters. As far as I can ascertain, the only interview he has ever given on anything related to banking was his recent conversation with The Wall Street Journal – the primary point of which was to defend Mr. Dimon staying on the New York Fed board. (I have asked Mr. Bollinger’s staff for any of his interviews, speeches or articles – academic or otherwise – on financial matters; they have been most cooperative but have not found anything that I missed.)

Please explain to me how having Mr. Bollinger as chairman of the board of the New York Fed is consistent with the Federal Reserve Act.

Taken together, these three questions raise a much bigger issue. If the intent and letter of the Federal Reserve Act are being followed in some ways and not in others – without proper notification to Congress or written rules available to the public explaining regarding exemptions and exceptions – how exactly does this help maintain the legitimacy of the Federal Reserve System?

An edited version of this blog post appeared this week on the NYT.com’s Economix blog.  It is used here with permission.  If you would like to reproduce the entire post, please contact the New York Times.

Who Wants Big Banks?

By James Kwak

Thirty years ago, Merton Miller, one of the giants of modern finance, was at a banking conference when a banker said he couldn’t raise more capital by selling stock because that would be too expensive: his stock was selling for only 50 percent of book value. Merton responded, “Book values have nothing to do with the cost of equity capital. That’s just the market’s way of saying: We gave those guys a dollar, and they managed to turn it into 50 cents.”*

Now that’s what a growing number of sophisticated investors are saying about today’s banking behemoths, especially JPMorgan Chase, Bank of America, Citigroup, Goldman Sachs, and Morgan Stanley. As Christine Harper reported in Bloomberg, stock in all of these banks is trading at or considerably below book value, while more focused competitors such as Wells Fargo and U.S. Bancorp trade for well above book value.

A brief aside: Book value refers to the amount that shareholders have historically invested in a firm, plus profits that have not been paid out to them as dividends. Market value is the amount that investors think the shareholders’ investment is worth today. The ratio of market value to book value is commonly used as a shortcut way to determine how well a company has performed.

For three years, various unimportant people like Simon and me, Fed bank presidents Thomas Hoenig and Richard Fisher, Senators Sherrod Brown and Ted Kaufman, and Andy Haldane of the Bank of England have been saying that the big banks should be broken up for policy reasons. Their size and interconnectedness create huge chokepoints of systemic risk; their complexity makes them too big to manage; their importance and power guarantee that they would be rescued in a financial crisis, as they were in 2008–2009; and that guarantee allows them to borrow money more cheaply than their competitors, distorting the competitive market.

But now people who matter (that is, people with real money) are also saying the banks should be broken up—because then they would be worth more to their shareholders. Harper quotes fund managers Michael Price and Ken Fisher saying that the banks would be worth more broken up than in their current form. In Fisher’s words, “It is not clear why a bank needs to do lots of activities in financial services that aren’t banking. It is not clear to me, other than perhaps in some very specialty cases, that being a bank helps you be an investment bank or an asset manager or an insurer.”

What’s especially remarkable is that the megabanks’ are performing poorly in spite of their implicit government guarantee, which gives them a competitive advantage. As Edward Kane has pointed out, the fact that the big banks aren’t more profitable than they are implies that, leaving aside their too-big-to-fail subsidy, they are actually less efficient than smaller banks.

The banks’ response is predictably laughable. Brian Moynihan, CEO of Bank of America, claimed that the bank’s customers needed them to be in consumer, corporate, and investment banking. I used to be a Bank of America retail customer. At the time, I was an executive of a software company. Did the fact that Bank of America has a lot of retail branches have any influence on our decisions about how to raise money? Of course not. I only recall us getting a bank loan once, and we got it from a bank that specializes in loans to private technology companies—and that is one one-thousandth the size of Bank of America. There are some synergies between banking activities—notably, within the set roughly known as “investment banking”—but it’s crazy to say that retail and investment banking have to be under the same roof. (If they did, Goldman would have streetcorner branches.)

So, if the banks would be more more broken up, why isn’t that happening? In general, the mechanism that breaks up inefficient conglomerates is the market for corporate control: takeovers. But the megabanks are virtually immune to takeover (except by each other, which would only make the problem worse). For one thing, the banking regulators wouldn’t let a private equity firm take over a systemically important megabank. For another, the banks are already leveraged to the hilt, so you couldn’t issue any new debt to fund a takeover. So to buy JPMorgan, you’d basically have to come up with $150 billion in cash, which isn’t going to happen.

So we get the current situation. In Price’s words: “Within the banks are wonderful assets. How long are the boards of directors going to stand by and take no action and let them be pounded? So far there’s no indication that any of these banks or boards of banks is willing to do anything about it.” In other words, CEOs and directors of midsize retail companies have to worry about being taken over by Bain Capital. But Jamie Dimon, Brian Moynihan, and Vikram Pandit have no one to fear. The basic rules of capitalism don’t apply to them.

* Thanks to Anat Admati for bringing this anecdote to my attention.

The End Of The Euro: What’s Austerity Got To Do With It?

By Simon Johnson

Most of the current policy discussion concerning the euro area is about austerity.  Some people – particularly in German government circles – are pushing for tighter fiscal policies in troubled countries (i.e., higher taxes and lower government spending).  Others – including in the new French government — are more inclined to push for a more expansive fiscal policy where possible and to resist fiscal contraction elsewhere.

The recently concluded G20 summit is being interpreted as shifting the balance away from the “austerity now” group, at least to some extent.  But both sides of this debate are missing the important issue.  As a result, the euro area continues its slide towards deeper crisis and likely eventual disruptive break-up.

The underlying problem in the euro area is the exchange rate system itself – the fact that these European countries locked themselves into an initial exchange rate, i.e., the relative price of their currencies, and promised to never change that exchange rate.  This amounted to a very big bet that their economies would converge in productivity – that the Greeks (and others in what we now call the “periphery”) would in effect become more like the Germans.  Alternatively, if the economies did not converge, the implicit presumption was that people would move – i.e., Greek workers go to Germany and converge to German productivity levels by working in factories and offices there.

It’s hard to say which version of convergence was more unrealistic.

In fact, the opposite happened.  The gap between German and Greek (and other peripheral country) productivity increased, rather than decreasing, over the past decade.  Germany, as a result, developed a large surplus on its current account – meaning that it exports more than it imports.  The other countries, including Greece, Spain, Portugal and Ireland, had large current account deficits – they were buying more from the world than they were selling.  These current account deficits were financed by capital inflows (including from Germany but also through and from other countries).

In theory, these capital inflows could have helped peripheral Europe invest, become more productive, and “catch up” with Germany.  In practice, the capital inflows – in the form of borrowing – created the pathologies that now roil European markets.

In Greece, successive governments overspent – financed by borrowing — as they attempted to stay popular and win elections.  Some of these same politicians will likely return to power following the elections last weekend.

Greece has already adopted a considerable degree of fiscal austerity.  Now it needs to find its way to growth.  Cutting the budget further won’t do that.  “Structural reform” – a favorite phrase of the G20 crowd – takes a very long time to be effective, particularly to the extent that it involves firing people in the short-run.  Throwing more “infrastructure” loans from Europe into the mix – for example, via the European Investment Bank – is unlikely to make much difference.  Additional loans of this kind are likely to end up being wasted or stolen as more and more well-connected people prepare for the moment when the euro is replaced by some form of drachma.

In Spain and Ireland, capital inflows – through borrowing by prominent banks – pumped up the housing market.  The bursting of that bubble has contracted their real economies and brought down all the banks that gambled on loans to real estate developers and construction companies.  Their problems are not much to do with fiscal policy.  As conventionally measured, both Ireland and Spain had responsible fiscal policies during the boom – but they were building up big contingent liabilities, in the form of irresponsible banking practices.

When the banks blew up in Ireland, this created a fiscal calamity for the government – mostly due to lost tax revenue.  It remains to be seen if Ireland can now find its way back to growth.

Spain still needs to recapitalize its banks – putting more equity in to replace what has been wiped out by losses — and, most important, must also find a renewed path to private sector growth.  Investors are rightly doubtful that the current policies are pointed in this direction.

In Portugal and Italy, the problem is a long-standing lack of growth.  As financial markets become skeptical of European sovereign debt, these countries need to show that they can begin grow steadily – and bring down their debt relative to GDP (something that has not happened for the past decade or so).  Fiscal austerity will not help, but fiscal expansion is also unlikely to do much – although presumably it could boost headline numbers for a quarter or two.  The private sector needs to grow, preferably through exporting and through competing more effectively against imports.

Peripheral Europe could, in principle, experience an “internal devaluation”, in which nominal wages and prices fall, and they become hypercompetitive relative to Germany and other trading partners.  As a matter of practical economic outcomes, it is hard to imagine anything less likely.

Some politicians still hint they could produce the rabbit of “full European integration” of the proverbial magic hat.  What does this imply about quasi-permanent transfers from Germany to Greece (and others)?  Who pays to clean up the banks?  What happens to all the government debt already outstanding?  And does this mean that all Europe would now adopt German-style fiscal policy?

These schemes are moving even beyond the far-fetched notions that brought us the euro.  “Europe only integrates in the face of crisis” is the last slogan of the euro-enthusiasts.  Perhaps, but crises have a tendency to get out of control – particularly when they produce political backlash.

Most likely, the European Central Bank will provide some big additional “liquidity” loans to bring down government bond yields as we head into the summer.  We should worry about how long any such feel-good policies last.  Historically, August is a good month for a big European crisis.

At these difficult times approach, some people will admonish governments to stand up to markets.  But when you are relying on capital markets to finance a large part of your continuing budget deficit and your debt rollover, this is empty bravado.

European governments should never have put their heads so far into the lion’s mouth with regard to public sector borrowing.  But the politicians – and many others – convinced themselves that they were all going to become more like Germany.

Peripheral Europe will never be like Germany.  It’s time to face the implications of that fact.

An edited version of this post appeared this morning on the NYT.com’s Economix blog.  It is used here with permission.  If you would like to reproduce the entire blog post, please contact the New York Times.

An Institutional Flaw At The Heart Of The Federal Reserve

By Simon Johnson.  This is a long blog post, about 2,800 words.

On the “PBS NewsHour” in late May, Treasury Secretary Timothy Geithner indicated that the continued presence of Jamie Dimon, the chief executive of JPMorgan Chase, on the board on the Federal Reserve Bank of New York creates a perception problem that should be addressed. He used the diplomatic language favored by finance ministers, but the message was loud and clear: Mr. Dimon should resign from the board of the New York Fed.

Mr. Dimon has been an effective opponent of financial reform over the past four years. He remains an outspoken advocate of the view that global mega-banks can manage their own risks, and he has stated publicly that the new international and national rules on capital requirements are “Anti-American.”

Mr. Dimon now finds himself at the center of a number of official investigations into how his bank could have lost so much money so quickly in its London-based trading operation – including whether adverse material information was disclosed to regulators and to markets in a timely manner.

(The Wall Street Journal reported this week that serious concerns about the London trading operation had been raised – but not made public – two years ago; the New York Times has reported similar concerns. On Wednesday, the Senate Banking Committee interviewed Mr. Dimon; the event was inconclusive, perhaps because JPMorgan Chase is a major donor to some members of the committee.)

On Monday, Lee Bollinger, chairman of the board of the New York Federal Reserve Bank and president of Columbia University, weighed in to contradict Mr. Geithner in no uncertain terms. The Wall Street Journal reported Mr. Bollinger’s view: Mr. Dimon should stay on the New York Fed’s board, and critics attacking the Fed have a “false understanding” of how it works. (Please note the correction to the original Wall Street Journal story, with an important change to the reporting of what Mr. Bollinger said.) This is a remarkable statement in part because Mr. Geithner is himself a former president of the New York Fed, so it is hard to see how he would have a false understanding of how the Fed works.

More generally, however, Mr. Bollinger’s intervention is inadvertently helpful, as it opens the door to a more productive conversation about the exact nature of the institutional weakness that lurks at the heart of the Federal Reserve System and that threatens our financial stability more broadly.

I stick up for the Federal Reserve System in many settings, including on Capitol Hill. We need a central bank that can provide emergency liquidity support when needed. That is a major lesson from the financial disaster and banking collapses that were an integral part of the Great Depression.

A significant number of Americans assert that the central bank should be abolished. With respect, I have argued elsewhere that this view is misguided. But the anti-Fed view continues to gain traction, and versions of it are increasingly manifest among mainstream Republicans (as well as some people on the left of the political spectrum).

The problem is that sensible liquidity support can easily become inappropriate subsidies, particularly when some financial institutions are considered too big to fail. Outsiders will never observe the real-time information on which central banks make decisions, so we need to be able to trust the people running our central bank, otherwise the system will go badly wrong — again.

As Esther George, president of the Kansas City Fed, put it recently, the “integrity, dignity and reputation of the Federal Reserve System” need to be preserved. As in ancient Rome, “Caesar’s wife must be above suspicion.”

Mr. Bollinger’s intervention brings a fresh spotlight to a deep governance problem at the heart of the Federal Reserve System – prominent financial sector executives and their close allies are much too involved in how the New York Fed operates. This is partly an anachronistic holdover from the original Federal Reserve Act of 1913 – and reflects the political milieu of that time, in which bankers had to be persuaded to accept a central bank (for more background and a lot of relevant technical detail, I recommend Edwin Walter Kemmerer’s “The ABC of the Federal Reserve System,” published in 1920).

But it is also an all-too-accurate reflection of where we stand today with regard to global mega-banks and the large, nontransparent and highly dangerous subsidies they extract from the rest of society by being too big to fail.

The people who run global mega-banks get the upside when things go well – they are paid based on their return on equity unadjusted for risk, so they prefer a lot of debt piled on top of very little equity. When things go badly, the downside is someone else’s problem – in the first instance, typically, the Federal Reserve’s.

The New York Fed has a special role – as the eyes and ears of the Federal Reserve System on Wall Street. It is also the repository for much of the expertise of the system on the complexities of modern capital requirements.

The board of directors of the New York Fed has, in part, the following mandate:

“In the exercise of its management oversight responsibilities, a Reserve Bank’s Board of Directors reviews and establishes with management the Bank’s annual goals and objectives, reviews and approves the budget, and conducts an independent appraisal of the performance of both the Bank (including its efficiency and productivity) and its president and first vice president. The Reserve Bank directors supervise, through a general auditor whom they appoint, and who reports directly to them, the maintenance of an effective system of internal auditing procedures.”

In the run-up to 2007, the complacency of the entire Fed System can be traced in part to the cozy relationship between the New York Fed (headed then by Mr. Geithner) and the Wall Street elite. We cannot let this happen again. Yet all too often with regard to financial reform today, we find the Fed lagging rather than leading the thinking and the implementation that Dodd-Frank calls for on many issues.

A version of the pre-2007 governance problem is playing out in full view, this time through interactions between different “classes” of directors at regional Feds. There are three directors in each “class”; nine directors in all at each regional Fed (the Federal Reserve provides this primer on its structure).

Class A directors are elected by member banks to represent banks. As a matter of practice, bankers have taken these positions – although there is no presumption that any of them should head a too-big-to-fail institution and no legal requirement that any should actually be bankers.

An elegant solution to the current problem would be to replace Mr. Dimon with a distinguished former banker, for example John Reed – previously chief executive of Citigroup and more recently a critic of very large banks. (Mr. Reed and I are both on the new systemic risk council created by Sheila Bair, the former chairman of the Federal Deposit Insurance Corporation. This general idea, but not Mr. Reed’s name, was suggested to me by a leading financial journalist.)

The awkwardness raised by the existence of Class A directors was recognized most recently by Congress during the debate on the Dodd-Frank financial reform legislation, as a result of which such directors are no longer involved in selecting the heads of the regional Federal Reserve Banks. They are also not allowed to be engaged in the selection and oversight of supervisory personnel. But this just shifts the exact locus of the problem.

Class B directors are elected by member banks “to represent the public.” This is a very strange concept; it’s hard to understand how it made sense even in 1913.

The heart of the matter is Class C directors, who are appointed directly by the Board of Governors also “to represent the public.” At most regional Feds today, these directors are typically the chief executive or chief financial officer of a significant regional business). At the New York Fed, however, the three Class C directors are all heads of nonprofits, at least two of which – Columbia University and the Metropolitan Museum of Art – have high-profile fund-raising efforts.

Only Class C directors (and Class B directors, if they are not involved in running a savings institution supervised by the Fed) are involved in the selection, appointment and compensation of Reserve Bank officers involved in supervision.

The Federal Reserve – both at the Board of Governors level and in New York — sets high ethical standards for its directors in generally.  But there are apparently no rules that effectively constrain the nature of interaction among directors.

According to a statement reported on Tuesday by The Guardian, a British newspaper, the JPMorgan Chase Foundation donated about $2 million to Columbia University in recent years. (I’m not sure this includes pledges and continuing support; we may learn more about this in the days ahead.)

There are many problematic issues associated with Mr. Dimon’s position on the board of the New York Fed, but he is kept well away from supervision. However, he is allowed to give money to Mr. Bollinger’s university. (I understand that the New York Fed allows a Class C director to solicit donations from a Class A director only in his “professional role” as president of Columbia University, not as a fellow board member. This strikes me as a meaningless distinction.)

If they saw such an arrangement at work in any other country, American officials would recoil in horror – as they did, for example, when the inner workings of countries such as Indonesia and Russia came into sharper focus during the 1990s and when the nature of governance in Greece became more widely appreciated recently.

Why then is such behavior tolerated not just in the United States, within the inner sanctum of arguably the single most powerful institution in the country?

To anyone who does not work at the Federal Reserve, this kind of monetary transfer to an organization run by a Class C director is obviously inappropriate. I’m surprised it is allowed under the ethics rules of Columbia University. (When I asked to put questions to Mr. Bollinger, I was told that he was traveling and unable to talk with me directly.)  However, through a representative, he did email a statement, part of which reads:

“The Federal Reserve Act embodies the policy judgment by Congress that by creating distinct classes of directors selected from different constituencies and diverse parts of the economy, and with different degrees of association with the financial industry, the Board will be constituted in a manner that allows it to effectively serve the public’s interest in expressing views on the state of the economy.  Significantly, neither the Board nor any of its individual members have any involvement in the Fed’s supervisory responsibilities over financial institutions, nor does the Board have any authority over supervised institutions such as JPMorgan.  Supervisory responsibilities are conducted by New York Fed officials under authority provided by the Federal Reserve Board.  Prior board chairs to have been drawn from New York’s major business, civic, cultural and educational institutions.  As required by statute, the chair is selected from among the Board’s Class C directors, appointed by the Board of Governors to represent the public.”

The board of the New York Fed may well express “views on the state of the economy.”  But it is also formally in charge of the organization in many respects.  If it were not, it could have been changed to a purely advisory group long ago.  Mr. Bollinger chairs not just the board but also its management and budget committee (MBC), which has specific oversight functions that are made quite clear on the New York Fed’s website).  Mr. Dimon is also a member of this committee.  Section 4 of the Committee’s charter reads in part:

“Except as otherwise prohibited in the Bank’s bylaws, the MBC is responsible for reviewing and endorsing the Bank’s strategic plan, the framework forcompensation of the Bank’s senior executives (Senior Vice President and above) and any policies regarding such compensation, the budget and self-evaluation of the Bank’s performance prepared by Bank management, prior to submission to the Board of Governors of the Federal Reserve System for action.”

And either the Class C directors of the New York Fed oversee the “selection, appointment, or compensation of Reserve Bank officers whose primary duties involve supervisory matters” or they do not.  This is not a question to which a satisfactory answer can be, “only a little bit.”  The fact that the Board of Governors is also involved is somewhat reassuring but not decisive – how on the outside are we to know who makes which final decision and what basis?

The good news is that the sum of donations from Jamie Dimon’s firm is small relative to the total fund-raising of Columbia University. A representative emailed me that, “regarding JPMorgan Chase and Columbia, it might be helpful to know that placed in the context of the $4.9 billion raised by the University since 2004, JPMorgan Chase is not one of Columbia’s major donors.   Specifically, over the eight-year period, JPMorgan has given $845,000, as well as $989,000 from its corporate foundation and $121,000 from employee matching gifts to support the university’s mission of scholarship, teaching and research.  This total represents .04% of overall university fundraising during this period.”  That should make it easy for them to return the money to the JPMorgan Chase Foundation. In fact, I don’t think that should even be a long or difficult conversation for the trustees of Columbia, which includes Vikram Pandit, the chief executive of Citigroup.  Avoiding even the appearance of a conflict of interest is most important for all involved.

To be clear, I am not accusing Mr. Bollinger of any wrongdoing. Mr. Bollinger is a leading legal scholar and one of the top thinkers on and defenders of the First Amendment. (I particularly recommend his “Uninhibited, Robust and Wide Open: A Free Press for a New Century,” published in 2010.)  I also understand that Mr. Bollinger has not personally solicited any donations from Jamie Dimon or JP Morgan Chase.

Of course, the question of who donates how much to elected officials permeates all of lobbying and modern American election campaigns – and it is an important theme in the commentary on Mr. Dimon’s gentle treatment by the Senate Banking Committee on Wednesday.  But just because bankers are powerful in general does not excuse the specific governance weaknesses within the Federal Reserve System – unless we are resigning ourselves to no longer be a serious country.

The fault here lies with the rules and expectations set by the Board of Governors of the Federal Reserve System. (I have for several weeks been seeking a meeting with any governor of the Federal Reserve, to present a petition I organized seeking Mr. Dimon’s removal from the board of the New York Fed. I am currently confident that I will be offered the opportunity to meet soon with senior staff; I will report on that conversation in this space.)

More broadly and with regard to the substance of the matter, Mr. Bollinger’s choice of words was unfortunate. No one has a false understanding of the situation. He has his understanding of how the New York Fed works within the Federal Reserve System. The rest of us, looking in, have a different understanding of the role of the Fed in the boom-bust-bailout cycle that has dominated the last decade or so.

The prevailing view at the top of Federal Reserve remains indifferent to how the rest of us view their legitimacy; they live in a bubble – in the old, pre-Greenspan meaning of the expression. And the Board of Governors is making a serious mistake in perpetuating this indifference (and borderline arrogance, in my experience) – jeopardizing, through inaction, the political future of the institution.

For Ben Bernanke, the chairman of the Federal Reserve, to attempt to shift the blame entirely onto Congress last week is, at best, disingenuous. The Fed Board of Governors has plenty of power to tighten governance at regional Feds, even within the framework provided by existing legislation – a point made in an important Op-Ed by Jonathan Reiss, an experienced financial services industry executive, which appeared last night on Bloomberg View.

In addition, the Federal Reserve Act should be amended. The boards of regional federal reserves should become advisory groups. If local boards are retained in any fashion, they should be filled with distinguished experts toward the end of their careers – as is the case at the National Transportation Safety Board.   (Mr. Reiss also has some very constructive suggestions.)

Columbia University should return the donations it received from JP Morgan and the JPMorgan Chase Foundation while Mr. Bollinger was a Class C director. And Mr. Dimon should resign from the board of the New York Fed.

An edited version of this post appears this morning on the NYT.com’s Economix blog; it is used here with permission.  If you would like to reproduce the entire column, please contact the New York Times.

Once More, With Feeling*

By James Kwak

Peter Orszag wrote an article for the latest Democracy** about political dysfunction and the “looming fiscal showdown” at the end of this year. A lot of it is a warmed-over description of political polarization, although Orszag ignores one of its most important causes: the growing influence of money in politics and the resulting need for politicians to go chasing after contributions from extremist billionaires. (Orszag instead subscribes to the theory that political polarization results from public polarization, which has been pretty well debunked by Fiorina and Abrams.)

Orszag’s recommendation, however, is spot-on: First let the Bush tax cuts expire; then, assuming that economic stimulus is necessary, push for a big, across-the-board, temporary tax cut. (Orszag proposes a payroll tax cut and an increase in the standard deduction; I’ve previously proposed a payroll tax cut.)

There are two major reasons why President Obama should pursue this strategy. First, one more time: the Bush tax cuts were bad policy a decade ago and they are bad policy now. Even if you believe in a large permanent tax cut, giving the vast majority of it to high earners, the investor class, and heirs of multi-millionaires is the wrong way to do it. We need to get rid of them, once and for all.

Second, trying to negotiate a partial repeal of the Bush tax cuts (Obama’s current strategy) is bound to fail. Grover Norquist said it very clearly:

“If there were no vote in Congress and taxes rose automatically, then no politicians would have voted for higher taxes and no elected official would have broken his or her pledge.

“But that is different from supporting a plan by some Democrats that would end some or all of these lower tax rates, higher per-child tax credits and the A.M.T. patches.”

In other words, any bill that would extend some but not all of the Bush tax cuts would violate the Taxpayer Protection Pledge, get zero Republican votes, and fail. Why? Because. Despite the fact that no Republican has violated the pledge in any significant manner since, oh, 1990, the administration thinks it can get such a bill to pass.

Instead, if you let all the Bush tax cuts expire, the baseline gets reset (for Pledge purposes). In January 2013, taxes will be at 1997 levels (negotiated by Clinton and Gingrich), and anything the administration proposes will count as a tax cut—not just for the Pledge, but also for public opinion. Republicans being the party of tax cuts, it would be strange to see a major tax cut with 100% Democratic support and 0% Republican support.

Yes, the Republicans might block it out of spite and try to shift the blame to the Democrats (for letting the Bush tax cuts expire), and they will have the debt ceiling to give them leverage. But I find it hard to see how getting the Bush tax cuts out of the way would make things worse—either for President Obama or for the country.

* The greatest TV episode of all time, by the way.

** The issue also includes my review of Why Nations Fail and what it means for contemporary America.

Why Raise Taxes on Poor People?

By James Kwak

My Atlantic column today is on the bizarre fixation that some conservatives have with taxing poor people, pointed out by Bruce Bartlett in his latest column. Here’s one explanation:

The other, even-more-disturbing explanation, is that Republicans see the rich as worthy members of society (the “producers”) and the poor as a drain on society (the “takers”). In this warped moral universe, it isn’t enough that someone with a gross income of $10 million takes home $8.1 million while someone with a gross income of $20,000 takes home $19,000. That’s called “punishing success,” so we should really increase taxes on the poor person so we can “reward success” by letting the rich person take home even more. This is why today’s conservatives have gone beyond the typical libertarian and supply-side arguments for lower taxes on the rich, and the campaign to transfer wealth from the poor to the rich has taken on such self-righteous tones.

Also, in some housekeeping news, I’ve switched to a personal Twitter account, @JamesYKwak. My blog posts should generate tweets in that account; Simon’s should generate tweets in the old account, @baselinescene. I’ll try to aggregate all the stuff I write in various places in my new Twitter stream.

The Baseline Scenario Facebook page should be aggregating both of our Twitter streams, but I had a little difficulty with it on Monday, so who knows. It seems like Facebook changes the way everything works every other Tuesday, so you never know when something will break.

Does Lindsey Graham Think Before He Opens His Mouth?

By James Kwak

“The debate on the debt is an opportunity to send the world a signal that we are going to remain the strongest military force in the world. We’re saying, ‘We’re going to keep it, and we’re going to make it the No. 1 priority of a broke nation.’  ”

That’s Lindsey Graham, as reported in the Times today (emphasis added).

Graham is trying to make the case that we should undo the automatic reductions in defense spending mandated by the Budget Control Act of 2011 (last summer’s the debt ceiling compromise). But as a conservative Republican, he is also wedded to the notion that the United States is “broke.” (Which, of course, is nonsense. If you’re not sure why, see chapter 5 of White House Burning.) Graham has also signed the Taxpayer Protection Pledge, meaning that the federal government can only solve its fiscal problems by cutting spending, not increasing tax revenues.

To make this balancing act work, Graham makes the claim that a country that is “broke” (again, his word) should continue to make military spending its top priority—including military intervention in both Syria and Iran. Does he really think that, under that assumption, we should continue slashing domestic spending so we can continue paying for expensive overseas adventures? Yet this is the unavoidable, nonsensical conclusion of today’s Republican orthodoxy.

Facebook’s Long-Term Problem

By James Kwak

Facebook went public a week ago, to great embarrassment. NASDAQ creaked under the strain and, more important, the price dropped from an offer price of $38 to as low as $27 over the next week as investors decided that Facebook wasn’t so exciting now that anyone off the street could buy it.

In the long run, this could become a footnote. (Remember all the criticism of Google’s IPO?) With over $200 million in profits per quarter, Facebook’s P/E ratio is still less than 100, which isn’t bad for an Internet company that dominates its market and hasn’t fully opened the advertising spigot yet.

In the long term, Facebook’s ambition is to succeed Google (or Apple, depending on how you see it) as the dominant company on the Internet. And that’s where its real problems lie.

The “buy” story for Facebook rests on the idea that it will become what non-technical people in the technology industry (most VCs, equity analysts, journalists, marketing people) call a platform. “Platform” is a poorly defined term in the technology world, but it roughly means “something that lots and lots of people depend on and that you can build other stuff on top of.”

Google is the closest thing we have to a privately-owned platform on the Internet. Everyone knows about Google’s dominance in Internet search. Google redefined the way we find things in the physical world—so well that it provides the maps for its arch-enemy’s flagship products, the iPhone and the iPad. When I arrived at Yale Law School in 2008, of the fourteen people in my small group, twelve used Gmail, and the other two soon switched to Gmail. Highly educated, twenty-something future law firm partners may not be the most representative group around, but they are one of the most valuable demographics. Google has so many deep hooks into people that the company can keep churning out more and more stuff, some of which makes money, as long as we’re alive.

Facebook wants to be this—and more. Its claim is that “social” is the key to the Internet: that when we do things online, we want to get the input of our “friends,” so we want Facebook embedded in everything we do; and so every website will have to pay Facebook for the privilege, or Facebook can serve us ads wherever we go.

The problem is that Facebook has already gone and messed up its core value proposition. At the beginning, the potentially great thing about Facebook was that you could use it to share personal information, stories, and photos with your friends, replacing the “new baby” email blast and solving a real problem that people face in our data-heavy world.

But Facebook no longer solves that problem, thanks to the 12% rule: on average, your news feed only shows you 12% of the items that your friends post. (Yes, that figure was originally reported as 16%, but now it’s down to 12%.) This means that Facebook is no longer a reliable way of sharing information. Instead, it’s turned into an information-consumption site: a place where you can giggle over the 12% of the stuff your friends posted that your other friends and Facebook’s algorithms are most giggle-worthy, but you can’t actually maintain meaningful contact with your real friends.

In other words, Facebook is the Internet’s #1 entertainment site.

What about the magic “Like” button, the glue that holds the social network together? Apparently, now if you “Like” something, you might show up as a paid ad in your friends’ news feeds (not the column of ads at the right). And there’s no way to turn this off. My first thought was: how is this different from Beacon, the much-maligned stealth advertising program that Facebook pulled under pressure? According to the Times, Facebook’s sophistic defense in court was that “it did not need consent because sponsored stories were actually ‘news,’ because all Facebook users were public figures to their friends.”

This is just another reason not to go around “Liking” commercial products—to go along with the more fundamental issue that there’s no particular reason to do so in the first place. Of course, lots of people will continue to do so because they enjoy it. But as any casual Facebook user realizes, the population is dividing into two categories: the people who really enjoy posting and “Liking,” and the rest of us who consume their content and occasionally comment on someone’s photo.

For most of Facebook’s hundreds of millions of “active users,” it’s just another content site: a place to waste a few hours (often in class) watching videos or reading funny articles. And that’s not much of a platform for anything. Sure, Facebook will make lots of money for lots of years. Facebook users are a valuable demographic (or they are for now, at least), and serving ads is cheap, so gross margins are high.

But for most people, Facebook is just delivering some laughs and smiles. That’s nice, as far as it goes. But it isn’t changing the world, much less the way the Internet works.

Jamie Dimon And The Fall Of Nations

By Simon Johnson

“Why Nations Fail: The Origins of Power, Prosperity, and Poverty,” by Daron Acemoglu and James Robinson, is a brilliant and sometimes breathtaking survey of country-level governance over history and around the world. Professors Acemoglu and Robinson discern a simple pattern – when elites are held in check, typically by effective legal mechanisms, everyone else in society does much better and sustained economic growth becomes possible. But powerful people – kings, barons, industrialists, bankers – work long and hard to relax the constraints on their actions. And when they succeed, the effects are not just redistribution toward themselves but also an undermining of economic growth and often a tearing at the fabric of society. (I’ve worked with the authors on related issues, but I was not involved in writing the book.)

The historical evidence is overwhelming. Many societies have done well for a while – until powerful people get out of hand. This is an easy pattern to see at a distance and in other cultures. It is typically much harder to recognize when your own society now has an elite less subject to effective constraints and more able to exert power in an abusive fashion. And given the long history of strong institutions in the United States, it appears particularly difficult for some people to acknowledge that we have serious governance issues that need to be addressed.

The governance issue of the season is Jamie Dimon’s seat on the board of the Federal Reserve Bank of New York. Mr. Dimon is the chief executive of JPMorgan Chase, currently the largest bank in the United States. This bank is “too big to fail” – meaning that if it were to get into difficulties, substantial financial support would be provided by the Federal Reserve System (and perhaps other parts of government) to prevent it from collapsing.

I am well aware of the moves afoot to carry out the intent of the Dodd-Frank reform legislation and to make it possible for such banks to fail, with consequent losses for their creditors. In my assessment, we are still a long way from putting in place the necessary resolution mechanisms and backing them up with sufficient political will.

If Greece were to default tomorrow – a hypothetical scenario, although I am worried about the current European trajectory – and this had devastating effects on the European and thus the United States financial system, would JPMorgan Chase be allowed to go bankrupt in same fashion as Lehman Brothers? It would not.

The Federal Reserve Bank of New York would be a key player in the decision in how to provide support and on what basis to huge financial institutions in distress – although the final determination would presumably rest with the Board of Governors in Washington.

In the Acemoglu and Robinson tour de force, I find one of the greatest elite wealth-making (for themselves) strategies of all time to be underemphasized. Persuade the government to let you build a big bank; take a great deal of risk in that bank (particularly by increasing leverage, i.e., debt relative to equity); pay yourself based on the return on equity, unadjusted for risk; get cash payouts while times are good; and when events turn against you, the central bank can bail you out – and keep you in place because you are regarded as indispensable. This is the history of modern America.

We had strong institutions for a long time in this country – including effective checks on the power of bankers. Many people remember that history and still hold its image in their mind’s eye as they look at modern Wall Street. It’s time to wake up. In recent decades we abandoned the governance mechanisms that previously served us well. Global megabanks have obtained excessive and inappropriate power – the power to take a great deal of risk, with cash for their executives on the upside and huge damage for the rest of us on the downside.

Since I wrote about this issue here last week, a great deal of support has been expressed for the recommendation that Jamie Dimon should step down from the board of the New York Fed – including by over 32,000 people who signed the petition I drafted. (The petition is addressed to the Board of Governors of the Federal Reserve, as only they have the power to remove a director of a Federal Reserve Bank. I have requested an appointment with a governor on Monday, in order to deliver this petition and discuss the substantive issues; a relevant Fed staff member is currently checking availability. I hope to write about that meeting here next week.)  (Update: no Fed governor is apparently available next week; we are looking for future dates.)

The pressure on Mr. Dimon is increasing with a steady flow of news articles concerning the care with which risk has been managed at his bank – including the suggestion that the board’s risk committee lacks sufficient experience to understand or monitor the complexity of JPMorgan’s operations. (See also the coverage from Forbes and CBS MoneyWatch.)

We need an independent inquiry into how exactly JPMorgan lost so much money so quickly on its London trading operations – which supposedly were just “hedging.” It would also be helpful to know how Jamie Dimon, widely regarded as a good risk manager, did not know what was happening in London until Bloomberg News brought it to his attention – and why even then he denied there was a serious issue. Is this is a systematic breakdown in management and risk control systems? What exactly went wrong with the relevant models? What can we learn that would help improve the safety of the financial system? Have the largest banks grown too big and too complex to be managed safely?

More broadly, how can we rely on the Federal Reserve to oversee and constrain the actions of Mr. Dimon while he continues to sit on the board of the New York Fed – with the job of overseeing and potentially constraining the actions of that organization?

Esther George, president of the Kansas City Fed, made a strong statement at the end of last week, emphasizing that all Federal Reserve Bank board members have a responsibility to uphold the integrity and perceived legitimacy of the Federal Reserve System. She ended with a powerful line that cuts to center of the current debate: “No individual is more important than the institution and the public’s trust.”

Those who would still prefer to keep Mr. Dimon in his current position rely on some combination of three counterarguments.

First, one line is that Mr. Dimon is elected to “represent the banks,” so he is just doing his job when he argues his corner – for example, against financial sector reform. Ernest Patrikis, former general counsel of the New York Federal Reserve, takes exactly this position; I quoted him in my column last week.

As a factual matter, any such statement defining Mr. Dimon’s responsibility as a board member at the New York Fed is inaccurate. Here are two passages from the first paragraph of the Guide to Conduct from the Board of Governors’ Web site:

“Directors of Federal Reserve Banks and branches have a special obligation for maintaining the integrity, dignity, and reputation of the Federal Reserve System.”

“To ensure the proper performance of System business and the maintenance of public confidence in the System, it is essential that directors, through adherence to high ethical standards of conduct, avoid actions that might impair the effectiveness of System operations or in any way tend to discredit the System.”

Ms. George made this point clearly and effectively in her press release last week. All board members have a responsibility – first and foremost – to the Federal Reserve System. If they have a problem with that, they should avoid serving or step down when appropriate.

For example, Jeffrey R. Immelt – chief executive of General Electric – stepped down from the New York Fed board in April 2011 when it became clear that GE Capital would be regulated by the Fed as a systemically important financial institution (and as a thrift). That was an entirely appropriate decision, removing any perception of a potential conflict of interest.

The second line – including from Mr. Dimon himself – is that at the New York Fed he plays “an advisory role.”

Again, this is not factually accurate. Here is some relevant text from the Guide to Conduct:

“In their capacity as directors, these individuals are charged by law with the responsibility of supervising and controlling the operations of the Reserve Banks, under the general supervision of the Board of Governors, and for ensuring that the affairs of the Banks are administered fairly and impartially.”

Plenty of governmental or quasi-governmental bodies have advisory groups. I’m on two – for the Congressional Budget Office (for economic forecasts) and for the Federal Deposit Insurance Corporation (for the resolution or liquidation of systemically important financial institutions). Advisory groups do not oversee budgets and are not involved in personnel decisions.

I have no problem with the Federal Reserve – or anyone else in government – seeking and receiving input on local economic conditions. But that is no reason for a “too big to fail” banker or any other excessively powerful special interest to be on the board of the New York Fed.

The board of the New York Fed is not “advisory.” If Mr. Dimon really thinks that, he needs another orientation session with New York Fed officials. Or he could read the Federal Reserve Act.

The third position acknowledges that governance at the regional Feds is an anachronism, but argues that Mr. Dimon has done nothing wrong and that these boards can be fixed only by legislative action (see this editorial in The Financial Times on Wednesday, for example).

To be clear, I am not accusing Mr. Dimon or anyone else of any wrongdoing. I am calling for an independent inquiry into the JPMorgan losses – along the lines that my M.I.T. colleague Andrew Lo has suggested for all serious financial “accidents.”

I am also agreeing with Treasury Secretary Timothy F. Geithner who, when asked about Mr. Dimon’s role at the New York Fed, told the PBS NewsHour:

“It is very important, particularly given the damage caused by the crisis, that our system of oversight and safeguards and the enforcement authorities have not just the resources they need, but they are perceived to be above any political influence and have the independence and the ability to make sure these reforms are tough and effective so we protect the American people, again, from a crisis like this.”

Legislative action to further adjust the governance of the New York Fed will not happen this year and is not likely in the near future. Frankly, saying in this context “we’ll wait for Congress” is the functional equivalent of saying, “let’s not fix it.”

Undermining the “integrity, dignity, and reputation of the Federal Reserve System” in current fashion poses grave risks. A powerful elite has risen with control over global megabanks – and the ability to mismanage their way into disaster, with huge negative implications for the broader economy.

We should be strengthening the power of the New York Fed and other institutions to constrain reckless risk-taking. Instead, we are standing idly by while our “extractive elite” (to use a great term from Professors Acemoglu and Robinson) enrich themselves and endanger the rest of us.

If you want to see where we are heading, on our current course, read “Why Nations Fail.”

A version of this post appeared this morning on the NYT.com’s Economix blog; it is used here with permission.  If you would like to reproduce the entire blog post, please contact the New York Times.

The End Of The Euro: A Survivor’s Guide

By Peter Boone and Simon Johnson

In every economic crisis there comes a moment of clarity.  In Europe soon, millions of people will wake up to realize that the euro-as-we-know-it is gone.  Economic chaos awaits them.

To understand why, first strip away your illusions.  Europe’s crisis to date is a series of supposedly “decisive” turning points that each turned out to be just another step down a steep hill.  Greece’s upcoming election on June 17 is another such moment.  While the so-called “pro-bailout” forces may prevail in terms of parliamentary seats, some form of new currency will soon flood the streets of Athens.  It is already nearly impossible to save Greek membership in the euro area: depositors flee banks, taxpayers delay tax payments, and companies postpone paying their suppliers – either because they can’t pay or because they expect soon to be able to pay in cheap drachma.

The troika of the European Commission (EC), European Central Bank (ECB), and International Monetary Fund (IMF) has proved unable to restore the prospect of recovery in Greece, and any new lending program would run into the same difficulties.  In apparent frustration, the head of the IMF, Christine Lagarde, remarked last week, “As far as Athens is concerned, I also think about all those people who are trying to escape tax all the time.”

Ms. Lagarde’s empathy is wearing thin and this is unfortunate – particularly as the Greek failure mostly demonstrates how wrong a single currency is for Europe.  The Greek backlash reflects the enormous pain and difficulty that comes with trying to arrange “internal devaluations” (a euphemism for big wage and spending cuts) in order to restore competitiveness and repay an excessive debt level.

Faced with five years of recession, more than 20 percent unemployment, further cuts to come, and a stream of failed promises from politicians inside and outside the country, a political backlash seems only natural.  With IMF leaders, EC officials, and financial journalists floating the idea of a “Greek exit” from the euro, who can now invest in or sign long-term contracts in Greece?  Greece’s economy can only get worse.

Some European politicians are now telling us that an orderly exit for Greece is feasible under current conditions, and Greece will be the only nation that leaves.  They are wrong.  Greece’s exit is simply another step in a chain of events that leads towards a chaotic dissolution of the euro zone.

During the next stage of the crisis, Europe’s electorate will be rudely awakened to the large financial risks which have been foisted upon them in failed attempts to keep the single currency alive.  If Greece quits the euro later this year, its government will default on approximately 300 billion euros of external public debt, including roughly 187 billion euros owed to the IMF and European Financial Stability Facility (EFSF).

More importantly and currently less obvious to German taxpayers, Greece will likely default on 155 billion euros directly owed to the euro system (comprised of the ECB and the 17 national central banks in the euro zone).  This includes 110 billion euros provided automatically to Greece through the Target2 payments system – which handles settlements between central banks for countries using the euro.   As depositors and lenders flee Greek banks, someone needs to finance that capital flight, otherwise Greek banks would fail.  This role is taken on by other euro area central banks, which have quietly leant large funds, with the balances reported in the Target2 account.  The vast bulk of this lending is, in practice, done by the Bundesbank since capital flight mostly goes to Germany, although all members of the euro system share the losses if there are defaults.

The ECB has always vehemently denied that it has taken an excessive amount of risk despite its increasingly relaxed lending policies.  But between Target2 and direct bond purchases alone, the euro system claims on troubled periphery countries are now approximately 1.1 trillion euros (this is our estimate based on available official data).  This amounts to over 200 percent of the (broadly defined) capital of the euro system.  No responsible bank would claim these sums are minor risks to its capital or to taxpayers.  These claims also amount to 43 percent of German Gross Domestic Product, which is now around 2.57 trillion euros.  With Greece proving that all this financing is deeply risky, the euro system will appear far more fragile and dangerous to taxpayers and investors.

Jacek Rostowski, the Polish Finance Minister, recently warned that the calamity of a Greek default is likely to result in a flight from banks and sovereign debt across the periphery, and that – to avoid a greater calamity – all remaining member nations need to be provided with unlimited funding for at least 18 months.  Mr. Rostowski expresses concern, however, that the ECB is not prepared to provide such a firewall, and no other entity has the capacity, legitimacy, or will to do so.

We agree:  Once it dawns on people that the ECB already has a large amount of credit risk on its books, it seems very unlikely that the ECB would start providing limitless funds to all other governments that face pressure from the bond market.  The Greek trajectory of austerity-backlash-default is likely to be repeated elsewhere – so why would the Germans want the ECB to double- or quadruple-down by suddenly ratcheting up loans to everyone else?

The most likely scenario is that the ECB will reluctantly and haltingly provide funds to other nations – an on-again, off-again pattern of support — and that simply won’t be enough to stabilize the situation.  Having seen the destruction of a Greek exit, and knowing that both the ECB and German taxpayers will not tolerate unlimited additional losses, investors and depositors will respond by fleeing banks in other peripheral countries and holding off on investment and spending.

Capital flight could last for months, leaving banks in the periphery short of liquidity and forcing them to contract credit – pushing their economies into deeper recessions and their voters towards anger.  Even as the ECB refuses to provide large amounts of visible funding, the automatic mechanics of Europe’s payment system will mean the capital flight from Spain and Italy to German banks is transformed into larger and larger de facto loans by the Bundesbank to Banca d’Italia and Banco de Espana– essentially to the Italian and Spanish states.  German taxpayers will begin to see through this scheme and become afraid of further losses.

The end of the euro system looks like this.  The periphery suffers ever deeper recessions — failing to meet targets set by the troika — and their public debt burdens will become more obviously unaffordable. The euro falls significantly against other currencies, but not in a manner that makes Europe more attractive as a place for investment.

Instead, there will be recognition that the ECB has lost control of monetary policy, is being forced to create credits to finance capital flight and prop up troubled sovereigns — and that those credits may not get repaid in full.  The world will no longer think of the euro as a safe currency; rather investors will shun bonds from the whole region, and even Germany may have trouble issuing debt at reasonable interest rates.  Finally, German taxpayers will be suffering unacceptable inflation and an apparently uncontrollable looming bill to bail out their euro partners.

The simplest solution will be for Germany itself to leave the euro, forcing other nations to scramble and follow suit.  Germany’s guilt over past conflicts and a fear of losing the benefits from 60 years of European integration will no doubt postpone the inevitable.  But here’s the problem with postponing the inevitable – when the dam finally breaks, the consequences will be that much more devastating since the debts will be larger and the antagonism will be more intense.

A disorderly break-up of the euro area will be far more damaging to global financial markets than the crisis of 2008.   In fall 2008 the decision was whether or how governments should provide a back-stop to big banks and the creditors to those banks.  Now some European governments face insolvency themselves.  The European economy accounts for almost 1/3 of world GDP.  Total euro sovereign debt outstanding comprises about $11 trillion, of which at least $4 trillion must be regarded as a near term risk for restructuring.

Europe’s rich capital markets and banking system, including the market for 185 trillion dollars in outstanding euro-denominated derivative contracts, will be in turmoil and there will be large scale capital flight out of Europe into the United States and Asia.  Who can be confident that our global megabanks are truly ready to withstand the likely losses?  It is almost certain that large numbers of pensioners and households will find their savings are wiped out directly or inflation erodes what they saved all their lives.  The potential for political turmoil and human hardship is staggering.

For the last three years Europe’s politicians have promised to “do whatever it takes” to save the euro.  It is now clear that this promise is beyond their capacity to keep – because it requires steps that are unacceptable to their electorates.  No one knows for sure how long they can delay the complete collapse of the euro, perhaps months or even several more years, but we are moving steadily to an ugly end.

Whenever nations fail in a crisis, the blame game starts. Some in Europe and the IMF’s leadership are already covering their tracks, implying that corruption and those “Greeks not paying taxes” caused it all to fail.  This is wrong:  the euro system is generating miserable unemployment and deep recessions in Ireland, Italy, Greece, Portugal and Spain also.  Despite Troika-sponsored adjustment programs, conditions continue to worsen in the periphery.  We cannot blame corrupt Greek politicians for all that.

It is time for European and IMF officials, with support from the US and others, to work on how to dismantle the euro area.  While no dissolution will be truly orderly, there are means to reduce the chaos.  Many technical, legal, and financial market issues could be worked out in advance.  We need plans to deal with: the introduction of new currencies, multiple sovereign defaults, recapitalization of banks and insurance groups, and divvying up the assets and liabilities of the euro system.  Some nations will soon need foreign reserves to backstop their new currencies.  Most importantly, Europe needs to salvage its great achievements, including free trade and labor mobility across the continent, while extricating itself from this colossal error of a single currency.

Unfortunately for all of us, our politicians refuse to go there – they hate to admit their mistakes and past incompetence, and in any case, the job of coordinating those seventeen discordant nations in the wind down of this currency regime is, perhaps, beyond reach.

Forget about a rescue in the form of the G20, the G8, the G7, a new European Union Treasury, the issue of Eurobonds, a large scale debt mutualisation scheme, or any other bedtime story.  We are each on our own.

A version of this material appears also on the Huffington Post.