“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.

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.

There are two diametrically opposed views of how the largest financial companies in our economy operate. On the one hand, there are those like Charles Ferguson, director of the Academy Award-winning documentary “Inside Job” and author of the new book, “Predator Nation.” Mr. Ferguson takes the view that greed and immorality now prevail to an excessive degree at the heart of Wall Street.

Academics and other experts have become corrupted, the responsible regulators have been intellectually captured, and law enforcement officials refuse to act – despite the accumulation of evidence before their eyes.

“Inside Job” was gripping and emotional; “Predator Nation” contains many more specific details and evidence, as this excerpt dealing with academics (one Republican and one Democrat) makes clear.

The second view is that the people in charge of large banks and bank holding companies have done nothing wrong. To see this view in action, look no further than this week’s debate about whether Jamie Dimon, chief executive of JPMorgan Chase, should resign from the board of the Federal Reserve Bank of New York. The New York Fed oversees his organization, including assessing whether it is taking dangerous risks, so there are reasonable questions about whether this creates a potential conflict of interest.

A balanced account of this debate appeared in American Banker, which kindly agreed to bring the entire article out from behind its paywall. The strongest statement from the pro-Dimon corner comes from Ernest Patrikis, a partner with White & Case L.L.P. and former general counsel of the New York Federal Reserve:

“I don’t see Jamie Dimon’s conflict of interest. What’s the conflict? He’s expected to represent the banks’ view, the lenders’ view.”

Yet even people who are generally sympathetic to banks feel that there is a perception problem with Mr. Dimon’s position. Treasury Secretary Timothy Geithner said exactly that to the “PBS NewsHour” last week.

Kenneth Guenther, the former head of the Independent Community Bankers of America, told American Banker:

“I do think there is a public perception problem when the head of the largest bank gets into a massive highly publicized trading loss, which he articulately condemns, when he’s tied to the Federal Reserve Bank of New York, and the president of the Federal Reserve Bank is vice chair of the Federal Open Market Committee. There is a perception problem. I don’t think there’s any way around it.”

What exactly is a conflict of interest? Narrowly defined, an actual conflict of interest would involve using public office for personal financial gain – and would be a matter for criminal prosecution.

There is only one case that I am aware of in which a director of the New York Fed went to prison for such a violation – Robert A. Rough was indicted in December 1988, on charges that he leaked sensitive interest-rate information to a brokerage firm. He was sentenced to six months in prison.

More broadly, however, in modern America we use the term “conflict of interest” when we believe someone may be promoting private interests while acting in a public role.

Allowing big bankers to become too influential is an important part of what Mr. Ferguson writes about. If you don’t understand the channels through which influence actually works in the United States today, you need to see “Inside Job,” which touched a nerve and won an Oscar precisely because it is profoundly undemocratic when powerful people are able behave in this way.

Elizabeth Warren, a Democratic candidate for the Senate in Massachusetts, said Mr. Dimon should resign from the board of the New York Fed. The recent spectacular trading losses at his company require a full investigation, which should include an examination of how the supervision process broke down. How can this be anything other than awkward for the New York Fed while Mr. Dimon – hardly known as a shrinking violet – sits on its board?

Senator Bernie Sanders, independent of Vermont, would go further, proposing legislation that would remove any bankers from the boards of Federal Reserve banks. For more background, you may want to consult Page 65 and other parts of this report from the Government Accountability Office, which deal with potential conflicts of interest in the Federal Reserve System, or at least read Senator Sanders’s summary of the report.

To be clear, directors of the New York Fed are in principle kept away from bank-supervision matters – a point that was codified in December 2010, following the passage of the Dodd-Frank financial reform legislation.

Under the current bylaws, directors are not involved in appointing, monitoring or compensating the head of supervision, although they have input into the selection and remuneration of the head of research (an important position, as this person helps to shape the Fed’s view on bank capital and all technical matters relative to risk management), and they oversee other management issues. Bill Dudley, the president of the New York Fed, interacts with the board at least several times a month, as you can see from his schedule.

Mr. Dudley, a former Goldman Sachs executive, was originally appointed president of the New York Fed by a board that included Mr. Dimon as a voting member.  The Dodd-Frank legislation stripped so-called “Class A” directors, of which Mr. Dimon is one, from voting on such appointments.  Mr. Dudley was subsequently reappointed by the Class B and Class C directors of the board.  (For more on the different classes of directors, see this page)

Mr. Dimon has also been an outspoken opponent of financial reform of late – including the Volcker Rule (on proprietary trading) and attempts to strengthen capital requirements. He is an intensely political figure, despite the fact that an important footnote in the Board of Governors’ policy on political activity by Reserve Bank Directors says,

In all instances, directors should avoid any political activity that would publicly identify the director as being associated with the Federal Reserve System or would embarrass the System or raise questions about the independence of the director or the ability to perform Federal Reserve duties.

Directors are allowed to lobby and engage in other specific activities. The issue is whether these actions undermine the effectiveness of the New York Fed.

There is recent precedent for New York Fed board members resigning when there is a perceived conflict of interest – and when the legitimacy of the Federal Reserve System would undoubtedly have been undermined if they had refused to resign.

Dick Fuld, the chief executive of Lehman Brothers, resigned (on Thursday, September 11, 2008) shortly before his firm collapsed (on September 15, but its last day of business was Friday, September 12) – and presumably because the New York Fed was at the center of intense discussions about who should suffer what kind of losses or get rescued. Did he resign of his own volition or was he encouraged to resign?

Stephen Friedman, then the former chief executive of Goldman Sachs, resigned in early 2009 when it became clear that he had bought Goldman stock after Goldman became a bank and therefore fell under the supervision of the New York Fed.

Mr. Friedman was chairman of the New York Fed at that time. (To be clear, Mr. Friedman was not involved in any of the decisions that saved Goldman in fall 2008, and I am not accusing him of using his public position for personal financial gain.)

For those of you keeping score at home, Mr. Fuld was a Class B director and Mr. Friedman was a Class C director.

If you think Mr. Dimon should resign from the New York Fed, you can express your opinion by signing this on-line petition, which I drafted. (For more background on why he should resign, see this blog post.)

If Mr. Dimon refuses to resign – as seems likely – he can removed by the Board of Governors of the Federal Reserve System (not by his fellow directors at the New York Fed). The petition is therefore addressed to the Board of Governors.

There is an undeniable perception problem. It is damaging the legitimacy of the Federal Reserve. As Treasury Secretary Geithner implied, this must be “addressed” – a great Washington euphemism – by Mr. Dimon leaving the board of the New York Fed.

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

Jamie Dimon, CEO of JP Morgan Chase, is a member of the board of the New York Federal Reserve Bank.  Mr. Dimon’s role there is sometimes presented as “advisory” but he sits on the Management and Budget Committee; here is the committee’s charter, which includes reviewing and endorsing “the framework for compensation of the Bank’s senior executives (Senior Vice President and above)”.  His advice apparently extends to important aspects of how the New York Fed operates, including its personnel policies.

The New York Fed is a key part of our regulatory and supervisory apparatus, involved in overseeing the activities of banks and bank holding companies, like JP Morgan Chase (currently the largest bank in the US).  Within the Federal Reserve System, the New York Fed also has some of the deepest expertise on financial markets and complex products, such as derivatives.  Almost all of the relevant supervision takes place behind closed doors, with representatives of the industry – including big banks – typically taking the position that they should be allowed to operate in a particular way or use various kinds of risk models.  The staff of the New York Fed often has a decisive voice in determining what kinds of risks are acceptable for systemically important financial institutions.

In recent weeks, risk management apparently broke down completely at JP Morgan Chase.  Even the most sympathetic accounts portray Mr. Dimon as out of touch with large parts of his business.  There are also press reports that one or more of Mr. Dimon’s hand-picked executives failed to understand and report on risks that became greatly magnified and quickly got out of control.  Puzzles remain about what exactly Mr. Dimon did not know and when he did not know it, including the question of whether he disclosed all adverse material information in a timely and appropriate manner.  Presumably, the New York Fed will be involved – directly or indirectly – in ongoing and future investigations (including answering questions about what its staff did or did not know).

At the end of last week, Treasury Secretary Tim Geithner called for Mr. Dimon to step down from the board of the New York Fed.  Mr. Geithner is former president of the New York Fed and fully understands how the board operates – and how big bankers win friends and influence people.  Mr. Geithner spoke in the usual Treasury Department diplomatic code – he suggested there is a “perception” problem that must be addressed.  To officials, this is as clear a statement as is needed.  As chairman of the Financial Stability Oversight Council, Mr. Geithner is ultimately responsible for the health of the financial system and its systemically important components.  He is telling Mr. Dimon to go.

Mr. Dimon is likely to resist, but the blatant conflicts of interest in the current situation are too great.  Mr. Dimon should not be in any position to influence or affect an organization that plays such an essential role in overseeing the activities of his company.  Given the evident breakdowns in risk management at JP Morgan Chase and the possibility that there were again problems with bank supervision in this instance, we need to have a proper independent investigation – and to changes the parameters of this banker-supervisor relationship going forward.

To have Mr. Dimon involved in overseeing the management of the New York Fed, an organization that oversees his activities, decisions, and potential losses, is no longer acceptable.  We do not accept such conflicts of interest in other parts of American society and we should not accept them in this instance.

JPMorgan Chase is too big to fail. As the largest bank-holding company in the United States, with assets approaching $2.5 trillion as reported under standard American accounting principles, it is inconceivable that JPMorgan Chase would be allowed to collapse now or in the near future. The damage to the American economy and to the world would be too great.

The company’s recent trading losses therefore call for greater public scrutiny than would be case for most private enterprise – and demand an independent investigation into exactly what happened. (Dennis Kelleher of Better Markets has already called for exactly this.) The investigation begun by the F.B.I. is unlikely to be sufficiently public.  Given the strong political connections between JP Morgan and the Obama administration, it would also be better to have an investigation led by a completely independent counsel.

Hopefully, too-big-to-fail is not forever. The Federal Deposit Insurance Corporation is working on a mechanism that could conceivably allow that agency to handle the “failure” of a bank-holding company while protecting the creditors of operating subsidiaries – limiting the potential contagion effect.

But this mechanism is not yet in place, it does not currently apply to cross-border banking (remember that JPMorgan Chase’s losses are in London), and even the F.D.I.C.’s acting chairman, Martin J. Gruenberg, was careful in describing its likely efficacy in a speech last week.

(Disclosure: I’m on the F.D.I.C.’s Systemic Resolution Advisory Committee, and I’ve helped the F.D.I.C. with some outreach activities, designed to help them receive constructive feedback on resolution. I am not paid by the F.D.I.C.)

In effect, JPMorgan Chase operates with the implicit backing of the United States government – primarily in the form of actual and potential access to borrowing from the Federal Reserve, with the implication that the Treasury could also provide support. Being effectively backed by the full faith and credit of the government is a great help; it lowers a bank’s funding costs because it reduces the risk to creditors. JPMorgan Chase and the other big banks in the American economy are effectively government-sponsored (and subsidized) enterprises.

There is no kind of market involved in determining the franchise value of mega-banks; this is a government subsidy scheme, pure and simple. People on the right of the political spectrum understand this, as do people on the left; see my blog post last week on the extent of cross-partisan agreement on this issue.

I would add to that list former Gov. Mike Huckabee of Arkansas. When I appeared on his radio show on Monday afternoon, we were in complete agreement on the need to break up or otherwise constrain the size of big banks.

There are many unanswered questions about the JPMorgan Chase losses and a great deal of informed guesswork about exactly what went wrong. By his own admission, Jamie Dimon, the chief executive, was unaware of what was happening on the relevant trading desk until Bloomberg News reporters brought it to his attention.

At that time he dismissed any concerns as a “tempest in a teapot.” In the weeks that followed, this supposed “hedge” – or risk-reduction strategy – blew up badly.

The question is not why a trader made a mistake; this can happen anywhere. The issue is how this was handled and reported by JPMorgan Chase’s risk-management professionals and their systems – believed by many insiders to be the best in the business.

Here are five questions that an independent investigation should consider:

1. What exactly was the trade? Who approved and reviewed the trade?

2. To what extent were the mistakes encouraged or condoned by particular quantitative models, for example those popularly known as Value-at-Risk? (For a critique, see Pablo Triana’s book, “The Number That Killed Us.”)

3. What did Mr. Dimon know and when did he know it? Was there disclosure to the board and to shareholders with appropriate timing? This is among the specific concerns raised by Mr. Kelleher.

4. Does the board have adequate depth of experience along the relevant dimensions of risk management?

5. What interactions did Mr. Dimon or any of his colleagues have with the Federal Reserve Bank of New York before and during these losses were incurred? Mr. Dimon is on the board of that institution, where his role is described as “advisory.” But on what exactly did he advise them in recent months and years, particularly with regard to risk management and capital levels in systemically important banks?

On the one hand, we hear from bankers that supervisors are watching them closely – and even undermining their business. On the other hand, clearly someone was not paying attention. Why not?

This is not about conducting a witch hunt. It is about establishing the facts and understanding if anything about standard operating procedures and emergency protocols should be examined.

The right analogy is National Transportation Safety Board investigations – a suggestion that has been made by Andrew Lo, my colleague at M.I.T., and his co-authors. We learn a great deal when companies actually go bankrupt; e.g., about Enron (see the excellent book “The Smartest Guys in the Room,” by Bethany McLean and Peter Elkind) and about Lehman (see the bankruptcy examiner’s report).

But we need to investigate near-misses as well.

This is awkward for the White House – look at any of Ben White’s recent pieces on the links between Wall Street and the Obama administration. But the power of big banks on Wall Street makes this kind of investigation even more necessary – see the reporting of Matt Taibbi for some graphic details.

Congress may also want to get involved, at least to understand if Dodd-Frank has been at all helpful. The Volcker Rule is not yet in effect but, if it were, would this have made a difference?

Mr. Dimon contends not, and he has been a consistent and vociferous opponent of the rule from the very beginning. It would seem foolhardy to accept Mr. Dimon’s view on this matter at face value. I testified in favor of the Volcker Rule before the Senate Banking committee in early 2010; Barry Zubrow, then chief risk officer of JPMorgan Chase, testified and strongly opposed it.

Some people in the private sector and within the banking community will push back, asserting that this would further expand the scope of government vis-à-vis legitimate private business. This misses the point — that it is the people who run our largest banks who have undermined the viability of the private sector and who threaten its future.

Cam Fine, president of the Independent Community Bankers of America, has shown strong leadership on this point over the last week (you can follow him @Cam_Fine on Twitter).

In the end, we may well come to the same conclusion as Elizabeth Warren – who has brilliantly seized the political moment and put her opponent for the Massachusetts senate seat, the Republican incumbent Scott Brown, on the defensive.

Ms. Warren is calling for the re-imposition of Glass-Steagall – separating commercial from investment banking. Mr. Fine is already pushing in the same direction. This position should be appealing across the political spectrum.

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

In an interview Thursday on PBS NewsHour, Jeffrey Brown and Treasury Secretary Tim Geithner had the following exchange:

“JEFFREY BROWN: Do you think Jamie Dimon should be off the board [of the New York Federal Reserve Board]?

TIMOTHY GEITHNER: Well, that’s a question he’ll have to make and the Fed will have to make. But again, on the basic point, which is 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. And we’re going to, we’re going to do that.”

In the diplomatic language of Treasury communications, Mr. Geithner just told Jamie Dimon to resign from the New York Fed board (here is the current board composition).  It looks bad – and it is bad – to have him on the board of this key part of the Federal Reserve System at a time when his bank is under investigation with regard to its large trading losses and the apparent failure of its risk management system.  (Update: Mr. Dimon is on the Management and Budget Committee of the NY Fed board; here is the committee’s charter, which includes reviewing and endorsing “the framework for compensation of the Bank’s senior executives (Senior Vice President and above)”.)

Mr. Geithner’s call is a major and perhaps unprecedented development which can go in one of two ways.

If Mr. Dimon resigns, that is a major humiliation and recognition – at the highest levels of government – that even the country’s best connected banker has overstepped his limits.  This would be a major victory for democracy and a step towards reopening the debate on financial reform, including introducing more restrictions on what global megabanks can do.

In modern American politics, symbols and substance are hard to disentangle.  The big banks have won many rounds, so many times in recent years – including with the help of Mr. Geithner at key moments during the Dodd-Frank debate, in subsequent discussions over capital requirements, and with regard to design and potential implementation of the Volcker Rule (which would limit proprietary trading and other forms of excessive risk taking by big banks).  If Mr. Dimon resigns, this could help open the doors to a broader reevaluation of power in the hands of Too Big To Fail banks – and how they undermine the rest of our economy.

If, as seems more likely, Mr. Dimon stays in place, that would be a great victory for the big banks – and a reminder of who is really in charge of the country.  Mr. Geithner will be forced to walk back from his statement; that would not exactly inspire confidence in our officials – or help President Obama get re-elected.

Keep in mind that Mr. Dimon himself decided to transform the relevant part of JP Morgan Chase into a risk-taking operation – and it is the people he chose and the systems he put in place that have now blown up.

The entire record of recent interactions between JP Morgan Chase and the New York Federal Reserve will presumably be looked at by investigators – including the total number of meetings, the precise content, and the involvement of Mr. Dimon himself.  For example, how often did Mr. Dimon meet with Bill Dudley, president of the New York Fed, over the past 12 months, either one-on-one or in a group meeting?  What exactly was discussed?  How did any of these interactions filter down into the supervisory process?

We need an independent investigation of the JP Morgan losses – as I argued Thursday morning on NYT.com’s Economix blog.  This investigation should examine, among other things, the relationship between Mr. Dimon, his bank, and the New York Fed.

Who will prove more powerful, Jamie Dimon or Tim Geithner?

Jonathan Macey, a former professor of mine at Yale Law School,* recently wrote an op-ed for the Wall Street Journal (paywall; excerpts here) arguing that we shouldn’t worry about JPMorgan’s recent trading loss because market forces will ensure that the bank does a better job next time. Here’s a key paragraph:

“Thus, far from serving as a pretext to justify still more regulation of providers of capital, J.P. Morgan’s losses should be treated as further proof that markets work. J.P. Morgan and its competitors will learn from this experience and do a better job of hedging the next time. They will learn because they have to: In the long run their survival depends on it. And in the short run their jobs and bonuses depend on it.”

Macey’s central point is that companies don’t like losing money, so losing $2 billion means that they will do a better job of figuring out how not to lose money in the future. That’s obvious. But it’s also beside the point.

Bankers don’t ask, “Do I want to gain or lose money today?” That’s not the relevant point at which incentives apply. Instead, they ask: “Do I want to engage in this specific class of activities that has a certain expected payout structure?” In the JPMorgan case, the question is: “Do I want to engage in trades that are, roughly, portfolio hedges but that also take significant long or short positions on the credit market as a whole, with the conscious intention of making money?” And what we care about is whether the bankers’ decisions are producing the socially optimal level of risk.

We know that Jamie Dimon pushed the Chief Investment Office to take more risk in pursuit of profits. We also know that the trade in question was not really a true hedge; if it were, there would be no news, because the $2 billion $3 billion loss would have been exactly balanced by a $2 billion $3 billion gain somewhere else, and Dimon wouldn’t be calling his own lieutenants “stupid.”

The problem is that two factors distort bankers’ incentives in the direction of excessive risk-taking (where “excessive” means greater than the socially optimal level). One is that JPMorgan is too big to fail. Macey himself has advocated in the Yale Law Journal for breaking up the largest banks, on exactly the same grounds as the rest of us: banks that are too big to fail have a distorted set of incentives because they can count on the ability to shift losses to the government in a pinch. That means that they have the incentive to engage in riskier activities than they would otherwise.

The other factor is that individual traders have skewed incentives: they get huge bonuses if they their trades make money, with no corresponding downside if their trades lose money. This also encourages bankers to take on excessive risk. And it’s not hard to see that if the payoffs are big enough, the potential loss of your job isn’t going to deter you from taking on that risk.

Now, it’s true, as Steven Davidoff has explained, that the traders in question at JPMorgan may also face clawbacks of their previous stock-based compensation. That is good, because it helps make the incentives symmetric: you get big bonuses if your trades make money, but you lose money you already had if they don’t. But JPMorgan’s clawback policy is a direct result of the reform pressures that resulted from the financial crisis; without the kind of pressure from regulators and reformers that Macey decries, JPMorgan would have no clawback policy at all, and its bankers’ incentives would be even more distorted than they are.

Obviously Jamie Dimon doesn’t like losing money. But he also likes making money, and for that reason he’s going to keep on pushing his people to take on additional risk in pursuit of profits. He can talk all he wants about how this trade went badly, but that doesn’t change the fact that he and his traders want to continue engaging in this class of trades—highly risky, proprietary, macro bets dressed up for as hedges for public consumption. The fact that one went bad is just a cost of doing business. “Markets” aren’t going to solve that problem because those markets are distorted. As long as those distortions exist, JPMorgan’s strategy isn’t going to change.

If you look at Macey’s YLJ article, you’ll see that he and I agree on the big picture: too-big-to-fail distorts incentives and therefore the big banks should be broken up. Do that, and I agree with Macey that we don’t need the Volcker Rule, since at that point I don’t really care what JPMorgan’s Chief Investment Office does, just like I don’t care what Small Hedge Fund X does.

But in this second-best world where we have TBTF banks, we have to do what we can around the edges (like the Volcker Rule) to reduce the distortions they create. Otherwise, losing $3 billion on a “hedge” is not an anomalous mistake that market pressures will eliminate; it’s the natural result of the dominant strategy for TBTF banks and traders with short-term incentives.

* Fans of 13 Bankers owe a debt to Jon Macey, since he was the professor who enabled me to get credit for writing it during my second year of law school.

It seems as if the Republicans, meaning both John Boehner and Mitt Romney, are trying to turn the national debt back into a major political issue. Now, a visitor from Mars might wonder how this is possible. How could a party that (a) passed the massive tax cuts that were the single largest legislative contributor to today’s record deficits, (b) increased spending rapidly the last time it controlled the federal government, and (c) cannot talk in detail about anything except deficit-increasing tax cuts possibly think that calling attention to deficits could be a political winner?

Well, despite the Republican Party’s abysmal record when it comes to fiscal responsibility, it could still turn out to be smart politics, for a few reasons. One is that many Americans reflexively associate large deficits with excessive spending, even though reductions in tax revenues have played just as big a role since George W. Bush became president. (Compare, for example, receipts and outlays in 2000 and 2011 as a percentage of GDP.) Then they associate excessive spending with Democrats, although the only president to reduce spending significantly in the past forty years was Bill Clinton. It turns out that if you repeat the same tired attack lines year after year—Democrats are all tax and spend liberals, for example—people believe them.

The other, more important reason why Republicans like talking about the national debt is that Democrats don’t have a good response. Sure, Democrats have lots of policy proposals, and theirs make a good deal more sense than the Republicans’; it was President Obama who proposed trillions of dollars in spending cuts and tax increases, which is what people supposedly want (according to opinion surveys, at least).

But most Democrats just don’t like talking about deficits and the national debt. They think it’s a distraction from talking about jobs and unemployment, or they think simply broaching the subject is succumbing to a vast right-wing conspiracy to slash entitlements, or both. The result is that there is no liberal progressive position on the national debt. There’s the Republican one (Romney, Boehner, Ryan), which is to cut taxes (boggle); and there’s the Obama one, which is basically the Republican-Lite position of George H. W. Bush, and which many liberal Democrats run away from. On the left, all there is is a vague belief that you can balance the budget by increasing taxes on the rich, but no one really wants to come out and say it. (Also, the numbers don’t add up unless you’re willing to boost the tax rates on millionaires to very high levels; just, say, repealing the Bush tax cuts for the rich won’t cut it.) Instead, the strategy is to demonize RyanCare, which is effective as a short-term tactic, but doesn’t really amount to a coherent message on the national debt.

This is one reason why I wrote White House Burning. I say “I” because Simon probably wouldn’t call himself a liberal, but I do call myself a liberal, and I think liberals need to have a coherent message on the national debt. I think the message should be something like this: the national debt is a real problem that needs to be addressed; we need to address it in the way that’s best for the American people as a whole; that means preserving the social insurance programs that almost everyone depends on; and we can preserve those programs, while bringing the debt under control, through a set of policy changes that make sense on their own grounds (eliminating distorting subsidies, eliminating tax expenditures, introducing Pigovian  taxes like a carbon tax and a financial activities tax).

You don’t have to agree with our recommendations. But as long as the liberal wing of the Democratic Party has nothing to say about the national debt, conservatives will be free to lead the debate, and the most likely outcome will be some sort of compromise between the moderate Republican Barack Obama an the now-”severe” conservative Mitt Romney. And you can expect the Republicans to bang on this drum from now until November.

I haven’t been writing about the JPMorgan debacle because, well, everyone else is writing about it. One theme that has stuck out for me, however, has been everyone’s reflexive surprise that this could happen at JPMorgan, supposedly the best and most competent of the big banks. For example, Lisa Pollock of Alphaville, who has provided some of the most detailed analyses of what happened, asked, “could this really happen under CEO Jamie Dimon’s watch?” Dawn Kopecki and Max Adelson at Bloomberg referred to “JPMorgan’s cultivated reputation for policing risk.” Articles about Ina Drew’s resignation are sure to point out her relative success at dealing with the financial crisis of 2007–2009.

“Highly intelligent women tend to marry men who are less intelligent than they are.” Why? Is it that intelligent men don’t want to compete with intelligent women?

No. It’s mainly because if you take two draws from a random distribution, and the first is at the high end, the second is almost certain to be lower, even if the two are somewhat correlated. This example comes straight from Thinking, Fast and Slow by Daniel Kahneman, which I’m finally reading (chapter 17).

The performance of anyone doing anything will exhibit regression to the mean. If you do well at something, it’s because of some combination of skill and luck. If JPMorgan came through the financial crisis well, it was some combination of skill and luck. Remember, JPMorgan didn’t have as big a portfolio of toxic assets as its competitors because it was late to the party; only in retrospect do we ascribe this good fortune to the supposed skill of Jamie Dimon. JPMorgan was never as good as people (both supporters and critics) made it out to be, so we shouldn’t be so surprised that it just lost $2 billion (and counting).

The more disturbing thing isn’t that commentators fell for this statistical red herring. It’s that people inside JPMorgan seem to have fallen for it, too. This was Dimon’s response to a question about whether the Chief Investment Office was becoming more aggressive, as reported by Bloomberg:

“I wouldn’t call it ‘more aggressive,’ I would call it ‘better,’” Dimon told analysts yesterday. “We added different types of people, talented people and stuff like that.” Until recently, they were careful and successful, he said.

People don’t suddenly go from being good to bad overnight. What happens is they go from lucky to unlucky. They are the same people doing the same things.

“Inside JPMorgan, leadership is stunned by the situation, according to two senior executives,” also as reported by Bloomberg. If that’s true, that’s bad news for all of us. It’s one thing if, as many of us thought, JPMorgan was consciously trying to take on more risk (as has been amply documented, Dimon pushed the Chief Investment Office into profit-seeking trades) while denying it to regulators and the press. That’s what we expect.

It’s another thing if the bank didn’t realize it was taking on risks of this magnitude. That implies that JPMorgan executives had started believing their own hype—that is, they believed that they really were just good, not lucky. And that should make all of us very worried.

Almost exactly two years ago, at the height of the Senate debate on financial reform, a serious attempt was made to impose a binding size constraint on our largest banks. That effort – sometimes referred to as the Brown-Kaufman amendment – received the support of 33 senators and failed on the floor of the Senate. (Here is some of my Economix coverage from the time.)

On Wednesday, Senator Sherrod Brown, Democrat of Ohio, introduced the Safe, Accountable, Fair and Efficient Banking Act, or SAFE, which would force the largest four banks in the country to shrink. (Details of this proposal, similar in name to the original Brown-Kaufman plan, are in this briefing memo for a Senate banking subcommittee hearing on Wednesday, available through Politico; see also these press release materials).

His proposal, while not likely to immediately become law, is garnering support from across the political spectrum – and more support than essentially the same ideas received two years ago.  This week’s debacle at JP Morgan only strengthens the case for this kind of legislative action in the near future.

The proposition is simple: Too-big-to-fail banks should be made smaller, and preferably small enough to fail without causing global panic. This idea had been gathering momentum since the fall of 2008 and, while the Brown-Kaufman amendment originated on the Democratic side, support was beginning to appear across the aisle. But big banks and the Treasury Department both opposed it, parliamentary maneuvers ensured there was little real debate. (For a compelling account of how the financial lobby works, both in general and in this instance, look for an upcoming book by Jeff Connaughton, former chief of staff to former Senator Ted Kaufman of Delaware.)

The issue has not gone away. And while the financial sector has pushed back with some success against various components of the Dodd-Frank reform legislation, the idea of breaking up very large banks has gained momentum.

In particular, informed sentiment has shifted against continuing to allow very large banks to operate in their current highly leveraged form, with a great deal of debt and very little equity.  There is increasing recognition of the massive and unfair costs that these structures impose on the rest of the economy.  The implicit subsidies provided to “too big to fail” companies allow them to boost compensation over the cycle by hundreds of millions of dollars.  But the costs imposed on the rest of us are in the trillions of dollars.  This is a monstrously unfair and inefficient system – and sensible public figures are increasingly pointing this out (including Jamie Dimon, however inadvertently).

American Banker, a leading trade publication, recently posted a slide show, “Who Wants to Break Up the Big Banks?” Its gallery included people from across the political spectrum, with a great deal of financial sector and public policy experience, along with quotations that appear to support either Senator Brown’s approach or a similar shift in philosophy with regard to big banks in the United States. (The slide show is available only to subscribers.)

According to American Banker, we now have in the “break up the banks” corner (in order of appearance in that feature): Richard Fisher, president of the Federal Reserve Bank of Dallas; Sheila Bair, former chairman of the Federal Deposit Insurance Corporation; Tom Hoenig, a board member of the Federal Deposit Insurance Corporation and former president of the Federal Reserve Bank of Kansas City; Jon Huntsman, former Republican presidential candidate and former governor of Utah; Senator Brown; Mervyn King, governor of the Bank of England; Senator Bernie Sanders of Vermont; and Camden Fine, president of the Independent Community Bankers of America. (I am also on the American Banker list).

Anat Admati of Stanford and her colleagues have led the push for much higher capital requirements – emphasizing the particular dangers around allowing our largest banks to operate in their current highly leveraged fashion. This position has also been gaining support in the policy and media mainstream, most recently in the form of a powerful Bloomberg View editorial.

(You can follow her work and related discussion on this Web site; on twitter she is @anatadmati.)

Senator Brown’s legislation reflects also the idea that banks should fund themselves more with equity and less with debt. Professor Admati and I submitted a letter of support, together with 11 colleagues whose expertise spans almost all dimensions of how the financial sector really operates.

We particularly stress the appeal of having a binding “leverage ratio” for the largest banks. This would require them to have at least 10 percent equity relative to their total assets, using a simple measure of assets not adjusted for any of the complicated “risk weights” that banks can game.

We also agree with the SAFE Banking Act that to limit the risk and potential cost to taxpayers, caps on the size of an individual bank’s liabilities relative to the economy can also serve a useful role (and the same kind of rule should apply to non-bank financial institutions).

Under the proposed law, no bank-holding company could have more than $1.3 trillion in total liabilities (i.e., that would be the maximum size). This would affect our largest banks, which are $2 trillion or more in total size, but in no way undermine their global competitiveness. This is a moderate and entirely reasonable proposal.

No one is suggesting that making JPMorgan Chase, Bank of America, Citigroup and Wells Fargo smaller would be sufficient to ensure financial stability.

But this idea continues to gain traction, as a measure complementary to further strengthening and simplifying capital requirements and generally in support of other efforts to make it easier to handle the failure of financial institutions.

Watch for the SAFE Banking Act to gain further support over time.

This is an updated version of a post that appeared in the NYT.com’s Economix blog on Thursday morning.  If you would like to reproduce the entire post, please contact the New York Times.

Experienced Wall Street executives and traders concede, in private, that Bank of America is not well run and that Citigroup has long been a recipe for disaster.  But they always insist that attempts to re-regulate Wall Street are misguided because risk-management has become more sophisticated – everyone, in this view, has become more like Jamie Dimon, head of JP Morgan Chase, with his legendary attention to detail and concern about quantifying the downside.

In the light of JP Morgan’s stunning losses on derivatives, announced yesterday but with the full scope of total potential losses still not yet clear (and not yet determined), Jamie Dimon and his company do not look like any kind of appealing role model.  But the real losers in this turn of events are the Board of Governors of the Federal Reserve System and the New York Fed, whose approach to bank capital is now demonstrated to be deeply flawed.

JP Morgan claimed to have great risk management systems – and these are widely regarded as the best on Wall Street.  But what does the “best on Wall Street” mean when bank executives and key employees have an incentive to make and misrepresent big bets – they are compensated based on return on equity, unadjusted for risk?  Bank executives get the upside and the downside falls on everyone else – this is what it means to be “too big to fail” in modern America.

The Federal Reserve knows this, of course – it is stuffed full of smart people.  Its leadership, including Chairman Ben Bernanke, Dan Tarullo (lead governor for overseeing bank capital rules), and Bill Dudley (president of the New York Fed) are all well aware that bankers want to reduce equity levels and run a more highly leveraged business (i.e., more debt relative to equity).  To prevent this from occurring in an egregious manner, the Fed now runs regular “stress tests” to assess how much banks could lose – and therefore how much of a buffer they need in the form of shareholder equity.

In the spring, JP Morgan passed the latest Fed stress tests with flying colors.  The Fed agreed to let JP Morgan increase its dividend and buy back shares (both of which reduce the value of shareholder equity on the books of the bank).  Jamie Dimon received an official seal of approval.  (Amazingly, Mr. Dimon indicated in his conference call on Thursday that the buybacks will continue; surely the Fed will step in to prevent this until the relevant losses have been capped.)

There was no hint in the stress tests that JP Morgan could be facing these kinds of potential losses.  We still do not know the exact source of this disaster, but it appears to involve credit derivatives – and some reports point directly to credit default swaps (i.e., a form of insurance policy sold against losses in various kinds of debt.)  Presumably there are problems with illiquid securities for which prices have fallen due to recent pressures in some markets and the general “risk-off” attitude – meaning that many investors prefer to reduce leverage and avoid high-yield/high-risk assets.

But global stress levels are not particularly high at present – certainly not compared to what they will be if the euro situation continues to spiral out of control.  We are not at the end of a big global credit boom – we are still trying to recover from the last calamity.  For JP Morgan to have incurred such losses at such a relatively mild part of the credit cycle is simply stunning.

The lessons from JP Morgan’s losses are simple.  Such banks have become too large and complex for management to control what is going on.  The breakdown in internal governance is profound.  The breakdown in external corporate governance is also complete — in any other industry, when faced with large losses incurred in such a haphazard way and under his direct personal supervision, the CEO would resign.  No doubt Jamie Dimon will remain in place.

And the regulators also have no idea about what is going on.  Attempts to oversee these banks in a sophisticated and nuanced way are not working.

The SAFE Banking Act, re-introduced by Senator Sherrod Brown on Wednesday, exactly hits the nail on the head.  The discussion he instigated at the Senate Banking Committee hearing on Wednesday can only be described as prescient.  Thought leaders such as Sheila Bair, Richard Fisher, and Tom Hoenig have been right all along about “too big to fail” banks (see my piece from the NYT.com on Thursday on SAFE and the growing consensus behind it).

The Financial Services Roundtable, in contrast, is spouting nonsense – they can only feel deeply embarrassed today.  Continued opposition to the Volcker Rule invites ridicule.  It is immaterial whether or not this particular set of trades by JP Morgan is classified as “proprietary”; all megabanks should be presumed incapable of managing their risks appropriately.

Dennis Kelleher and Better Markets are right about the broad need for implementing Dodd-Frank and they are particularly right about the problems that surround non-transparent derivatives (follow them @bettermarkets for some of the smartest lines and best links as the JP Morgan debacle continues to develop).  The Better Markets press release on Thursday night put the entire situation in a nutshell:

“Jamie Dimon and JP Morgan Chase just proved what anyone not getting a paycheck from a Wall Street bank already knows: gigantic too-big-to-fail banks are too-big-to-manage.”

Anat Admati and her colleagues at Stanford (and her growing band of supporters in the US and around the world) are right about bank capital.  The people in charge of Federal Reserve policy in this regard are dead wrong – perhaps because they spend far too much time talking to Jamie Dimon and his fellow executives, while consistently refusing to engage with their better informed critics.

Ms. Admati skewered Jamie Dimon at length and in detail 18 months ago on exactly these issues.  You must read her original Huffington Post piece.  She has been relentless ever since – see this material.  She was right then and she is right now: we need much higher capital requirements and much simpler rules – focus on limiting leverage.  Big banks should be forced to become smaller – small enough and simple enough to fail.

It is time for the Federal Reserve to move its policy on these issues.

While working on a new Atlantic column, I came across this article by Donald Luskin (hat tip Felix Salmon/Ben Walsh) arguing that “Taxmageddon” (the expiration of the Bush tax cuts at the end of the year) will cause the stock market to fall by 30 percent.* His argument is basically this: if the marginal tax rate on dividends increases from 15 percent to 43.4 percent, the after-tax yield falls by 33.4 percent, so stock prices should fall by about the same amount.

Ordinarily I don’t bother with faulty claims like this—there are only so many hours in the day—but it bothered me so much it cost me some sleep last night.

The first problem is the only one that Luskin acknowledges: lots of investors don’t pay taxes on dividends. He mentions pension funds; there are also non-profits and anyone with a 401(k) or IRA. According to Luskin, only about one-quarter of dividends are received by people who will pay the top rate. Maybe they are the marginal investors who set prices, he speculates. Well, maybe. But an increase in the tax rate will make dividend-paying stocks more expensive for them but the same price as before for non-taxpaying investors—so as long as we’re going to stick to theory, the former should sell their stocks to the latter for some price between the two.

More important, the price of a stock (in theory, again) is the discounted present value of its future dividend stream aggregated over an infinite horizon. So we need to know what the tax rates will be in all future years. That’s clearly unknowable. If the tax rate goes up on January 1, 2013, that will give us no information about the tax rate in 2113. On the other hand, it will give us very good information about the tax rate in 2013. And it will give us a little bit of information about the tax rate in 2023. In other words, the informational value of a change in tax rates only affects a small part of the summation you have to do if you want to value a stock by its dividend stream. If a company is going to shut down in 2013, liquidate its assets, and return one massive dividend to shareholders, it affects most of the value. If a company is Facebook and is unlikely to pay dividends for a long time, it affects very little of the value. So the impact of such a change on stock prices will be a lot less than the theoretical 33.4 percent that Luskin calculates.

Then there’s the little matter of markets. Luskin’s article chides the “stock market” for ignoring the upcoming change in tax rates on dividends. How does he know? Did he ask the market? More likely, the market is pricing in the possibility of a change in tax policy. In theory, market prices today should reflect the expected future tax level, which is somewhere between 15 percent and 43.4 percent—closer to which one, we don’t know. This is another reason why the actual impact of a tax increase will be smaller than 33.4 percent; the latter assumes that every single investor today is blindly assuming that the tax rate will remain at 15 percent.  (Actually, since the Medicare surtax is already law, every single investor knows that the tax rate will be at least 18.8 percent, not 15 percent.)

But this is all theory. There is actually a way to test these things. To the extent that a change in the dividend tax rate affects stock prices, it should affect high-dividend stocks more than low-dividend stocks. Even on the theory that the value of a stock is the discounted value of its future dividend stream, for a high-dividend stock, much of that value comes from dividends in the next decade, which are likely to be affected by a change in the tax rate. By contrast, for a company that doesn’t pay dividends, the value of its dividend stream is located far out in the future, where a change in today’s tax rate has little expected impact. So if Luskin is right, the 2003 tax cut (which established the 15 percent rate for dividends) should have caused not only a sharp increase in stock prices but also a sharp increase in the price of value stocks relative to growth stocks.

So, courtesy of Yahoo! Finance, here are the closing prices of the Vanguard Value Index (red), which includes high-dividend stocks, and the Vanguard Growth Index (blue), which includes low-dividend stocks, for November 2002 through May 23 2003, the day the final bill was passed by both houses. The question, though, is when the 2003 tax cut would have affected stock prices. There’s no separation between value and growth stocks around November 5, the day the Republicans won the midterm elections.  (Remember, the Democrats had a Senate majority in 2002.) There’s none around January 28, when President Bush called for tax preferences for dividends in his State of the Union address. There’s no reaction around February 27, when the bill that would cut taxes on dividends was introduced.

Now, there is a separation around May 15, when the Senate version initially  passed. (Passage in the House was assured because of the Republican majority there.) This implies that there was significant uncertainty about whether the bill would pass; when the uncertainty cleared, high-dividend stocks gained relative to low-dividend stocks. Score one for Luskin!

But if there was uncertainty that cleared on May 15, and Luskin is right, then two things should have happened: high-dividend stocks should have gained relative to low-dividend stocks, and all stock prices should have shot up. But that’s not what happened. High-dividend stocks went up; low-dividend stocks went down. Investors’ overall appetite for U.S. stocks didn’t change; at the margin, some realized that after-tax dividend yields had just gone up, so they switched from low-dividend to high-dividend stocks.

By May 23, the last date on that chart, passage was a certainty, so the impact of the tax change should have been 100 percent priced in. Do you see a 30 percent increase? I don’t.

Want more evidence? Here are the same two index funds for December 1 through December 17, 2010, when the dividend tax cut was extended for two years. The extension was in serious doubt until December 6, when Democrats and Republicans reached a compromise agreement. Again, you can see an increase in the price of high-dividend stocks relative to the price of low-dividend stocks, starting around December 6. This indicates that the market was reacting to a significant change in the probability of an extension. But there’s no sharp, 30 percent increase in the overall level of stock prices.

So the tax rate on dividends does seem to have a small but visible impact on the relative price of high- and low-dividend stocks. And it may have a small impact on the overall price level, which would make sense. But 30 percent, or anything close to it, is pure fantasy.

So why all this hysteria about a collapse in the stock market on January 1? Well, here’s one hint, from Luskin’s article:

“If there’s a bargaining failure and the scheduled tax hikes on dividends aren’t stopped, we’ll be sorry we’re spending so much political energy now debating about the ’1%’ and their supposed privileges. It’s the 30% down in the stock market we ought be worrying about.”

This is just another attempt to mask the blatant unfairness of the Bush tax cuts by arguing by arguing that that they are good for all of us (well, at least all of us who own stocks, but that’s a matter for another post). They’re not.

* Luskin also talks about “trillions more in new tax hikes under ObamaCare.” Huh? The revenue provisions of the Affordable Care Act are projected to bring in $520 billion over the next decade; even if you include the revenue-increasing coverage provisions (like the excise tax on high-cost health plans), you only get up to $813 billion. That’s not “trillions,” unless you’re talking about an undiscounted infinite horizon.

The Internet has made possible a golden age of commentary. Anyone with a computer and an Internet connection can create a blog and comment to her heart’s content.

Yet as one of those commenters with a free blog, I am painfully aware that this hypertrophy of analysis has not been matched by corresponding growth in the stuff that we analyze: facts. There is no way we could have written White House Burning, with its one hundred pages of endnotes, without someone else to do the primary research: either the journalistic kind, calling around to sources in Washington to figure out what’s going on, or the data-gathering kind, visiting grocery stores in Brooklyn to track prices and calculate the inflation rate.

So I would just like to second what Menzie Chinn said about the importance of government statistical organizations, which are (along with most of the rest of the government) under attack from Paul Ryan and his troops. Even if you don’t agree with what I say, if you like reading economics blogs, you should realize that they couldn’t really exist without the BEA, BLS, Census Bureau, etc.

Of course, if your economic policy prescriptions are based entirely on pure theory, then I guess you can do without data.

Catherine Rampell wrote a post last week about how Americans expect to retire later and how more elderly Americans are working. Her last chart also showed that a growing proportion of nonretirees expect Social Security to be a major source of their income in retirement.

That shows that Americans are becoming more realistic. But still, just 33 percent?

Just how important is Social Security, anyway? Let’s look at some numbers. Around 2003, Barbara Butrica, Howard Iams, and Karen Smith analyzed the composition of household income for people at age 67. They projected that median-income early baby boomers, when they reached 67, would have mean per capita family income of $33,000 (Table 3), of which Social Security made up $13,000, or 40 percent. Does 40 percent qualify as a “major source” of income? I would say so. Imagine losing 40 percent of your income.

But Social Security is actually more important than that. Remember, these are 67-year-old people, and 49 percent of them are still working. Yet most people hope to stop working someday. If you subtract out earnings, imputed rental income (the non-cash benefit you get from living in a house you own), and co-resident income (earnings of younger family members who happen to live with you), you’re down to a total of $23,000, of which Social Security is now 57 percent.

Another way to look at Social Security is to compare it to the things that, in some people’s eyes, were supposed to make it unnecessary: 401(k) plans. In the projection, for early baby boomers (people retiring now), about half were expected to have defined benefit pensions and the other half were expected to have individual retirement accounts like 410(k)s and IRAs. The latter group are getting about $4,000 from those retirement accounts. That could go up; maybe people are withdrawing less while they are still working. It could also go down; maybe people are withdrawing money at an unsustainable rate. But in any case it isn’t much, and it’s not even close to what Social Security contributes. (Remember, the Social Security figure of $13,000 also doesn’t include people who have chosen to delay taking benefits until after age 67.)

In 2008, Andrew Biggs and Glenn Springstead did a similar analysis, with similar results. Social Security provided 41 percent of income for beneficiaries ages 64–66 (Table 5), but when you strip out earnings and co-resident income, that figure goes up to 53 percent.

Both of these analyses focus on people in their 60s. As people get older, it seems that they rely on Social Security even more—not only because they stop working, but probably because they exhaust their other assets, or because their other pensions are not indexed for inflation (unlike Social Security). According to Sylvia Allegretto, if you look at retirees in the middle of the income distribution in California, a full 70 percent of their income comes from Social Security, with only 16 percent coming from retirement funds.

There’s a lot of talk today, some of it coming from Simon and me, about how the federal government is in danger of running out of money. But at least the federal government has some pretty potent options, like raising taxes. But American families as a whole are also running out of money, and they don’t have a lot of options. That’s a major reason why now is not the time to dismantle our social insurance programs.

The conventional wisdom in American presidential politics is that once a candidate has secured a party’s nomination, he tends to move away from articulating the views of the party faithful toward the political center. This makes sense as a way to win votes in the general election, and there has been a presumption that Mitt Romney will head in that direction.

However, in a panel discussion on Tuesday, Vin Weber, a senior adviser to Mr. Romney, indicated that the campaign may be moving toward positions on fiscal policy that are close to those proposed by Representative Paul D. Ryan of Wisconsin and his Republican colleagues on the House Budget Committee.

To be sure, when Mr. Ryan presented his budget in March, Mr. Romney described it as “marvelous”. In the Wisconsin primary, Mr. Ryan campaigned with Mr. Romney and speculation arose that Mr. Ryan might be the Republican vice presidential candidate.)

Yet Mr. Romney’s embrace of the Ryan plan during the general election campaign would represent a significant shift toward a much more extreme view on the future of government than many Romney proposals during the primaries (see this assessment of his primary proposals by the Committee for a Responsible Federal Budget). Mr. Weber said he was not speaking for Mr. Romney; I was on the same panel, and my strong impression is that Mr. Weber was floating trial balloons.

Mr. Ryan’s proposals would substantially phase out the federal government’s role in providing basic social insurance for older people by massively reducing Medicare and by eliminating almost all nonmilitary discretionary spending. The House Budget Committee is also proposing to remove the only safeguard we have against the failure of another mega-bank. Some libertarians praise these proposals. But these Republicans’ strategy is not so much to remove government in favor of abstract “markets” but to shift the balance of power away from government and toward entrenched private lobby groups, particularly in the health-care sector and on Wall Street.

On Medicare, Mr. Ryan’s proposal is very simple. He wants to cap increases in spending on Medicare below the rate at which health-care costs increase. By his own estimates, the share of Medicare spending relative to the size of the economy would shrink dramatically over the coming decades. (Mr. Ryan proposes to keep Medicare in place for people currently retired and soon to reach the eligibility age of 65, so his proposal would affect people 55 and under today (I, by the way, am not yet 55).

Mr. Ryan’s approach certainly reduces this dimension of government spending over time. But keep in mind how the nonpartisan Congressional Budget Office has assessed these ideas: according to the C.B.O., this approach would increase total health-care costs as a share of the economy and as paid by you (see Figure 1 in this C.B.O. document, which analyzes the proposal Mr. Ryan presented last year; while some details are different this year, the essential substance is the same).

The idea behind this C.B.O. scoring is simple. At present the government buys health care for about 100 million Americans. Certainly, the government could use this buying power more effectively as a way to hold down costs. The government has much more market power than you or I would have relative to health-care providers and insurers when we are in our 70s, 80s and 90s.

The C.B.O. scoring is based on actual experience, including administrative costs in Medicare compared with private insurance. These costs will fall directly on older Americans and their families.

Before Medicare was created in the 1960s, there was no meaningful health-care insurance for older Americans – and there will be none after Medicare is phased out. For the private sector, this is a set of uninsurable risks.

The federal government provides a minimum level of social insurance to all of us, in case we outlive our assets and our families’ ability to support us. Mr. Ryan – and now perhaps Mr. Romney – would end this role.

According to the C.B.O., the net impact would be to increase what you pay for health care. The government-provided piece would decline, but your insurance premiums and other out-of-pocket expenses would increase.

Just as striking is Mr. Ryan’s proposal for nonmilitary discretionary spending. This currently amounts to about $650 billion, about 4 percent of gross domestic product, and it has been around this size relative to the economy for about 50 years.

This now represents about 20 percent of federal government activity. The federal government is roughly a $3.3 trillion shop, annually, with the big chunks of spending being Social Security, Medicare and other government-backed health care, and the military. The United States economy has a total annual production, or G.D.P., of about $15 trillion.

Mr. Ryan is less clear on the details, but assuming that he would seek to maintain military spending at no less than 3 percent of G.D.P. – which is its lowest level in the postwar period – my colleague James Kwak has projected that the domestic discretionary spending would fall to almost zero in the coming decades (see the charts at the end of this blog post).

I’m all in favor of bringing the federal debt under control – and stabilizing it at a reasonable level relative to the size of the economy (say, 40 or 50 percent of G.D.P.). But there is no need to eviscerate the federal government in order to achieve this over a reasonable time frame.

Mr. Ryan’s plan would effectively shut down the federal government’s ability to set rules for the economy and to provide essential public services, such as air-traffic control, the monitoring of hurricanes and the provision of disaster relief.

Big private companies will no doubt do well under this approach; there will be less restrictions on what they do (e.g., as the Environmental Protection Agency winds down or food-safety rules go unenforced), and they will be able to increase their market power (as the Department of Justice drops its remaining interest in antitrust issues).

This is bad news for entrepreneurs or anyone seeking to invest in start-up companies. The playing field will become ever more uneven – just as it was when J.P. Morgan and his colleagues were building the original industrial, railroad and energy trusts at the end of the 19th century.

From the perspective of too-big-to-fail banks, the news from Mr. Ryan is even better. The House Republicans are proposing to repeal Title II of Dodd-Frank, which creates the legal authority to wind down large financial institutions in an orderly fashion.

Without this, we are back at the situation of fall 2008, where big banks can blow themselves up, inflict great damage on the economy and also receive large-scale bailouts (see my recent post in this space for more on exactly how that works).

None of these Republican proposals should be dismissed as pure rhetoric. For many Republicans in Congress, the Ryan proposals are a very real agenda. And, as Ezra Klein has argued, if Mr. Romney is elected president, the Republicans are likely to gain control of the Senate and would almost certainly be able to push through a version of the Ryan agenda – particularly as the key details would be immune to filibuster in the Senate.

Under such a Ryan-Romney approach, big risks – such as severe ill health and the danger of other calamities – would be shifted from society to individuals. Large corporations in health care and finance and perhaps in other sectors would benefit. So, too, would the people who control those favored legal entities.

This is a return to the way the United States economy operated more than 100 years ago – in what Mark Twain ironically labeled the Gilded Age. A few people would do very well; almost everyone else is in for a hard time.

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 post, please contact the New York Times.