Simon Johnson is the Ronald A. Kurtz Professor of Entrepreneurship at the M.I.T. Sloan School of Management and co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.”

Source: nytimes.com

“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 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 the same fashion as Lehman Brothers? It would not.

The Federal Reserve Bank of New York would be a key player in the decision on 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 it has 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.)

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 risk committee of the JPMorgan Chase board lacks sufficient experience to understand or monitor the complexity of the bank’s operations. (See also the coverage from Forbes and CBS MoneyWatch.)

We need an independent inquiry into exactly how 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 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 had a responsibility to uphold the integrity and perceived legitimacy of the Federal Reserve System. She ended with a powerful line that cuts to the 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. That was an entirely appropriate decision, removing any perception of a potential conflict of interest. (To be clear, both Mr. Immelt and the New York Fed said that he resigned because of pressures on his time.)

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.”

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