Senior Fellow Kevin A. Hassett

Last week the New York Federal Reserve made what may go down as the most misguided move in the history of the Federal Reserve system. They laundered money for North Korea.

A painful flurry of hearings may soon be on the horizon. Last week a group of influential Republicans, including the ranking member of the House Committee on Foreign Affairs, Ileana Ros-Lehtinen, asked the Government Accountability Office to investigate whether anti-laundering and counterfeit laws were broken. They may well have been.

Here is the back story.

Last February, North Korea approved a new version of the Clinton administration's framework for shutting its renegade nuclear reactor program. As part of the deal, the U.S. agreed to unfreeze $25 million at Banco Delta Asia, a Macao bank that has been a primary conduit to the outside world for North Korea.

This bank was formally determined by the U.S. Treasury to be a "primary money laundering concern." The Macao bank denies any wrongdoing. The U.S. doesn't allow such banks to do business in the U.S. Accordingly, reputable banks from Singapore to Russia won't do business with Banco Delta Asia. Even China refuses to do deals with the bank.

This U.S. action significantly impeded the ability of North Korea to wash illicit funds through the world financial system. If it sells a missile to Iran, it must take the payment in cash. If it deposits counterfeit money in its account, there is no easy way to get the money into the world economy.

The U.S. committed to unfreeze the funds last February, but didn't agree to let this pariah state resume its allegedly criminal banking activities. In other words, if North Korea wanted to, it could go to the bank, and withdraw the money physically and fly it back to North Korea.

Wired Home

North Korea didn't want to do that, however.

The country then reneged (as it always seems to), and said that it needed the money to be wired home, something the U.S. never agreed to.

North Korea clearly added this new condition because it hoped to reenter the world financial system. No bank would transfer money from Banco Delta Asia without express approval from the U.S. Treasury. If that permission was given, the prohibition was broken, signaling to other banks around the world that they could resume business with the rogue state.

So the U.S. State Department, ever the naive optimist with regard to North Korea, got the clever idea that it could ask the New York Fed Bank to be the conduit for the North Korean funds, since it might not be covered by the U.S. law prohibiting commercial entities from doing business with money launderers.

Avoiding Politics

Historically, the Fed has tried to avoid such complicated political entanglements, but incredibly, it agreed to help in this case.

On June 14th, in a web of intrigue worthy of a James Bond movie, the New York Fed wired the North Korean money to the Russian central bank, which then transferred it to a dormant North Korean account in a Russian bank.

Many in the foreign policy community are incensed that the State Department engineered this concession to the North Koreans. Since the New York Fed has done business with Kim Jong Il's regime, directly, or indirectly, one can expect other banks around the world to line up to do so again as well. After all, the Fed has given the North Koreans the financial equivalent of the Good Housekeeping Seal of Approval.

Worst Outcome

It may or may not have been sound foreign policy to make this concession to the North Koreans. The problem for the Fed is that there are enough people in Washington who think it was a catastrophic error. There will almost certainly be a lengthy investigation into the matter. If that investigation turns up legal technicalities that go against the Fed, then hearings will happen, and heads may roll.

The worst outcome is this: If somebody in Congress disagrees with the Fed's monetary policy, they now have a weapon they can use against the central bank. That can't be good for monetary policy.

Back in 1993, Alan Greenspan, Fed chairman at the time, was widely criticized for attending President Bill Clinton's first State of the Union address, allowing himself to be photographed sitting next to Hillary Clinton. He was rapped because Americans rightly expect the Fed to focus on monetary policy, and stay out of the political fray.

By allowing the New York Fed to be a pawn of the State Department and the North Koreans, Chairman Ben S. Bernanke has introduced the Fed into a complicated diplomatic game that has nothing to do with its legal responsibilities.

He isn't sitting next to Hillary Clinton; he is sitting next to Kim Jong Il. It is hard to imagine why anyone at the Fed would think that is a good idea.

Kevin A. Hassett is a senior fellow and director of economic policy studies at AEI.