March 24, 1995
"Derivatives Dealing Indeed is Dangerous -- For the Reckless"
San Jose Mercury News
By Timothy Taylor
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FINANCIAL transactions are growing, relative to the production of goods and services. Silas Keehn, president of the Federal Reserve Bank of Chicago, offered these estimates in a speech last year: "In 1970, there were $15 of financial transactions for every dollar of gross domestic product (GDP). By 1980 the ratio had increased to $30 to one, and by 1990 it was $78.

"And this is not solely a U.S. phenomenon," Keehn continued. "In Japan, for example, the growth in financial transactions has been even more staggering, going from 15 yen of financial transactions for each yen of their GDP in 1970 to a ratio of over 115 to one by 1990."

Keehn noted that the growth in financial markets has been due to foreign exchange transactions and securities, including derivatives. The importance and instability of foreign exchange and securities markets has only intensified in the last few years.

Currency markets are fluttering everywhere; for examples, see the shrinking U.S. dollar, the Mexican peso meltdown, the booming German mark, and many others. Derivatives have left a recent body count of bankruptcies and losses: Procter & Gamble, Orange County, Barings investment bank.

In theory, financial markets should help in the efficient production of goods and services by smoothing transactions, channeling capital from savers to the most promising investors, and offering tools to manage risk. In practice, it can seem as if these markets are injuring companies and even entire economies.

But before arresting, convicting and executing financial markets for crimes against the economy, their necessity and virtues deserve a day in court.

Global trade and investment have expanded dramatically. In the United States, for example, exports were 4 percent of GDP and total foreign investment abroad was 1 percent of GDP in the 1970s. Now, exports are over 7 percent of GDP and investment abroad is almost 3 percent of GDP. These trends were bound to expand exchange rate markets.

Derivatives also serve a vital economic function: they let businesses concentrate on their core area of expertise. Consider, for example, a U.S. firm that exports much of its output. If the dollar strengthens, the company will suffer, since its earnings in foreign currencies would be worth relatively less. If the dollar weakens, the company will benefit, since its earnings in foreign currencies would be worth relatively more.

Faced with this situation, the company signs a derivative contract: If the dollar weakens, the company pays out some of its extra windfall profits, and if the dollar strengthens, the firm receives some money to make up for its windfall losses. Now the company has some protection against exchange rate movements, and it can focus on what it actually produces.

When wisely used, derivatives simply allow companies (and investors) to ameliorate risks they can't control directly, like volatile exchange rates, interest rates, the stock market, or the price of key raw materials like oil. But along with the good they do, foreign exchange markets and derivatives are also open to speculation.

Back in 1971, 90 percent of foreign exchange transactions were linked to trade and to long-term investment, according to an estimate cited in a recent report by the International Labour Organization in Geneva. Today, 90 percent of all foreign exchange transactions are short-term.

According to a description in Fortune magazine, Procter & Gamble got into trouble with derivatives by making this deal: If a particular German interest rate didn't rise by more than .75 percent or fall by more that 1.3 percent over a year, then P&G would save $940,000 in interest payments. But when interest rates rose, P&G was on the hook to pay an interest rate that was 16 percentage points higher for the next three years!

This deal wasn't about managing interest rate risk so that P&G could focus on its core business. It was a reckless gamble that went wrong.

Excessive financial speculation is a danger of long standing. The economist John Maynard Keynes once put it this way: "Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a byproduct of the activities of a casino, the job is likely to be ill-done."

In a world where financial markets run 24 hours a day, around the globe, speculation isn't going to disappear. But if all countries would keep inflation reliably low and stable, then currency values wouldn't jump around as much, and exchange rate speculation would be less profitable.

As to derivatives, the best way to discourage speculation is heavy publicity of large losses. Any treasurers or CEOs who claim they didn't understand their derivative investments should immediately lose their job, because investing ignorantly is not an excusable business practice.

Government has a role to play in establishing a stable economic framework and requiring openness in securities transactions. But the more extreme concerns about the growth of finance are overdone.

Remember, Keynes was writing about speculation in the 1930s; Keehn's data go back more than two decades. But the growth of finance has not stopped the U.S. economy from growing in the last half-century. The even faster rise of finance in Japan hasn't prevented even more rapid growth in the Japanese economy.

The overwhelming majority of financial transactions are sensible and successful for investors, businesses and economies. Of course, these deals don't make headlines like the stories of losses, lawsuits, bankruptcies and crashes.

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