If Only There Was Some Place To Hedge Exchange Rate Risk

John Quiggin argues in Jacobin that Wall Street needs to shrink.  I think there are many persuasive arguments that the financial sector is too large, but I didn't think Quiggin made a very compelling case.  Particularly, this passage stood out quite a bit.

Since differences in inflation rates have generally been small, and changes in patterns of comparative advantage are usually gradual, it was expected that market-determined exchange rates would be relatively stable, contrasting with the sharp devaluations (of as much as 20 or 25 percent) occasionally forced on governments during the Bretton Woods era. This stability would, in turn, help to stabilize national economies. 

In fact, the reverse has been the case. Exchange rates have gyrated wildly even in the absence of significant changes in fundamentals. For example, the Australian dollar traded at $US1.10 when it was first floated in 1983, before falling below 50 cents and then rebounding all the way back to $1.10. The current rate is around $US 0.90. These fluctuations have had catastrophic effects on trade-exposed sectors like manufacturing.

The central bank of a country can only target one thing.  If the central bank decides to print money and buy foreign exchange in such a way to keep its foreign exchange rate with some other currency constant, it cannot conduct counter-cyclical monetary policy.  It cannot let the currency fall during recession to stimulate exports and help the faltering economy recover.  After the fall of Bretton Woods, many countries decided that stabilizing their currency was not the appropriate goal, and they'd be better off conducting counter-cyclical monetary policy to help prevent recessions.  Thus, it's very strange to point to the instability of exchange rates, when countries obviously knew they were trading the stability of their exchange rates for more control of the stability of their economies.

He goes on to point out that the gyrations in the exchange rate were devastating to manufacturing.  What a strange point to make in a piece about the excess of the financial sector!  One of the benefits of a highly developed financial sector is that manufacturing firms can hedge their exposure to foreign exchange risk.  By trading sometimes complex derivatives, firms can lock in the price at which they export by offsetting any changes in the exchange rate with derivatives contracts.  Their counter-parties may in part be import firms looking to lock in the price of their imports.  And if the relative prices are off, speculators or just "insurance sellers" will step in and absorb the foreign exchange risk in exchange for a risk adjusted return.

There is considerable risk in the world and one thing a well-developed financial market can do is carve up that risk, so that a company or person can only hold the right kind of risk.  McDonald's is willing to hold the risk that their burgers don't sell abroad, that's a risk they understand and is central to their business, but they may not want to hold the risk that the profits they make abroad are worth considerably less in US dollars due to exchange rates they have little to do with.  If there are considerable risks of this type, a well developed financial sector can carve them up and sell them off to individuals more able and willing to bear them.  Ironically, the way they'd do this is with complex financial derivatives.