I talked at the Council for European Studies conference in Philly last night, and was surprised by one aspect of the discussion. As you might expect if you’re into these things, my take on the euro was strongly informed by the theory of Optimum Currency Areas; I expected pushback. But I didn’t realize how many people now seem to believe that real exchange rates don’t matter for adjustment — that is, that even internal devaluation (downward adjustment of prices and wages relative to trading partners) isn’t necessary in the aftermath of unsustainable capital inflows.

It turns out, however, that we’re seeing a significant revival of the “elasticity pessimism” widely prevalent during the post World War II “dollar shortage”. This was the belief that trade flows barely respond to price signals, and hence that devaluations don’t help alleviate imbalances. Now as then, the argument rests in large part on specific cases where large changes in relative prices don’t seem to have produced large changes in trade (Greece’s lagging exports), or conversely, where large changes in trade seem to have happened without large changes in relative prices (Spain’s export recovery, maybe).

The difference is that in the late 1940s this kind of argument was deployed in support of more government intervention — keep those exchange controls in place, because devaluation won’t work — whereas now it’s being deployed as an argument against activism — never mind the euro, it’s all rigidities that must be cured with structural reform.

But while the purposes may be different, the substantive issues remain. What is the case against elasticity pessimism?

I guess I’d offer several answers.

First, it’s worth thinking about where those big external imbalances came from. Big capital flows to the European periphery led to inflation and rising real exchange rates, and this was associated with huge trade imbalances. How did that happen, if real exchange rates don’t matter?

Second, my sense is that at least some analyses aren’t taking sufficient account of cyclical factors. Devaluation that takes place along with an economic recovery may not be associated with a falling trade deficit, because rising demand is offsetting improved competitiveness — I think this is relevant for Iceland. Also important for understanding why sudden stops produce large import contractions even under fixed rates.

Third, there are lots of other factors, so you have to avoid picking and choosing your stories too much. One way to do this may be to do what one recent IMF study did: focus only on large real exchange rate changes, estimate elasticities for lots of countries, and pool the results. The result is to diminish the noise, both by eliminating small fluctuations that may be statistical illusions and by exploiting the power of large numbers.

Beyond all this, however, we probably need to revisit the classic 1950 Orcutt analysis of likely biases in estimates of trade response to prices.

I guess I’m showing a strong preconception here — that done right, analysis will show that trade elasticities remain fairly large. Certainly willing to be proved wrong — but we need to do this carefully, because it’s really important for future policy.