Europe is facing not just the risk of financial instability, but also that of rising political instability. Financial crises create tensions within economic classes that quickly become political tensions.
As far back as 1922 John Maynard Keynes made the point that the choice between inflating debt away and deflating wages came down to the agonising outcome of a struggle among interest groups. Over the next few years many countries in Europe are going to face similar struggles among interest groups.
For many of the European countries struggling with the financial crisis, whose domestic cost structure is too high to allow them to compete, there is an urgent need to adjust their domestic costs to foreign competition. There are broadly three ways for a euro-zone country to do so: it can abandon the euro, and devalue the new currency; it can force down the cost of labour by running very high levels of unemployment for many years; or it can impose trade barriers.
Similarly any euro-zone country whose debt levels are too high will have to improve its ability to repay. In that case there are also roughly three ways it can do so: it can regain control of monetary policy by abandoning the euro and then inflate the debt away; it can threaten to default on the debt, and receive significant debt forgiveness; or it can regain fiscal credibility by raising consumption or value-added taxes, by raising income taxes, or by cutting expenditures sharply.
Most of the afflicted European countries suffer from both of the above problems - an uncompetitive economy and excess debt. In the aggregate, all of the above resolutions accomplish more or less the same thing. They allow the country to bring costs of production back to some sort of manageable level, and to reduce financial distress costs. But although economists agree that any of these strategies can resolve the underlying imbalances, they have less to say about which of these strategies is optimal because that, ultimately, is a political decision.
