As the euro crisis continues to unfold, the economic as well as political difficulties associated with producing large and indispensable gains in Southern Europe’s periphery economies’ competitiveness are becoming ever more visible.

The textbook answer for regaining competitiveness is exchange rate devaluation, fiscal discipline, and structural reforms. Obviously for euro countries that have no independent monetary and exchange rate policies, the devaluation option is not available. So to regain competitiveness, other policy measures that will lead to an internal devaluation must be contemplated.

Economists generally outline four factors for an internal devaluation to be successful and to pull a country back from a decline in competitiveness:

  • The economy in question needs to be small and open.

  • It needs to have flexible labor markets.

  • It should have trade partners that do well.

  • It needs to be willing to put up with a loss of output and employment. In other words, a society should accept a loss in real incomes and living standards.

It is this last point that constitutes the sensitive nexus between economics and politics. How are democratic governments going to convince their population to accept declining living standards? But also how are these costs going to be distributed across society? How much will the state finance? How many workers will accept a readjustment in their wages? How many capital holders will accept a drop in their rent incomes?

A tentative answer to this set of troubling questions can be found in literature on the political economics of trade. The question back then was to understand how governments dealt with globalization and trade liberalization.

Harvard economist Dani Rodrik had argued that the answer was dependent on whether the country had actually nurtured domestic institutions that could arbitrate process adjustment and help to reach a consensus about the distribution of costs. For countries that had reached this level of institutional maturity, trade liberalization proved to be positively related to growth. For countries that had no such institutions, the answer was much more mitigated. It was more costly for these countries to adjust to trade liberalization.

This analogy is very pertinent to the Southern countries that are faced with the burden of adjustment. The peeling back of the layers of the current crisis reveals a test of the strength, maturity, and effectiveness of domestic conflict management institutions. In other words, a successful management of the euro crisis, with all its insidious ramifications, is inherently conditional on the effectiveness of governments, political parties, parliaments, trade unions, trade associations, the media, etc., and the established patterns of interaction among them as platforms for internal conflict management.

There are two fundamental conclusions to be drawn from this analysis. The first one is that there are no technical or even economic solutions to the present crisis. It needs a political approach and a political answer.

The second is that there is a limit to what can be accomplished at the EU level. The EU institutions, primarily the European Central Bank, can, at the most, give breathing room to countries that face the burden of adjustment. But the answer still lies with domestic policies and institutions.