The answer to your chicken-and-egg question is probably, alas, both. That is, you can't sustain democracy without a more or less marketized system; it's hard to have a free press when the government controls the paper supply; and you can't have a well-functioning market without a somewhat democratic rule of law--otherwise banks end up being devices to allow the minister's nephew to gamble with the public's money. How you get here from there is the big question; and if the disappointments of transition economies and the crisis in Asia are any indication, we don't really know the answer.
You could say that the great fallacy of our time is the belief that economic reform can be the advance guard of political reform. So we urge Russia to privatize fast, without a mature political system, and the result is that everything ends up in the hands of a few big oligarchs, and the whole idea of reform is discredited. Or, what might not seem a similar case, Europe tries to pursue a political dream via a supposedly practical plan to create a common currency; when the euro turns out not to be a panacea, and perhaps even a modest liability, the effect will be to set the goal of European unity back another couple of decades.
I'm sure you are right that tough economic times help feed sectarian violence. Above all, unemployment, which undermines not only material living standards but also individual dignity, is a breeder of hatred--which is one reason to be concerned about the prospect that unemployment rates, especially among young men, will stay very high in Europe for the foreseeable future. (There was a very good piece by Martin Wolf in the Financial Times today, by the way, about how the currency unification in Europe seems to ensure a protracted slump in Germany.)
But while economic distress certainly makes bad political outcomes more likely, it's not at all clear that prosperity by itself leads to political strength. Really effective polities seem to grow only out of struggles that create some sense of shared destiny and identity--the kind of thing that Serbia, alas, seems to have. I've also noticed the surprising willingness of the British to take on this cause, in contrast to the rest of Europe; but if you've spent any time in Britain you know that World War II has a special meaning there, as it does in the United States to a lesser extent. I hate to sound like an old-fashioned nationalist, but nations really are always forged from struggle, and that struggle usually involves war.
One random thought I've had, along these lines, is that it is just possible that something good will come out of this disaster. Suppose, just suppose, that NATO really does rise to the challenge--that its European members, in particular, manage to find the willpower to really reclaim Kosovo and bring the war criminals to justice. That could be the kind of thing that makes Europe a spiritual reality, not just a source of agricultural subsidies.
I wish I could take this fantasy seriously ...