We’re witnessing what are almost surely the dying gasps of the European Union (EU) as we know it. By that, I mean the number of countries in the Euro’s common currency zone will decline. The markets are spooked, because how it happens will have huge economic consequences.

Most economists — I’ve seen references that it is as many as 70 percent — thought that Europe was making a mistake when it became a common currency zone in 1999. Milton Friedman said that it would not make it past the first large recession. He was correct.

There are two fundamental ways that economists look at currency unions. One question is: What is the likelihood that countries will stay in a currency zone? This is the traditional theory of optimal currency zones. The other asks: What are the challenges to individual countries in a currency zone? This is what economist Greg Mankiw calls the fundamental trilemma of International finance.

The traditional theory of optimal currency zones holds that, for a currency zone to be successful, the countries need to be similar in fundamental ways. Inflation rates need to be similar. Openness to trade needs to be similar. The countries should be diversified in what they produce. Policy should be integrated, as should the countries’ financial sectors. Capital and labor should be mobile between countries.

In Europe, the countries are just too diverse to create a long-lasting currency zone. Languages and cultures are very different across European countries.

A large currency zone works better in the United States. There are fewer differences between, say, New York and California than between, say, Greece and Germany.

Still, even in the United States, states would choose different monetary policies if they could. For instance, California today would prefer a more expansionary policy than would Texas. This is because the Texas economy is doing far better than is California’s, and Texas has fewer fiscal challenges than California faces. An expansionary monetary policy would presumably stimulate California’s economy, while simultaneously allowing the state to inflate away part of its debt.

This reflects the trilemma. Here’s an abbreviation of how Mankiw described the trilemma in a 2010 New York Times op-ed:

“What is the trilemma in international finance? It stems from the fact that, in most nations, economic policy makers would like to achieve these three goals:

Make the country’s economy open to international flows of capital.
Use monetary policy as a tool to help stabilize the economy.
Maintain stability in the currency exchange rate.

But here’s the rub: You can’t get all three. If you pick two of these goals, the inexorable logic of economics forces you to forgo the third.”

As Mankiw goes on to say, the United States has chosen the first two options, while China has chosen the second and third, and Europe has chosen the first and third. Right now, Greece and many of the other peripheral countries would like the ability to use the second option.

The troubled European countries not only have no monetary policy choices, their fiscal options are limited, too. In trying to force countries to meet the characteristics of an optimal currency zone, the EU puts severe limits on fiscal policy choices. This is why at least one country, Greece, has simply lied about its debt.

In the end, the Greeks and the citizens of other peripheral countries will demand that their governments use all the economic tools available to a sovereign country. The governments will have to comply. The euro zone will shrink.

This appeared previously at newgeography.com

I believe the probability of at least one sovereign default is disturbingly high, and the financial sector will be hard hit if one or more sovereign defaults materialize.  Bailouts will only postpone the day of reckoning, and a delayed reckoning will be more difficult.

We’ll be lucky if that is all we see. Multiple defaults are not out of the question, and the riots in Greece show how difficult it is to cut government spending.  Any social disturbances will only increase the economic pain and delay the ultimate recovery.  Multiple defaults too will exacerbate the economic problems.

Why would they do this? Countries join hoping to benefit from increased trade efficiency and access to markets. Are the benefits of joining the Eurozone worth the costs? That depends on how correlated a country’s economy is with the Eurozone economy.

If a country’s economy is highly correlated with the Eurozone economy, then that country will be happy with the European Central Bank’s monetary policy, and the fiscal constraints will likely be relatively minor irritants. However, if a country’s economy is not highly correlated with the Eurozone economy, the European Central Bank’s monetary policy could be counter-productive, and the constraints on fiscal policy can be painful. It can put a country in a bind.

That is exactly where countries such as Spain and Greece find themselves today, in a bind. If they could, these countries would follow a much more expansive monetary policy and an expansive fiscal policy. The price they pay for membership is higher unemployment, a slower-growing economy, and the potential for social unrest. For these countries, joining the Eurozone is starting to look like a deal with the devil. We may see some countries leave.