In 1981 the countries of Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates formed the Gulf Cooperation Council (GCC) with an ambitious goal of economic unity. Since that time, the GCC has created a customs union that brings their external trade policy in line with one another. In early 2008 the GCC announced the creation of their common market, which allows free movement of labor and capital across the region. Their most ambitious step yet is still to come - to have a single currency by the year 2010.

Although it seems that this idea will come to fruition, the monetary unification has not been without its setbacks. Its first major bump came in 2006 when Oman declared it would not be ready to adopt a common currency by the deadline. Despite this, the other five nations agreed to continue on schedule. All of the Gulf states have pegged their exchange rate to the dollar for decades, which implicitly means they are pegged to each other as well. A state's joining a currency union is to some extent a mere formality. In May 2007, however, Kuwait broke from its historical peg to the dollar and is now pegged to a basket of currencies, which suddenly put plans for a common currency on uneven footing.

Earlier this month, as the dollar hit a record low against the Euro and the US Federal Reserve slashed interest rates, there was talk by some Gulf countries about revaluing their peg to the dollar. Although they quickly retracted their statements and reaffirmed their commitment to the peg, it was another sign that the developing world is losing confidence in the dollar.

The GCC is facing record inflation from two sources due to their exchange rate policy: matching the Fed's interest rate cuts and rising import costs from the falling exchange rate. In response to the credit crisis the Fed is attempting to spur growth by printing money, which lowers the interest rate and also spurs inflation. Countries pegged to the dollar must adjust their monetary policy to be in line with that of the United States, thereby effectively "importing" US inflation. Moreover, being pegged to a falling currency means that the cost of imports is rising. Inflated costs are dangerous for a region so dependent - especially during a time of booming growth - on foreign goods. Several of the Gulf countries are attempting to institute measures such as price controls and subsidies to control or offset the inflation, but these are ineffective policies that will only harm them in the long run.

The other option - dropping the peg to the dollar or reevaluating - would have several consequences. Although this move may ease inflationary concerns, it would likely peg to a basket of currencies or the Euro, which means they would still not possess monetary autonomy. Besides, if the all the GCC did not adjust their peg in the same manner, it would cause their proposed monetary union to be only more difficult to achieve. The political pressure on the GCC is also considerable, as widespread Gulf revaluation could precipitate a US dollar currency crisis. Completing a currency union in the near future, however, could give the GCC exactly the opportunity it needs. None want to unilaterally revalue their currency against the dollar; however, when they declare their new currency, it can be set at a revaluated peg. The only downside is that the GCC countries hold a combined $500 billion in US dollar-denominated assets, the value of which would decline with a revaluation.

At the other end of the spectrum from a currency union, they could all adopt individual currencies with floating exchange rates. A currency union has distinctive benefits and costs, and it is important to weigh them against each other to see whether this is a beneficial step for the Gulf states. Floating exchange rates would allow them to have monetary autonomy, giving them more control over their economy, but at the possible cost of instability.

Floating exchange rates would solve many of the temporary problems the GCC faces. By relinquishing their peg to the dollar, they can gain control of their own monetary policy. They can choose their own optimal level of inflation and interest rates, which are much better suited for their rapidly developing economies. However, this step also allows the government to print money freely in order to finance itself with the resulting seignorage, which leads to runaway inflation. If the government cannot be trusted with monetary autonomy, maintaining a peg essentially ties the hands of the central bank. A floating regime also exposes firms and individuals to the risk of exchange rate fluctuations, which can produce future income uncertain and discourage investment.

Essentially, a currency union is a stronger version of a fixed exchange rate between the member countries, regardless of whether they have a fixed or floating rate against other world currencies. A currency union will result in increased trade and decreased transaction costs between the Gulf states, but the extent of these benefits is highly dependent upon the average level of integration between the countries. Although estimates vary, it is believed that a currency union can double the amount of trade between a block of countries. The average level of trade as a percent of GDP with other member countries is an important measure of how much there is to gain from a currency union. For the Gulf states, this figure is less than half that of the European Union.

It is also important to have few societal barriers between the countries in order to maximize the gains from economic integration. For example, lowering the legal barriers on labor and capital movement is meaningless if there are still linguistic or cultural barriers. In this regard, the Gulf states are very well positioned to reap the rewards of economic integration: they all speak the same dialect of Arabic and have similar cultures. Therefore, there is a great amount of mobility between the countries, and so labor and capital can move easily to where it is most productive. This serves as a contrast to the European experience, in which one has to learn a completely new language in order to work effectively in a new country.

The major cost of a currency union is in the loss of monetary policy as a method of controlling the economy. Suppose that one country needs a monetary contraction while another needs a monetary expansion. While they share a common currency, both cannot occur simultaneously. The best measure of the cost of a currency union is the correlation of economic shocks between member countries. This has proved to be a substantial problem in the EU, where very different economies have been forced to endure the same monetary policy. Luckily, the Gulf states are more homogeneous than European states. They have in common the reliance on oil revenues to finance their current investment boom. Still, it is conceivable they will have different economies in the future.

The GCC is hardly the only group of countries seeking increased economic integration. The United States struggled with NAFTA and CAFTA, and there are several coalitions of African countries seeking some form of integration. However, such unions require very specific conditions to ensure there will be sufficient gains from integration that outweigh the costs.

In the post-EU frenzy, trading blocks around the world are creating radical economic proposals, many of which are unfeasible. From language to culture to economy, the Gulf states share several similarities: this in itself is the most important factor in determining the success of an economic union. Many proposed unions are of dubious benefit. The GCC, however, has the necessary conditions for success. Given their earlier establishment of a customs union and a common market, a currency union is logical and powerful next step.