EU representatives including Angela Merkel (far right) and President of the European Commission José Manuel Barroso (fourth from left) at a summit in Brussels. © ALAIN JOCARD/AFP/Getty Images

Britain and the EU: On the way out?

The UK's relations with the rest of Europe are unsustainable
July 17, 2014

In the early days after the fall of the Berlin Wall, a joke made the rounds in Germany. “We are one people,” said the East German. “So are we,” replied the West German. As an outside observer of Britain’s European debate for almost 30 years, I feel a similar sense of alienation in the European debate—between Britain and the rest of Europe. The fundamental issue is not that a British Prime Minister disagrees with his continental counterparts. This is not new, and has a long tradition. The problem is that they no longer agree on what they disagree on. When European leaders quarrel about Europe it is as though they are discussing different continents.

Pro-Europeans in the UK are living in a European Union of the single market and the single external trade policy. On other issues, such as foreign policy and immigration, they see the integration as largely completed. The EU is still a Europe of sovereign nation states that have voluntarily transferred important but limited sovereign rights to a centre for the pursuit of economic integration. The debate in Britain is about whether this process has gone too far, and whether some of those central powers should be revoked.

On the continent, they see things differently. The single market has long been superseded as the EU’s main economic project by the euro. The eurozone has proved largely dysfunctional and is now in need of repair. There is no agreement on the nature of the crisis and what needs to be done. But no matter whether you are a Protestant northern European believer in fiscal rules and penalties, or a Catholic southern European advocate of a federal European state, you are likely to favour greater central control over economic policy. If you live in Berlin or Paris or Rome or Helsinki, the issue is not federalism versus supranationalism. The argument is between Keynesian and neo-classical economic policies. They disagree on the role of government and on what the central bank must do. But they do not disagree that there needs to be a much greater degree of integration.

These different perspectives also lead to different views about European democracy. Once your macroeconomic policies are decided in the centre, you are bound to favour direct democratic control-—some form of direct parliamentary representation at the level where the decisions are being taken. If not, you are better off with your elected government defending your interests in Brussels. This debate is thus not about right and wrong, but about where you live.

The recent debate over Jean-Claude Juncker that culminated in David Cameron’s infamous defeat in the European Council exemplifies the disconnect between the two and the different perspectives, more than anything else. It is not so much the fact that virtually everybody in the UK universally rejects Juncker. I am German and I, too, am sceptical, but for different reasons. I never questioned the legitimacy of a Juncker nomination. Nor did I question the principle that parties elect their Spitzenkandidaten (German for leading candidates) in the European parliamentary elections. Nor did I question the link between the winning candidate and the presumptive next president of the European Commission. Juncker was simply not my preferred candidate because of his indecisive leadership during the eurozone crisis.

German Chancellor Angela Merkel also had objections. Shortly after the elections she told the press that Juncker was only one of several plausible candidates. But what happened then was a case study of how quickly politics is changed by events. When German media reported on Merkel’s hesitation, the universal reaction was one of outrage. For the first time since her new “grand coalition” with the Social Democratic Party (SPD) was formed in the autumn, that party criticised her in public. The philosopher Jürgen Habermas wrote a long and angry article in the Frankfurter Allgemeine Zeitung in which he condemned Merkel’s disrespect for the democratic vote. On the same day, Matthias Döpfner, Chief Executive of Springer, the newspaper publisher, wrote a furious editorial in Bild, condemning Merkel with essentially the same arguments-—tabloid-style.

The pressure came from the left, from the right, and from the tabloid and broadsheet equivalents of the German press. And when that happens, as we have seen many times before, Merkel is unusually quick to shift her position, just as she did over energy policy after the Fukushima nuclear incident. German politics is full of ex-politicians who placed their trust in the lady. Cameron should have been warned about this. With Germany inside the eurozone, and Britain seemingly forever out, there are limits of the extent to which Germany and Britain can forge a strategic relationship inside the EU.

When the public reaction is as furious as it was in Germany, it would have been impossible for the European Council to find another candidate. No politician would have accepted a nomination given the high probability of being voted down in the parliament. It is no surprise, then, that Christine Lagarde, Managing Director of the International Monetary Fund, ruled herself out. Not one of the alternative candidates mentioned in the British debate would have attracted a majority. In the end, the council opted for the path of least resistance, with a 26-2 majority.

This huge shift in the political dynamics was brought about by a subtle rephrasing of the procedure in the Lisbon Treaty, which came into force in late 2009. Previously, the European Council-—the EU’s heads of state and government—selected the President of the European Commission unanimously, and parliament then confirmed. The Lisbon Treaty changed the procedure: the council nominates the commission President with a qualified majority after consultations with the parliament. Then the parliament elects.

In European constitutional law, expressions such as “nominate,” “consult,” and “elect” have precise meanings. In Germany and Italy for example, a similar phrasing applies to the nomination of the Prime Minister, or Chancellor in Germany’s case. The head of state would consult with parliament and nominate the person who commands a majority in the parliament. It is largely a ceremonial procedure. Everybody in Germany and Italy understood this change in the Lisbon Treaty constituted a real shift in power from the council to the parliament. Almost nobody in Britain did.

How could it come to this? The first 10 years of the euro were marked by a dual illusion—a German one and a British one. The German establishment believed that monetary union would require only an independent central bank and a set of fiscal rules. The way the system was drawn up, it allowed no bailout, no default and no exit—an impossible trinity. The British illusion consisted of believing the German illusion, and to draw the conclusion that it could happily co-exist with such a monetary union, and that it might even benefit by becoming the eurozone’s banker.

The crisis has destroyed both illusions. While a survival of the euro now looks more probable than it did two years ago, its long-term viability still depends on policy action to be taken, on a readiness for debt forgiveness, fiscal transfers and unconventional monetary policies. It is still possible for the euro to fail. Another financial crisis would stretch the political willingness of the northern creditor countries to bail out the south. Financial markets may at some point re-evaluate their current optimism about the eurozone. The European Court of Justice may throw out the European Central Bank’s lender-of-last-resort pledge. Or Italy’s reform programme may falter, and the country elects an anti-European government in 2018. Many scenarios are possible. But even a break-up of the euro would offer no consolation for Britain. The euro would not disappear. More likely, its membership would become smaller. In such a case, a divorce between the eurozone and the EU becomes more likely. It is hard to see any winners in such a scenario.

Still, the most likely scenario is that the eurozone will muddle through, and fix its problems gradually through stepwise integration. It will need to revisit the recent but inadequate agreement on a banking union and it will one day introduce some form of direct democratic control in the form of a parliament that could, for example, be made up of a mixture of national MPs and members of the European Parliament.

Member states still disagree on what needs to be done in what order. The debate is very messy. They also disagree on how it should be done, whether through a change of the treaties, by fudging the existing rules, or through multilateral treaties outside the present framework of the EU. But they are all pushing in the direction of more integration. For a eurozone member, more European integration is as existential as it appears anachronistic from a British perspective.

The question now becomes: can a permanent outsider such as Britain happily co-exist with this monetary union? And what would the relation become if Britain were to opt out of further policy areas, such as immigration? Until about 10 years ago, Britain still had allies for its own European ideas. One might recall the unfortunate distinction that was drawn between “new Europe” and “old Europe”—and Silvio Berlusconi’s attempt to brand himself as an ally to Britain in this debate.

Today, Britain’s position is far more isolated. Of the 28 EU member states, 18 are in the eurozone. Lithuania will join next year. Poland and the Czech Republic want to join, too, at some point. Bulgaria, Romania and Croatia are not ready, but also want to join eventually. Denmark, like Britain, has an opt-out, but the Danish government behaves as though the country will eventually join. It has signed up to the banking union treaty and to the fiscal compact—two multilateral treaties that further enhance the degree of economic co-ordination.

For the countries in the European periphery there is simply no option of a large decentralised EU. Their economic interests determine their support for an integrationist policy. If you look at some recent proposals by various groups of German and French intellectuals, they all share some vision of an EU that is ultimately usurped by the eurozone—a monetary union firmly embedded in a single political framework, with direct democratic accountability.

So where does that leave Britain? For the moment, Britain’s main ally is Victor Orban, the Hungarian Prime Minister—an ally you do not want to have. Orban started off in politics as a grass-roots pro-democracy activist but is now leading an authoritarian, right-wing government with an absolute majority in parliament. When the Hungarian government changes, Hungary will probably shift away from its eurosceptic position, just as Poland and the Czech Republic did. The biggest political impact of the eurozone is that it has shifted allegiances.

And it shifts majorities, too. The Juncker vote is only one example of an insider-versus-outsider style voting pattern. The eurozone and those that aspire to join in the future have a qualified majority in nominating the president. A qualified majority is based on a complicated formula. If Cameron had been able to persuade Italy, the Netherlands and Sweden to join him in opposition to Juncker, he would have been able to block the decision. To overcome the qualified majority, he only needs a handful of allies, including one large country, but he does not even have that.

As the banking union develops—however imperfectly—I would expect that majority to assert itself over the single market for financial services, which is so crucial for Britain. For the moment, Britain secured a deal giving the 10 member states that are not in the eurozone some protection against being outvoted in the European Banking Authority. The London-based European Banking Authority is the EU-wide banking regulator. One of its jobs is to set the criteria for banking stress tests. The idea behind this agreement is to prevent the eurozone outvoting the non-eurozone. But over the next 10 years the relative weights will change. It is currently 18 versus 10. With Lithuania’s adoption of the euro next year, it will be 19 versus 9. As more countries join the eurozone, the non-eurozone will become small. Within 10 years, I would expect Poland, the Czech Republic, and possibly even Denmark and Sweden to have joined the eurozone, or at least be preparing to do so. The point will come when the eurozone will no longer accept an effective veto right by non-members.

I would also expect the monetary union to exert its influence on trade policy. Why should the EU not restrict trade access to countries that it suspects of currency manipulation, as the United States does? If so, the reference for any such assessment would be the euro/dollar exchange rate. This is not an issue today as the euro and pound are both relatively strong. But this will eventually happen.

The eurozone will eventually want to create a common labour market that allows free movement of labour. There is no way that Britain can, or will want to, participate. It would impose more regulation, and possibly more immigration, too. The list of opt-outs that Britain will want to secure will grow and grow. The reason is that monetary union will unleash a degree of economic and political integration, for which a non-participant simply has no need.

Legally, the single market is off-limits for the eurozone. It is an EU-wide project. Eurozone member states cannot restrict market access to non-eurozone members. But there is nothing to stop them from out-voting the others in setting the rules. Life with a group of countries that are organised in a monetary union will become progressively more uncomfortable. Further policy opt-outs seem to be an obvious answer for Britain, but they only make the problem worse as the two sides’ interests become even less aligned. And it is far from clear whether they would be granted.

The real in-out decision is not the 2017 referendum, if it comes. The real decision was taken in 1991, when John Major negotiated the opt-out from monetary union at Maastricht, famously declaring “Game, set and match.” The next acts in the drama were the pound’s ejection from the European Exchange Rate Mechanism in 1992, and the decision by Tony Blair’s government in 1998 to exercise the opt-out.

These were the decisions that set Britain on a different path, ultimately leading to the fiasco of Cameron’s isolation in the European Council. His diplomacy may not have helped. Nor did his decision in 2009 to leave the centre-right European People’s Party group in the European Parliament, which made it even more difficult for him to forge a strategic alliance with Merkel and other European leaders. Yet the driving force of this process is not diplomacy but the decision to stay away from the euro.

The decision was economically justified. It would have been a disaster for Britain. The asset price bubble would have been bigger. The European Central Bank was initially much less forceful in dealing with the crisis than the Bank of England. If Britain had joined the euro, the eurozone would probably have fallen apart by now, and the EU would be under even more strain.

Where to go from here? The choice for Britain in 2017 is not really between in and out. If it votes to stay in, Britain will still not join the eurozone. Britain will seek even more areas of policy opt-out. On the positive side, such a vote would cement various rights that EU membership bestows on the citizens of its members, including the right of free travel and the right to set up residency anywhere in the EU. It gives members influence in setting up the rules of the internal market and external trade agreements. The single biggest advantage would be the theoretical possibility of entering the euro—if this is what one wanted to do. If the euro were to become an improbable success, perceptions could conceivably change. I doubt, however, that this will happen.

While a Yes vote would not propel Britain into the centre of the EU, a No vote would not turn Britain into a western European Belarus either. Under the Lisbon Treaty, the terms of a departure are freely negotiable. Britain could negotiate a long transition period that may be followed by another referendum. Britain could leave with a re-entry clause, should the country change its mind later on. There would be little advantage for Britain to join the European Economic Area—an enlarged single market that comprises the EU itself, Norway, Liechtenstein and Iceland. The EEA leaves members with no influence over single market legislation. Britain would have ended up with the worst of all worlds: continued regulation from Brussels but with no influence. Britain could, instead, negotiate its own sweetheart deal.

This is also what makes the economics of an exit so hard to calculate because one would have to make assumptions about the exit agreement, which we just do not know. I would not recommend to Britain that it seek an exit, but my suspicion is that if it were to happen, it would probably not have as dramatic an economic impact as some fear. Life in the outer sphere of the inner circle (the EU in this case) may ultimately not be all that different from life in the inner sphere of the outer circle (outside the EU, but with close relations to it) except that the former may be harder to sustain.

How is this conflict resolved? The best outcome for everybody would be a formal two-tier EU, with the eurozone at the centre, and a group of countries around it that require and prefer less integration. It would allow the eurozone to become more autonomous, more democratically accountable and more integrated. Market integration would be stronger inside the eurozone than within the EU as a whole.

It is not just British demands for renegotiation which might bring this about. The EU would want to avoid a British exit. Its members are not indifferent to this; it would be a huge reputational loss as well. A majority of countries, including Germany, would probably support such an arrangement if it is reasonable.

Of all the options, there is one that is not sustainable: for Britain simply to stay in the EU, not join the eurozone, and hope that it will all end well.