On October 22, 1957, a London Times headline declared: “Heavy Fog in Channel – Continent Cut Off.” Britain’s tabloid press displayed similar insularity in early December, 2011 after Prime Minister David Cameron vetoed an effort by the other members of the European Union to amend the Lisbon Treaty.



The amendment would have enshrined legally binding rules governing budgetary discipline and economic policy coordination in the eurozone with the aim of avoiding another Greek debt disaster. Echoing one of its notorious front pages from the 1990s that urged its readers to tell then-European Commission President Jacques Delors “where to stuff” the European Union’s new single currency, the Sun claimed that Cameron had blasted the “bully boys of Europe with a sensational Winston Churchill-style ‘Up Yours.’”


However, not everyone agreed that the Prime Minister had displayed admirable “bulldog spirit.” Nick Clegg, Deputy Prime Minister and leader of the Liberal Democrats—the Conservative Party’s coalition partner—complained that Cameron had not only undermined Britain’s influence in Europe and the United States but also put the interests of the City above those of the wider economy. Ed Miliband, the leader of the opposition Labour Party, claimed that the veto had been a “diplomatic disaster” which had “exposed, not protected, British business.” While Sir Richard Branson and a group of British businessmen warned the government of the risk that Britain would no longer be closely involved in the EU decision-making process, a poll indicated that a large majority of business leaders agreed with the Prime Minister and favored a looser relationship with the European Union.


Many EU leaders, above all German Chancellor Angela Merkel, had favored making budgetary discipline legally binding in EU treaties through a “fiscal compact” to save the euro. This approach was attractive in that it would have extended its rules equally to all EU member states inside and outside the eurozone. The European Commission would have had the ability to sue member states for non-compliance, and existing treaties would be amended to ensure maximum legal certainty. Cameron’s veto has not prevented all eurozone members and non-members—except the UK and the Czech Republic—from signing a new treaty on an intergovernmental basis. Still, the result is legally messy as the treaty has been superimposed on—and alters—a substantial body of existing legislation without formally amending it. Once implemented in January 2013, this treaty will require member states to pass “binding and permanent legislation” that caps budget deficits at 0.5 percent of GDP over the economic cycle and reduces total government debt to 60 percent of GDP or less over time.


It is questionable whether these new rules will succeed when the similar 1997 Stability and Growth Pact, which required member states to respect certain “convergence criteria” by capping budget deficits and national debt as a percentage of GDP, failed because most members ignored its rules. Even if the rules succeed, it is possible that the treaty will simply compound the structural imbalances at the heart of the eurozone crisis by requiring even more austerity of debtor countries. The treaty does not appear to address the European Union’s core challenge: stimulating demand and imports in surplus-creditor countries and encouraging the eurozone’s growth and competitiveness. In mid-January, Standard & Poor’s justified its downgrading of the credit rating of many EU countries, including previously triple-A rated France and Austria, in part on the basis that “a reform process based on a pillar of fiscal austerity alone risks becoming self-defeating.”


Still, while the British government may well have shared these legitimate concerns about the content of the treaty, its veto was not the best way to address them. It may have negative consequences, not only for Britain’s domestic politics and its relationship with the European Union and United States, but also for the orientation of the European Union itself.


 



 


The Rejection of UK Safeguards


Cameron returned from the EU Summit claiming that he had endeavored to respond in good faith to the Franco-German proposal for a treaty change among all of the European Union’s 27 member states. The legally binding protocol Cameron unsuccessfully sought included five key safeguards that he deemed “modest, reasonable, and relevant.” First, EU financial services harmonizing legislation must not prevent member states from imposing stricter national requirements like minimum bank capital on financial institutions. Second, the transfer of supervisory power over financial firms from national to EU agencies and the imposition of substantial levies on financial transactions cannot apply to the UK without its approval. Third, any agreement to tighten fiscal discipline among eurozone members must not distort the single market. Fourth, the new European Banking Authority must remain based in London. Finally, non-EU financial institutions—especially from the United States—based in the UK but without any other EU activities would not be subject to EU regulation.


In response to these demands, French President Nicolas Sarkozy claimed inaccurately that Britain wanted to “create an offshore zone in the heart of Europe” by securing an exemption from all financial service regulations. Britain did not ask for the right to “opt out” of EU financial regulation or for an “emergency brake” clause similar to that in the Lisbon Treaty enabling members to impede the application of specific EU legislation on their national laws in certain circumstances. Although the safeguards Cameron advocated were highly specific and technical, their implications were far-reaching: they would have imposed a unanimous voting requirement on decisions relating to some issues currently governed by qualified majority voting in the Council of the European Union, the principal EU decision-making body which shares legislative powers with the EU Parliament. This voting system assigns each member state a weighted vote—with smaller countries getting a greater vote than their populations would warrant—and sets thresholds for the approval of legislation by certain percentages of total weighted votes. The safeguards would have partially overturned the principle, enshrined in the 1986 Single European Act with the blessing of Prime Minister Margaret Thatcher and expanded in the 1992 Maastricht Treaty, that qualified majority voting should apply, with few exceptions, to single market legislation. If the UK were granted such safeguards, other countries could have sought protection for their sensitive national industries, such as the agricultural sector in France and the automotive sector in Germany.


The rejection of Cameron’s requested safeguards was due as much to annoyance with his tactics and a general impatience with the UK’s policy toward Europe as it was to substantive objections. Seen from the continental European perspective, Cameron had improperly attempted to hold the rest of the European Union hostage to Britain’s parochial concerns at a time when the future of the euro and potentially the single market itself was at stake. As Sarkozy was widely quoted for asking Cameron at the summit, “Why should we pay you to save the euro?” The fact that on the eve of the summit the UK Treasury circulated the draft protocol to the legal service of the European Council, the EU institution comprising the heads of government of the member states, and thereby left little time for analysis and clarification, reinforced the general impression that the British were acting in bad faith.


The 26 heads of government were not enthusiastic about granting the UK any favors when mainstream opinion considers the City of London a nest of speculators and the UK financial services industry the cause of the prolonged world financial crisis. Moreover, they were frustrated with the contradictions within Cameron’s position. On one hand, he called on the eurozone leaders to do more to save the single currency and requested that the UK be consulted on major eurozone decisions, including bank recapitalizations. On the other, he refused to contribute to the 500 billion pound European Stability Mechanism, the eurozone’s permanent bailout fund, or to contribute to the IMF-organized eurozone bailout package. One French official attending the summit compared Cameron’s position to that of a “man who wants to go to a wife-swapping party without taking his own wife.” Merkel and Sarkozy were particularly irritated by Cameron’s efforts to appease the diehard Euroskeptics within his party on whom he still depends for his majority in the House of Commons. His earlier decision to pull the UK Conservative Party out of the European Parliament’s alliance of center-right parties had been one important example of this appeasement.


 



 


It remains a mystery, however, how the UK found itself alone at the summit after having aspired to be the leader of the European Union’s ten non-eurozone members. The result was a serious and public split within the European Union and the risk that the 17 eurozone members, plus up to nine EU non-eurozone members, would agree to far-reaching financial rules amongst themselves without UK input. An oral opinion from the European Council’s legal service concluding that the amendments to the Lisbon Treaty could only be achieved by unanimous vote among the 27 members may have emboldened Cameron to table his protocol. In doing so, he appeared to neutralize the threat that the eurozone and other EU members would sign a separate treaty.


Many member states did not share Germany’s enthusiasm for a full-scale amendment to the Treaty because of the complexity, time, and risks it would involve, especially due to its requirement of national referendums in several member states and its likely rejection by the House of Commons. The legal service concluded that these obstacles could be avoided by enshrining the “fiscal pact” in a unanimously agreed-upon protocol. According to some commentators, the critical turning point in the negotiation process came when Cameron refused—despite prior indications to the contrary—to scale back his demands in light of the more modest Treaty amendment and the legal service’s clarification that a separate treaty would be compatible with existing EU law. At that point, it became clear that Cameron’s veto would not prevent the other EU member states from moving ahead without the UK.


Domestic political constraints significantly limited what Cameron could have negotiated at the summit. The Euroskeptic wing of his party, on whom his parliamentary majority depends, is larger and more vocal than it has ever been since Britain joined the European Economic Community in 1973. Ever since his election, Cameron has sought to engage in the political contortionism of publicly recognizing the benefits of full EU membership while conceding ever more ground to Euroskeptic demands. The Conservative Party’s 2009 withdrawal from the center-right coalition in the European Parliament only appears to have encouraged the Euroskeptic wing of the party to make further demands of the party’s leadership. One month prior to the summit, Euroskeptic members of the party made a motion in the House of Commons calling for referendum on the UK’s membership in the European Union by May 2013. The Prime Minister narrowly defeated this motion despite more than half of the non-Cabinet Conservative members voting against the government notwithstanding strict instructions to respect the views of the leadership. Cameron may well have worried that any EU treaty agreed among the 27, either in the form of an extensive amendment or a more modest protocol, would have triggered a rebellion within his own party and would have only passed, if at all, with Labour support.


The Fallout from the Veto


While Cameron’s room for political maneuvering was limited, the veto was unnecessary and potentially counterproductive to the UK’s national interests. It was unnecessary because the proposed EU treaty amendments did not, unlike previous ones, involve any loss of sovereignty since the “fiscal compact” would have only applied to the eurozone members. It is unclear whether there was any need for further “safeguards” for the UK’s financial services industry when the UK has never been outvoted on any material EU financial services legislation and when certain controversial EU proposals (such as the “Tobin tax” on financial transactions) could never be implemented at the EU level without the UK’s agreement. In many other areas of financial services, such as short selling and capital adequacy, the UK long ago surrendered significant control to the EU. Moreover, the UK is ironically as concerned about its ability to impose financial services regulations that are more stringent than those applied by the EU as it is by excessive red tape from Brussels. For example, no other country in the EU has gone as far as the UK in requiring high bank capital ratios (10 percent rather than 7 percent as recommended by the global Basel III Agreement) and the ring-fencing of retail and investment banking operations. What is more, the EU has insisted that it will not interfere with efforts by the UK to set such higher standards.


The veto was also a misnomer because it did not stop the members of the “Eurozone Plus” caucus from moving ahead on their own. As EU Economic Affairs Commissioner Olli Rehn stated after the summit, “If [Britain’s] move was intended to prevent bankers and financial corporations of the City from being regulated, that’s not going to happen.” The veto could actually be damaging to UK interests because it will result in all EU member states (except the UK and the Czech Republic) meeting at least twice per year, with the UK attending only as an “observer” to discuss issues of relevance not only to the euro but perhaps also to the single market. By offering an opportunity to align policy prior to EU meetings among the 27, this caucus may complicate the UK’s ability to defend its interests, as it has done so effectively in the past, on a wide range of policy areas, not just financial services.


 



 


Yet, isolation does not in and of itself mean that the veto was misguided. The Euroskeptics may well feel vindicated in opposing UK adoption of the euro on the basis that the monetary union would not work without political and economic union. As The Economist has rightly pointed out, Britain is also unique in the EU in that its membership has always been a matter of a cold cost-benefit analysis rather than the product of faith in or need for European integration. For example, the French have needed integration to manage German power and magnify French influence, while the Germans have (until recently) been loath to exercise their power for fear of frightening their neighbors. Furthermore, some countries, such as the Benelux, have been too small to manage alone, while others, such as Italy, have welcomed the imposition of rules and discipline from the outside when national institutions have been sadly lacking in legitimacy. By contrast, the UK sees the EU as only one source of influence and advantage.


Nonetheless, a decision to abdicate its seat at the EU negotiating table would reverse more than 50 years of UK policy toward the EU. In 1955, the Foreign Office sent a junior official to the Messina Conference, which gave birth to the 1958 Treaty of Rome establishing the European Economic Community. The official famously declared: “Gentlemen, you’re trying to negotiate something you will never be able to negotiate. If negotiated, it will not be ratified. And if ratified, it will not work.” The result, of course, was rather different. After signing the Treaty without having been able to influence its contents, the UK resolved to be present at and influence discussions within EU bodies on issues relevant to its interests. Until Cameron’s non-veto “veto,” UK negotiating policy had been governed by the fear that “when you’re not at the table, you’re on the menu.” Now, having marginalized itself and confirmed long-standing suspicions that the Euroskeptics and the City are bedfellows, the UK may find that it has compromised its ability to forge coalitions with like-minded EU members.


In the weeks following the EU Summit, Cameron objected to the use of existing EU institutions to enforce fiscal discipline under their intergovernmental treaty, but he subsequently reversed course. The European Commission will have the right to monitor the compliance of the member states with their treaty obligations and to make recommendations in the event those obligations are breached. The member states undertake to support those recommendations unless a qualified majority of them is opposed. Moreover, the member states are required under the treaty to implement proposals of the European Commission regarding the corrective actions that will be triggered automatically in the event of significant deviations from the budget and deficit rules. In the event that a member state has breached its obligations under the treaty, other member states may request that the European Court of Justice issue a binding judgment on the matter and, if necessary, to impose penalties of up to 0.1 percent of GDP. Although Cameron’s reversal reflects the reality of how difficult it would be to prevent other EU member states from using EU-wide institutions in this manner, it begs the question of what precisely the government achieved by staying out of the intergovernmental treaty.


Initial indications suggest that the agenda for the “Eurozone Plus” summit meetings may be ambitious. The intergovernmental treaty states that the agenda will include questions regarding not only the single currency and the governance of the euro area, but also “strategic orientations for the conduct of economic policies to increase convergence in the euro area.” The parties to the treaty shall “ensure that all major economic policy reforms that they plan to undertake will be discussed ex ante and, where appropriate, coordinated among themselves.” The UK fought successfully to ensure that the text does not refer to the single market, except to make explicit that no measures to strengthen the euro area would undermine it. However, the dividing line between issues strictly related to eurozone stability and those related to the single market may often be hard to distinguish. For example, the eurozone members may wish to discuss further convergence of banking regulations—which, like other single market issues, are subject to qualified majority voting—as part of their efforts to bolster the euro. Overall, the creation of this caucus represents a victory for the French ideal of an EU run on an intergovernmental basis by a “Directoire” of leaders from larger states, above all France and Germany. This vision aims to jettison the more liberal and market-oriented policies of the Anglo-Saxon, Central European and Scandinavian “periphery.”


 



 


The increasingly unhappy marriage between the Conservatives and the Liberal Democrats in the UK may well survive this latest crisis as it has survived prior crises like the reform of the National Health Service. However, if the Euroskeptics ever define their alternative vision of UK’s role in the world beyond the EU, they may discover that it is a mirage. The UK cannot afford to emulate a non-member such as Norway, lacking the latter’s sovereign wealth fund and vast oil and gas reserves. Moreover, the EU will not permit the UK to be a deregulated financial center like Hong Kong on the periphery of Europe. Nor would the UK be able to withdraw from the EU and negotiate the same deal as Switzerland has, with its membership in the European Free Trade Association, as this move would fundamentally alter the nature of the single market.


It is also unlikely that the UK could strengthen its ties with the United States or with emerging powers if it withdraws from or even weakens its ties with the EU. Deputy Prime Minister Clegg made this point very clearly when he said, “There is nothing bulldog about hovering in the mid-Atlantic...If we stand tall in Europe, we’re taken seriously in Washington. If we don’t stand tall in Europe, I don’t think Washington will be particularly interested in us.” David Miliband, foreign secretary from 2007 to 2010 under the Labour government, has argued that the UK’s influence in Beijing, Delhi, and Moscow would wane for the same reasons.


The impact of the veto on the EU as a whole, including its institutions and its members that share the UK’s economic and political philosophy, will be significant, especially if events unfold in a way that leads to the UK’s eventual withdrawal. A two-speed Europe has emerged, composed of an increasingly integrating core, guided by Germany and France, and a disengaged periphery. Now that the UK may find itself as one of a few members of this periphery, its ability to influence the core will diminish. As European Commission President Manuel Barroso has rightly pointed out, the question is whether such a split union attuned to contradictory objectives and dominated by “an unhealthy balance of power or indeed any kind of directorium” can work.


The UK has certainly made significant contributions to the EU since joining. These include not only the expansion of its external defense policy, notably the reinforcement of its Atlanticist orientation, but also the deepening of its single market and competitiveness in an increasingly globalized economy. A diminished role for the UK in the EU will disappoint other EU member states like Denmark, Sweden, the Netherlands, and Poland, which have always wanted the UK to balance the power of Germany and France and which have welcomed a forceful ally in promoting an economically liberal agenda. The United States would also lose an important voice within the EU to promote common objectives across a wide variety of economic and political areas. In the new intergovernmental arrangement, it is also possible that the European Commission and the European Court of Justice will be weakened and therefore less able to protect the single market. These institutions, though reviled by the Euroskeptics, are in fact allies on many important fronts such as promoting free trade, economic liberalization, and competition. The end result of such an arrangement may be a more protectionist and inward-looking union, which would not be to the benefit of the UK or to the world.


The veto was no doubt useful as a piece of political theatre, as Cameron has solidified his majority in the House of Commons, at least for the time being. However, it would be a pity if it encourages the rest of the EU to adopt a new orientation, resulting in increased public disillusionment in the UK and unstoppable pressure for a referendum on EU membership. A recent poll indicates that 70 percent of British voters already desire such a referendum and that 49 percent would vote for UK withdrawal. There is still a low risk that the situation will degenerate to this point, as Cameron continues to emphasize that the UK is a committed member of the EU and the single market. Yet, for the first time, full withdrawal is a real possibility. Martin Schulz, the recently elected President of the European Parliament, believes that it is even likely to occur in the long-term. With all that is at stake, Britain’s friends should wish for clear skies over the Channel.


 



 


Anthony Luzzatto Gardner is the Managing Director of Structured Finance at Palamon Capital Partners. He was the former Executive Director of European Leveraged Finance for Bank of America, and served as Director for European Affairs in the National Security Council from 1994-1995.