On doing the right thing

Great Britain Saves Itself by Rejecting the EU

The French and Germans may howl with outrage, but David Cameron did the right thing in pulling up the drawbridge to a continent on the verge of collapse, says Niall Ferguson.

by Niall Ferguson

To listen to some conservative commentary in London on Friday, you would think the British Prime Minister David Cameron just morphed into Winston Churchill, valiantly upholding England’s ancient liberties against German aggression. In fact, what happened in Europe this week was nothing so grandiose. 

David Cameron’s refusal to back a Franco-German plan to revise the European Union treaty was the culmination of a consistent Conservative policy, dating back to Margaret Thatcher and continued under John Major. That policy has been to resist any steps taken in the name of European integration that would in practice lead to Britain’s becoming a member of a federal Europe.

Cameron is not—despite the opprobrium that has been heaped on his head by everyone from the French President Nicolas Sarkozy to the shadow foreign secretary Douglas Alexander—a pathologically insular Little Englander. Like Margaret Thatcher, he believes in the single European market. Like John Major, he opposes British membership of the European monetary union. As over the Schengen Agreements on passport-free travel, as over the euro, Britain has once again reserved its right to retain sovereignty over key areas of policy.

Nor is this an exclusively Conservative policy tradition. Gordon Brown, too, resisted the siren calls of the Europhiles in his own party to take Britain into the EMU. I don’t think he did this out of high principle, mind you. I suspect it was partly to spite Tony Blair, partly to maximize the economic power he retained as chancellor of the Exchequer and partly to please his friends in the City, many of whom were rather put off of monetary union by the trauma of Britain’s brief membership of the Exchange Rate Mechanism. Nevertheless, Brown’s preservation of the pound was his single greatest achievement. Had he yielded, the British economy would now be suffering a far more agonizing economic contraction, because we would have lacked the monetary flexibility that was so successfully used by Sir Mervyn King to mitigate the impact of the 2008-9 financial crisis.

So it is not that British policy has dramatically changed. The real historical turn is the one now being taken by the 17 euro zone members and the six non-euro states that have chosen to follow them. For there should be no doubt in anyone’s mind that what they have just agreed to do is to create a federal fiscal union. Moreover, it is a fundamentally flawed one. The only surprising thing is that so few other non-euro countries—Sweden, maybe the Czechs and Hungarians—have joined Britain in expressing reservations. I quite see why countries with the euro are prepared to give up their fiscal independence to avert a currency collapse. But what on earth is in this for the others?

Nicolas Sarkozy, as usual, bad-mouthed the British prime minister in the hope of maximizing his own personal glory at the expense of la perfide Albion. “Very simply,” declared the French president, “in order to accept the reform of the treaty at 27, David Cameron asked for what we thought was unacceptable: a protocol to exonerate the U.K. from financial-services regulation. We could not accept this as at least part of the problems [Europe is facing] came from this sector.” This is claptrap of the lowest order.

To see why, you need to read the “international agreement” announced in the early hours of Friday. The stated aim of the agreement—which would have been the aim of EU treaty revision had Cameron rolled over—is to establish and enforce “a new fiscal compact and strengthened economic policy coordination” in the euro area. The phrase “fiscal stability union” is explicitly used. It is to be based on “common, ambitious rules” and “a new legal framework.”

How will this work? The answer is that there will be a “new fiscal rule”: “General government budgets shall be balanced or in surplus; this principle shall be deemed respected if, as a rule, the annual structural deficit does not exceed 0.5 percent of nominal GDP.” This balanced budget rule is to be adopted in the national constitutions of euro zone members. But there will also be an “automatic correction mechanism,” enforceable by the core EU institutions—the commission, the council, and the court—if member states violate their own constitutions.

Moreover, the document states that there will henceforth be “a procedure … to ensure that all major economic policy reforms planned by euro area Member States will be discussed and coordinated at the level of the euro area” with regular euro zone summits to be held at least twice a year. The French and Germans leaders have made it clear that they envisage harmonizing labor law, taxation, and financial regulation on this basis.

This, in sum, is the founding charter of the United States of Europe. Notice two problems however. First, it is not clear how the European Commission, Council, and Court can act in this way, policing a 23-member fiscal union that is not covered by any treaty. Second, the balanced-budget rule is nuts. As it stands, it’s a recipe for excessive rigidity in fiscal policy—unless you think the rest of the Brussels Agreement implies a significant centralization of fiscal policy. Because you cannot have a balanced budget rule for member states if you don’t also have a federal government with flexible fiscal rules (as in the U.S.).

So where is the clause describing the new USE Treasury, with the right to issue bonds as well as to transfer resources from the more productive to the less productive member states? The answer is there isn’t one because the German voter refuses to countenance such a thing. That means one of two things. Either it’s going to be created by stealth—or this is a federal union that will be dead on arrival. I think it’s supposed to be the former, but I am not sure.

Remember, none of this would be happening if it wasn’t for a disastrous crisis of the Eurocrats’ own making. Twelve years ago, I was one of a small band of commentators who warned correctly that a monetary union without some fiscal component would fall apart after about 10 years. Four years ago, I was also one of a handful of people who pointed out that the German banks were in worse shape than the American banks and needed urgent attention. Europe’s leaders ignored these arguments. The result has been an entirely predictable combination of fiscal crisis and banking collapse.

There is now a depression on the other side of the English Channel, and it is the continent that is cutting itself off—from sane economic policies.

In the past few months, incompetent leadership has brought the euro-zone economy, and with it the world economy, to the edge of a precipice strongly reminiscent of 1931. Then, as now, it proved impossible to arrive at sane debt restructurings for overburdened sovereigns. Then, as now, bank failures threatened to bring about a complete economic collapse. Then, as now, an excessively rigid monetary system (then the gold standard, now the euro) served to worsen the situation.

For some time it has been quite obvious that the only way to save the monetary union is to avoid the mistakes of the 1930s. That means, first, massive quantitative easing (bond purchases) by the European Central Bank to bring down the interest rates (yields) currently being paid by the Mediterranean governments; second, restructuring to reduce the absolute debt burdens of these governments; third, the creation of a new fiscal mechanism that transfers resources on a regular basis from the core to the periphery; and finally the recapitalization of the ailing banks of the euro zone.

The problem is that the Brussels Agreement only does these things in the most half-hearted way. Aside from new borrowing, euro-area governments have to repay more than €1.1 trillion euros of long- and short-term debt in 2012, with about €519 billion of Italian, French, and German debt maturing in the first half alone. Meanwhile, the European banks need, we are now told, €115 billion of new capital—of which €13 billion is required by German banks.

Yet the European Financial Stability Fund has been capped at €500 billion, of which more than half has already been committed. The International Monetary Fund is to be given (by whom?) just €200 billion to recycle back (to whom?). And the ECB has committed itself to spend no more than €20 billion a week on bond purchases in the secondary market.

It is all, quite simply, too little. And the result is that the euro zone is about to repeat history. In the absence of sufficient resources for the new federal model, the new rules about budgets (and bank capital) are going to lead to pro-cyclical fiscal and monetary policies, deepening rather than alleviating the economic contraction we are witnessing.

“Eurozone Deal Leaves Britain Isolated” trumpets the Financial Times, for many years an ardent proponent of monetary union. But if David Cameron can succeed in isolating Britain from the disaster that is unfolding on the continent, he deserves only our praise. For once the old joke—“Fog in the Channel: Continent Cut Off”—seems applicable. There is now a Depression on the other side of the channel, and it is indeed the continent that is cutting itself off—from sane economic policies.

Last month I warned that the disintegration of the European Union was more likely than the death of the euro. You now see what I meant. The course on which the continent has now embarked means not just the creation of a federal Europe, but a chronically depressed federal Europe. The Eurocrats have exchanged a Stability and Growth Pact—which was honored only in the breach—for an Austerity and Contraction Pact they intend to stick to. The United Kingdom has no option but to dissociate itself from this collective suicide pact, even if it strongly increases the probability that we shall end up outside the EU altogether.

Many more brickbats will rain down on David Cameron in the days to come. But he has done the right thing. And he will swiftly be vindicated by events on the cut-off continent.