Britain should preserve its free trade status in Europe but cut loose from the tentacles of political union, argues Patrick Minford.

John Major went to war with Europe over our cows. With him marched the Tories' Europhiles, including Michael Heseltine and Kenneth Clarke. But a truce was declared at the subsequent Inter Governmental Conference summit in Florence. A "framework" was set. Our European Union partners cannot afford such a war dragging on, as they desperately want to build the next stages of political union.

Having recently returned from a conference in central Europe, I can report that the desire for union burns stronger than ever in the breasts of the Belgians, Dutch, French and Germans; and the Italians and Spanish would love to join in too. Elite opinion is determined to give the ordinary continental punter no chance of stopping European union. Should there be protests in Bild and Stern about our Deutschmark, the people will be treated to severe lectures on their duty to European union and will fall, ashamed, into line. Postponement of monetary union is still an option; but even if exercised it will be tactical. There is a palpable drang nach union.

Union means federalism. The game is up, for us, and for our notions of a Europe of nations. De Gaulle is dead, Chirac is not to be trusted, and the establishment in France has decided union is the thing; the French will then be the Greek head to Germany's Rome. And they will put the Italians in the front line as grateful spokesmen. So what do we do, now the beef war is at least cooler, if not over? I believe that we can cut a deal whereby we preserve a free trade arrangement with Europe and let it go its own way. There are good political reasons for such a deal: Europe wants to unite, and we can veto its doing so via the Treaty of Rome. So there is a strong political incentive to give us what we want as the price of our not using that veto. But what about the economics of the deal?

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Much is made of trade deficits and surpluses between ourselves and Europe. But these are strictly irrelevant; when trade is multilateral one can have deficits with some, surpluses with others and this just reflects comparative advantage. Japan, which has no natural resources, has a huge deficit with the Middle East (oil) and a large surplus on manufactures with the rest of the Organisation for Economic Cooperation and Development. This does not mean the OECD "loses" to Japan, and the Middle East "gains" from Japan. They are merely exchanging their produce at world prices, and so both gaining from trade.

If we left the EU entirely one major concern would be the Common Agricultural Policy. The CAP is well-known. We would be better off if we were outside it, to the tune of about 1.5 per cent of our national income. This is because we are a net importer of food and the CAP makes us pay more for our imports, wherever they come from. By the same token, since we pay this over to our EU partners, they gain this amount from us - roughly 0.4 per cent of their national income.

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But, on other trade, virtually the only goods on which the EU, and so we too, place restrictions are consumer durables, especially cars and electronics from the Far East. In 1992 we were net importers of these goods, to the tune of Pounds 6 billion. These EU arrangements raise their price by some 30 per cent, all of it paid over to those mostly Far Eastern producers. Hence being in the EU at that time would have cost us a few billion: basically 30 per cent of Pounds 6 billion plus a bit more.

But look a bit further ahead and factor in the effect of our very low labour costs on like-for-like plants and labour practices (about 40 per cent of Germany's for example) and the wave of inward investment that has capitalised on them in the past 16 years. These are poised to add substantially to UK production of cars, electronics and other consumer durables and convert our deficit on these goods into a surplus. That means that we will be gaining an extra 30 per cent in value on this prospective surplus, compared with our not being in the EU; and we will have generated well-paid jobs for people who might have remained jobless.

We might also want to argue that the broader single market gives our large competitive service firms such as British Airways, BT and the insurance industry some advantages. Figures are hard to come by and the precise help given by the single market unclear, but overall our gains from being in the single market in non-agricultural trade could amount to around the same 1.5 per cent of national income that our CAP bill costs us.

It is this that Michael Heseltine has in mind when he defends our EU membership. Clearly he has a point. Another way of putting it is to say that within the EU we are like an emerging market economy with our much lower labour costs but our full access to the protected EU market in cars, electronics and other consumer durables. On these calculations our EU partners do not lose from our new-found surplus on these goods. The reason is that their extra imports from us are matched by lower imports from the Far East. If matters were just to rest there, the outline of an economic deal is clear. Consider the cards in our hand: we hand them over CAP money, and we have a veto on their further union via the treaty. Now consider the cards in their hands: they know we gain from our transplant trade (of Japanese and Korean companies operating in Britain), and they themselves are indifferent over keeping this transplant output out of their market.

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The natural deal is for us to retain the trade status quo with the EU. Were we to withdraw from the CAP they could retaliate for their loss by protection against UK-based manufactures. Were they to threaten to dump the treaty and assert protection against us, they would lose the benefit of our CAP money, besides having to create a new treaty and indeed act illegally in dumping the treaty - for which there is no provision.

Best for both sides to stick to the status quo on trade, the CAP and the single market. Meanwhile we can trade our veto on union for a comprehensive political opt-out, including explicit limits on the scope of the European Court.

So far so good. But I have left out some awkward future issues. Indifference about our transplants would soon turn to fury were they to expand beyond mere import-substitution and start to wipe out continental production. From our side we cannot afford the social costs that threaten from the social chapter. Nor can we stand the single currency, given our worldwide trading relations. Yet our partners see these as a way of stopping us becoming excessively competitive; the Germans worry about our low social costs, the French about our competitive devaluations.

Our aim should be to protect our present and prospective investments aimed at this protected EU market. But to go any further with building up these investments courts great risk. We could find ourselves blackmailed into accepting the social chapter and European monetary union as the price of continuing to let our goods into the continent. This would all change if the EU became free market - but that looks unlikely. So in practice our deal would be accompanied by understandings that we would not undermine protected continental production. That way we can have free trade within limits with the continent and unlimited free trade with everyone else.

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Should they refuse to agree any such deal, we can then refuse any further changes to the Treaty of Rome. Should the measures taken under the treaty as presently constructed become intolerable - I have in mind such decisions as those on common standards for the single market in buses banning the double-decker, or the imposition of working time limits under health and safety rules - then the option remains to leave. We would lose about the same on our access to the EU single market as we would gain from leaving the CAP: a depressing end to a long and well-intended EU policy initiative, and a let-down to our "transplant" investors, but hardly a national disaster.

The EU is a project many aspects of which are going sour. However, with goodwill on the continental side as well as from ourselves I have sketched out here the basis for a "new deal". It is hard to say whether that goodwill is likely to be forthcoming. I hope so. But if it is not, then we can walk away from the EU without economic damage.

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Patrick Minford is professor of applied economics, University of Liverpool. Europe - the Balance Sheet is published by MCB University Press for the Centre for European Studies.