George Osborne has raised the prospect of Britain leaving the European Union if the 28-nation bloc fails to undertake fundamental reforms to improve competitiveness, create jobs and protect the rights of countries which are not in the single currency.
The Chancellor suggested that if the UK was unable to secure support for reform from all EU states, it was ready to press ahead with a smaller group of like-minded countries under what he termed "enhanced co-operation".
In a keynote speech, the Chancellor said that the treaties underpinning the EU were no longer "fit for purpose" and failure to reform will condemn the continent to a future of economic crisis and decline, warning: "We can't go on like this."
Mr Osborne stressed the Government's determination to renegotiate the terms of British membership in order that the UK can remain in the EU following a referendum in 2017.
But he said that growing integration of the eurozone had posed threats to the position of Britain's financial services industry and the City of London and said it was "absolutely necessary" to introduce proper legal protection of the rights of EU states which are not in the eurozone. He warned Brussels not to put the UK in a position where it has to choose between joining the single currency to protect its interests or leaving the EU.
Speaking to a conference hosted by the thinktank Open Europe and the Fresh Start Project in London, Mr Osborne said: "Europe urgently needs economic reform. Eurozone integration is necessary if the euro is to survive. But proper legal protection for the rights of non-euro members is absolutely necessary to preserve the single market and make it possible for Britain to remain in the EU.
"I believe it is in no-one's interests for Britain to come to face a choice between joining the euro or leaving the European Union. We don't want to join the euro, but also our withdrawal from a Europe which succeeded in reforming would be bad for Britain. And a country of the size and global reach of Britain leaving would be very bad for the European Union."
Mr Osborne added: "It is time to change the European Union and to change Britain's relationship with it and then to place the decision in the hands of the British people. Do we want to stay in a reformed Europe or would we prefer to leave?
"That is our policy and that is our commitment to the British people."
He said: "Now we have the chance to give the British people a real choice. The biggest economic risk facing Europe doesn't come from those who want reform and renegotiation, it comes from the failure to reform and renegotiate. It is the status quo that condemns the people of Europe to ongoing economic crisis and continuing decline.
"There is a simple choice for the European Union - reform or decline.
"Our determination is clear - to deliver the reform and then let the people decide, and that is exactly what we will do."
Mr Osborne's intervention came after Euro-sceptic backbenchers shattered the Tory truce on Europe with a call for Parliament to be given a veto over EU legislation.
Ministers were quick to dismiss the plan - set out in a letter signed by 95 Conservative MPs - as "unworkable", warning that it would undermine the single market.
Mr Osborne however made clear that ministers recognise a need for reform of the EU, at a time when Europe is falling behind the rising economic powers of Asia, while its welfare spending outstrips the rest of the world.
The financial crisis of 2008 had dramatically exposed the underlying weakness of the European economy, he said.
"We knew there was a competitiveness problem in Europe before the crisis. But the crisis has dramatically accelerated the shifts in the tectonic economic plates that see power moving eastwards and southwards on our planet," said the Chancellor.
"Over the last six years, the European economy has stalled. In the same period, the Indian economy has grown by a third. The Chinese economy by 50 per cent. Over the next 15 years Europe's share of global output is forecast to halve.
"Make no mistake, our continent is falling behind. Look at innovation, where Europe's share of world patent applications nearly halved in the last decade. Look at unemployment, where a quarter of young people looking for work can't find it. Look at welfare.
"As (German chancellor) Angela Merkel has pointed out, Europe accounts for just over 7 per cent of the world's population, 25 per cent of its economy, and 50 per cent global social welfare spending."
Mr Osborne said that to avoid decline, the EU must expand free trade, increase competitiveness and take action to ensure that member states cut their deficits.
"The hard truth is that if we want to maintain our way of life in Europe we've got to get more competitive," he said. "And that's going to require some tough steps: living within our means, making our labour markets competitive, expanding free trade."
He said other EU members shared Britain's concerns, and indicated that he was ready to consider "enhanced co-operation" with these countries on measures like trade liberalisation and completing the single market in energy, services and digital.
"I'm attracted to Open Europe's thoughts on using enhanced co-operation to allow a smaller group of member states to move forward toward trade liberalisation in areas like services among themselves, if not all EU member states can agree," said Mr Osborne.
"If enhanced co-operation can be used by others to create expensive job-destroying ideas like a financial transaction tax, why don't we think about using it for job-creating measures that others oppose?"
Britain did not oppose measures required to stabilise the single currency, such as banking union and new mechanisms to bail out eurozone banks, said Mr Osborne.
But he said the UK had fought to protect the interests of non-eurozone states, demanding a new system of "double majority" voting to prevent eurozone states - including some with no financial services industry of their own - using their combined voting weight to impose regulations on the City of London, as well as taking the European Central Bank to court over plans to force clearing zones with large single currency transactions to move to the eurozone.
"We have been clear from the outset that in return for this integration, non-euro members like the UK would need safeguards to protect their rights and interests," he said.
"Some on the continent like to assume this is just the UK pursuing its own self-interest, at the expense of the collective good. But it's the opposite. If we cannot protect the collective interests of non-eurozone member states then they will have to choose between joining the euro - which the UK will not do - or leaving the EU."
Eurozone integration was exposing the need for the EU's treaties to be rewritten, said Mr Osborne.
"What is becoming clearer, as eurozone integration increases, is that we are now at a point where we are stretching the EU institutional architecture to its limits," he said. "We risk going beyond what is legally possible or politically sustainable.
"The European treaties are not fit for purpose. They didn't anticipate a European Union where some countries would pursue dramatically deeper integration than others.
"Rather than face up to the truth, those in Brussels are being forced into legal gymnastics as they try to stretch the existing treaties to fit a situation they were not designed for."
He added: "Ultimately I don't think we will be able to maintain this approach of patching things up as we go along with contorted legal innovations and short-term fixes. We are taking a great risk with the future economic security of Europe if we do so.
"Instead of make-do-and-mend, we should make the treaties fit for purpose."
Labour said that, instead of threatening a British exit from the EU, the Chancellor and Prime Minister David Cameron should be driving reform in Europe.
Shadow foreign secretary Douglas Alexander said: "The Conservative leadership seems to be spending more time negotiating with their backbenchers than negotiating with Europe to deliver real reform.
"All of us know change in Europe is needed, but the tragedy is that David Cameron's internal party weakness is preventing him from approaching the need for reform in a sensible way.
"A year on from his Bloomberg speech, David Cameron's approach to the EU has been shown to be not just bad policy, but also a bad party management strategy, with nearly half of his own backbenchers just this week demanding more.
"Instead of threatening exit, David Cameron and George Osborne should be focused on delivering reform in Europe. Reform in Europe, not exit from Europe, represents the right road for Britain."
UK Independence Party leader Nigel Farage dismissed Conservatives' claims to be able to lead a process of reform in Europe as "utter bunkum".
Speaking outside the European Parliament in Strasbourg, Mr Farage said: "Once again we have the Conservatives talking about EU reform, and once again their claims are utter bunkum.
"The Conservatives are not going to get re-elected with a majority next year so we can wave goodbye to that referendum pledge, even if anyone trusted another David Cameron referendum pledge. The EU is not going to suddenly turn around and be dictated to by a man with only 15 months left as Prime Minister and who has repeatedly caved in to their demands and given away any leverage in the negotiations he may have had by declaring his support for EU membership."
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