Observer writers analyse the political and financial implications of the PM's refusal to fall in line with the rest of Europe

Question 1: how did Britain wind up on the fringe of Europe?

France, Germany and their neighbours have waved us goodbye. Political editor Toby Helm examines Britain's fractious history within Europe

"Auf Wiedersehen, England!" was how German magazine Der Spiegel reacted in the early hours of Friday. "Der Euro ist wichtiger als die Briten," (the euro is more important than the British) concluded the German tabloid, Bild.

It was as much in sorrow as in anger that the Germans and French bid a weary farewell to the UK as part of the European mainstream and waved it over into the EU's slow lane.

Indeed, Le Monde devoted an editorial to all that it admired in its neighbour – from the BBC, to John le Carré, to Elizabethan poetry and Liverpool FC. But its conclusion was blunt: "As dawn broke on 9 December, Europe was right to say No to London."

Down the years, German and French leaders, from Kohl and Mitterrand to Schröder and Chirac had tried their best to accommodate the UK as a fellow traveller on the great European journey.

But it had always been a struggle. During the UK's 38-year membership of the European Community, and latterly Union, the true believers had, too often in their eyes, to make special exceptions for the "awkward Anglo-Saxons". The "Brits" wielded handbags and threatened vetoes, insisting all the time on remaining at the top table of discussions despite opting out of Europe's more ambitious ventures – the Schengen open borders agreement and the euro being chief among them.

Around 4am on Friday the EU finally ran out of patience with the UK and David Cameron ran out of road. Under intense pressure from his Eurosceptic party to show the "bulldog spirit" he applied the veto and found himself suddenly alone.

Although the UK originally thought it had the support of others including Hungary, in the end it turned out to be the only EU member state to refuse to sign a new intergovernmental accord designed to save the euro. The talks broke down when Cameron failed to get the assurances he was seeking for the City of London and Britain's place in the single market. The prime minister insisted upon a legally binding "protocol" to protect the City from more EU financial regulations. He didn't get one so he blocked a deal.

French president Nicolas Sarkozy, furious that the British were lobbing in their own last-minute demands when everyone else was there to save the euro, told the prime minister: "You can't have an offshore centre taking Europe's capital."

Playing to the domestic gallery, Cameron said he had acted in the national interest. Tory Eurosceptics were delighted. But Cameron's veto – while releasing short-term pressure at home – is a massive political gamble.

The UK is now likely to be out of the loop at the outset of crucial EU debates for years to come. Our partners now have a forum in which to seal alliances on single-market issues in advance of votes being taken. But the UK will be locked out.

Cameron has also set a time-bomb ticking under the coalition with the pro-EU Lib Dems. Several party grandees and Lib Dem MEPs are furious that the Tory/Lib Dem government has put the UK on the EU's sidelines where Nick Clegg has always insisted it must never be.

The 1990s and 2000s saw successive British leaders, Labour and Tory, trying to reconcile the largely irreconcilable as they attempted to ride two horses at once, the broadly sceptical British one and the European one. It was well nigh impossible. Tony Blair was blocked from joining the euro by Gordon Brown and so lost kudos in the EU.

Reel forward to David Cameron and the same tensions have applied. His problems, however, have been deeper for two reasons. First he made rash promises to the right of his party that have come back to haunt him. Critics say this was because he never bothered to engage his mind on Europe.

Britain and the EU

During his leadership campaign in 2005 he attracted sceptic support by promising to pull the Tories out of the pro-integration alliance of centre-right parties, the European Peoples' Party (EPP). He infuriated Merkel and Sarkozy when he did so and formed a rival anti-integration group with a hotch-potch of eastern European parties with nationalist, homophobic and anti-semitic connections and no influence in the EU.

His second difficulty has been one of timing. His premiership has coincided with the euro crisis, and Cameron felt he had no option but to call for more fiscal union to prevent European and global financial disaster. Conservative sceptics saw their chance when euro leaders suggested a new EU treaty to deliver that union. Here was Cameron's opportunity to demand repatriation. But he was wisely advised it would be mad to push such demands when the euro was on the edge. He pulled back. The sceptics cried "betrayal" again, and turned up demands for a referendum. Again Cameron's answer was no.

As he headed to Brussels on Thursday, some Tories were mumbling about a leadership challenge. Politically Cameron simply had to deliver. Now he and the UK must face the consequences.

What Europe's voters say. Photograph: Guardian

Question 2: how will voters respond?

Britons are split on Europe – but all parties think Friday's events will help them at the polls, writes Policy Editor Daniel Boffey

It is a strange fact that all the political parties believe David Cameron's actions in Europe last week will benefit them electorally in the coming years. The reasons they give centre on Britain's tortuous and complicated relationship with the continent.

Britons are split on their feelings over the EU with 42% of people having a positive or very positive image of it, compared to 39% holding the opposing negative view and 19% with no view at all, according to the latest European Commission poll.

But Britons, more frequently than not, cannot shake off the feeling, whether pro-European or not, that the country is somehow being short-changed by the EU; that the economic costs of being a member exceed the benefits.

On average, Britons believe we lose out by around 19% of the country's gross national product every year to the EU. In reality, the latest figures show that the UK contributes just 0.12% more of its GNP than it receives.

By so publicly standing up for Britain's interests in the face of overwhelming opposition, the prime minister, one Tory MP said, is likely to strike a chord across Britain. "And of course, now that this European club is free to make decisions against our national interest on a routine basis, even more people will feel a Eurosceptic urge," he added. Senior Tory MPs believe that not only will there be a referendum on our future with Europe before 2015 but it will demonstrate a rise of Euroscepticism across the political spectrum that could help deliver a Tory majority.

That isn't the Liberal Democrat view. While irritated by Cameron's tactics, and in particular the bragging rights last week's development provides the Eurosceptic right, there is quiet confidence that Cameron's isolationism will prove once and for all that Britain needs to be at the centre of Europe or fail.

Evan Harris, the former Lib Dem MP for Oxford West and Abingdon, said: "This is a victory for the Tory right but it is a victory over the Tory left. There is a good chance that being on the sidelines will hurt our economic recovery and our electoral hopes are rather tied to that. But we would rather be competing against a rightwing Tory party than a leftwing progressive one. If it looks as if what the Tory right has done is merely prevent the bankers from being regulated, there will be a price to pay." David Rendel, the former Lib Dem MP for Newbury, added: "As decisions which affect us are made, the electorate will see what a disaster David Cameron's actions have been for the country and, in fact, for his party."

Meanwhile, Labour leader Ed Miliband has this week been adamant that Cameron's actions in Brussels were a disaster for the Tories. Should the economy continue to struggle or even suffer a further downturn, Labour will now be able to say that not only have the Tory-led government's economic policies led to the average worker being less prosperous but that its foreign policy has led to the country losing its voice at the level the big decisions that could have saved the economy are being made.

The latest polls show Labour 6% ahead of the Conservative party, a relatively small lead given the awful economic times. Miliband and his team believe they have just been given a new weapon in their armoury.

Question 3: how can Clegg and the coalition survive?

Reactions among Lib Dems to David Cameron's veto have varied – but only in their degrees of disbelief and anger. By Toby Helm and Daniel Boffey

"If you were a Liberal Democrat at the last election what were your unique selling points on the big issues?" one of the party's peers pondered. "You believed in electoral reform and you were pro-European."

Her point was that things had changed for the worse since then and the Lib Dems had lost the causes that had once made them distinct. They were also running out of reasons to stay in the coalition.

In May this year electoral reform was rejected in a referendum. Seven months on no one believes there is the remotest chance the country can return to the subject for a generation.

Nor, after Friday's summit fiasco, could the Lib Dems so readily display their pro-European credentials, now that the government they were part of had left the UK isolated in the EU. Party members could be forgiven for asking what the point was.

The reactions among Lib Dems to David Cameron's actions on behalf of the coalition have been varied, but only in their degrees of disbelief and anger.

On Friday, one senior Lib Dem said the deal was a "disaster" that placed Britain "on the precipice" of Europe and would destroy the coalition.

"A referendum is inevitable and it will be lost because we will be on the outside of everything, not in any of the conversations, not invited to any of the dinners. What is the point of being in a club like that?" he said.

Initially, on Friday, a stunned Nick Clegg came out in broad support of the deal, saying he had been kept in touch and that he backed Cameron's actions.

But on Saturday, after pondering things further, sources made clear to the Observer that the deputy prime minister was, in fact, deeply unhappy about what had gone on.

It was an astonishing about-turn that showed Clegg had, in this case, decided to put his own credibility and that of his party above his support for Cameron. If the coalition was to survive, the Lib Dem leader had to retain respect among his people and he could not if do so if, as an ardent pro-European, he backed an outrightly eurosceptic agenda.

Friends of the deputy prime minister said Clegg was fed up with taking flak for policies with which he did not agree and of being accused of betrayal. The scars of the Lib Dem about-turn on tuition fees are still fresh. On Europe, of all subjects, Clegg has decided to stand up for what he believes.

Just six weeks ago he wrote in the Observer that "being shoved to the margins [of the EU], or retreating there voluntarily, would be economic suicide: a surefire way to hurt British business and lose jobs". It was hard for any Lib Dem on Friday to argue that their leader's worst fears had not been realised. Equally difficult for the Lib Dems was the fact that Cameron returned from Brussels saying he had blocked the EU deal to protect the City of London. So the beneficiaries – the reasons for the veto – were the very bankers whom the Lib Dems want to see subjected to more regulation, not less, despite considerable Tory opposition.

A Lib Dem government source said: "Cameron not only left us on the sidelines in the EU but he did so in order to defend the City, while doing nothing for real jobs, real manufacturing. It is completely wrong."

During the first 19 months of the Tory/Lib Dem alliance Clegg had been able to boast, with some justification, that he had reined in the Tories on Europe, curbed their natural scepticism. After the election he persuaded them to shelve their commitment to repatriating powers over social and economic policy – something which infuriated Conservative sceptics. Tory ministers, including the foreign secretary, William Hague, even praised the role of the Lib Dems in framing a sensible coalition foreign policy.

But the Lib Dems' influence infuriated the Tory sceptics who demanded more and more of Cameron until he delivered his veto in Brussels. Lord Oakeshott, the Lib Dem peer who is close to business secretary, Vince Cable, said the whole Brussels fiasco had destabilised the coalition. "This has done serious damage to coalition unity as well as our future in Europe. David Cameron needs to stop running the country in the interests of a few Eurosceptic backbenchers," he said.

Clegg is the most European of the pro-EU Lib Dems. His political home is Europe. His mother is Dutch and his wife Spanish and he speaks several European languages including Spanish, German, French and Italian. Europe not only helps define him and his party: it is central to his mindset.

If anything is likely to break the coalition and tip Clegg over the edge it is Europe. The Lib Dems have forged difficult compromises with the Tories on numerous issues including reform of the NHS, reform of the benefit system, tax for lower earners and free schools. But on Europe, it is difficult to see how the two sides can be reconciled– particularly after Friday morning.

Most Lib Dems believe the coalition will not break up in the short term because there would be dreadful consequences if it did. "I think everyone knows that the bond markets would release their furies on us if we walked out and we would be blamed," said one.

But it is an increasingly unhappy marriage and the main sticking point is Europe. When Clegg sits down next to Cameron in the Commons on Monday they will be further apart on the issue than ever.

Question 4: is it likely the euro has been saved?

The common currency has been sliding towards disaster for months. Business editor Heather Stewart looks at its survival hopes

One City wag compares the serial summitry of the past 18 months in the eurozone to a repeatedly unsuccessful "amateur escapology trick": each time, Europe's leaders set the scene with a great, theatrical buildup, warning that they have "10 days to save the euro" (in the words of EU commissioner Olli Rehn) and promising a daring escape, but when the drum roll ends, they're still trapped underwater in a padlocked box.

Last week's Brussels summit was less of a flop than most, and Europe's leaders did at least start to outline an escape route. First, they've made progress towards the "fiscal compact" demanded by European Central Bank president Mario Draghi, by promising to enshrine budgetary rules – including strict ceilings on deficits – in their constitutions, and enforce automatic punishments on eurozone members that fail to comply.

Ngaire Woods, professor of global economic governance at Oxford, last week compared this process to "designing their summerhouse while their house is burning around them".

But EU leaders believe it will help to convince financial markets that they're serious about fiscal discipline, restoring confidence and reopening the lending taps to countries in a shaky financial position such as Italy and Spain – and perhaps persuade Draghi and the ECB to ride to the rescue by buying those government's bonds on a far larger scale.

Second, the sums of money now being set aside by eurozone leaders to rescue stricken neighbours also look somewhat more convincing: Europe will channel €200bn through the IMF, which it hopes will be boosted by contributions from wealthy developing countries such as China and Brazil. The European stability mechanism, the new bailout fund, which should now be up and running next year, will have a total of €500bn at its disposal.

Third, eurozone leaders also promised to focus on measures that would improve competitiveness and create jobs; but some economists were warning this weekend that there was still no convincing answer to the question of how Italy would manage to borrow the €400bn it needs to repay bonds due in the next 12 months alone.

There's also a tough political challenge for countries such as Portugal and Greece, which have already imposed painful austerity measures – tax rises, pay cuts and reductions in public spending – at the behest of Brussels and the financial markets, and will have to convince their electorates to stay the course.

Many analysts believe Greece, Portugal and perhaps Ireland will eventually have to write off part of their outstanding debt. "At the very next downturn, one treasury or another in the southern states is going to be stretched to breaking point," says Neil Mellor, of BNY Mellon. He predicts that Italian bond yields – the interest rate Rome pays on its debts – could be back in the "danger zone" above 7% within days.

There are further doubts about the role the ECB could play in the coming months. Euro-watchers interpreted a closely-watched speech by Draghi earlier this month as suggesting that once a deal on tax-and-spending discipline is in place, the ECB could act as a so-called lender-of-last-resort, and step in to aid distressed sovereigns. But while the Italian ECB president did announce a battery of emergency measures to unblock the frozen financial markets last week, he used his regular Frankfurt press conference to insist that it's not his job to bail out governments.

And just to spice things up further, Standard and Poor's has warned that it may be about to downgrade the credit ratings of much of the eurozone, risking a fresh round of market panic. There's no great escape yet.

Question 5: has Cameron really protected the City?

The inner core of countries will still press ahead with a 'Robin Hood Tax' and Britain won't get a say in new regulation of banks, argues Heather Stewart

For the past year or so, a determined group of anti-poverty campaigners, with the high-profile support of the actor Bill Nighy and the film-maker Richard Curtis, have been demanding a so-called "Robin Hood Tax" on City trading, to ensure that banks and other financial firms bear their share of the costs of the credit crisis.

Their original motivation was for the funds to be directed to tackling poverty and climate change; but as the idea has gathered pace, and been adopted by France and Germany, it has become clear that the revenues would go directly to Europe's treasuries.

It is ironic, given that the worldwide campaign emerged from the UK, and fed on public fury that the bloated banks had got off scot-free, that scuppering a transaction tax became a totemic issue in Cameron's standoff with the rest of Europe.

What was puzzling City insiders this weekend, however, was what exactly Cameron has won. The inner core of countries will still press ahead with the Robin Hood Tax, which will apply to banks registered in their countries – including, for example, German banks trading in London.

Cameron's demands, which included the freedom to implement the proposals of the Vickers commission on banking, and an assurance that financial regulations would be even-handedly applied right across the single market, were relatively modest. But they made it easy for Sarkozy to caricature him as the dastardly Sheriff of Nottingham, defender of the rapacious Anglo-Saxon capitalists who caused the crisis.

Despite lobbying hard against the Robin Hood Tax and a slew of other Brussels regulations, few City insiders were cheering Britain's new isolationist stance: they're nervous that while most regulation will still in theory be decided at EU level, the inner core of everyone-but-Britain will over time come to dominate decision-making.

They also know much of the regulation born in the UK is stricter than anything being drawn up on the continent.

As for the rest of the economy, Sir Mervyn King has made clear that the future of the eurozone poses the single biggest threat to the UK. The Bank of England's monetary policy committee is predicting zero growth in the current quarter; but that's assuming the latest flurry of euro summitry is successful. It believes the consequences of a "disorderly" break-up of the single currency would be so dire that it can't even model them.

Many analysts now believe that even if the worst outcome of a complete euro-collapse is avoided, the severe shock to confidence and the strains on the banking sector, which are driving up the cost of borrowing right across Europe, mean a downturn on the continent is all but inevitable.

Question 6: how will the world see Britain's isolation?

The UK will lose influence globally – and the 'special relationship' with the USA will be a casualty. By Foreign Affairs Editor Peter Beaumont

"It is an undeniable privilege of every man to prove himself right in the thesis that the world is his enemy," the celebrated US diplomat George F Kennan once said. "For if he reiterates it frequently enough and makes it the background of his conduct he is bound eventually to be right."

Britain may be forced to recognise sooner rather than later that by embracing the self-fulfilling prophecy of Eurosceptic rhetoric – that Europe has it in for us – Europe and the world has indeed become a more difficult place for the UK to exert its influence.

Even as senior foreign office officials were reported to be privately furious at David Cameron's performance in Brussels, other figures were warning publicly of the huge potential damage inflicted on British foreign policy, and its ability to influence other countries.

Chris Davies, chief whip of the Lib Dem MEPs, wrote just after Cameron exercised his veto: "Today Britain has taken a step towards irrelevance. There will be other dinners of European leaders. At too many of them, there will now be no place set for the prime minister of the United Kingdom."

Richard Whitman, an associate fellow at Chatham House and an expert on European politics was equally critical. "I'm shell-shocked," he admitted. "Without over-dramatising it, I believe this signals a profound crisis for British diplomacy. The UK strategy in Europe for decades – a successful strategy – has been to nudge and influence political developments." That strategy, Whitman argues, now lies in ruins and with it decades of careful diplomacy.

It is not merely within Europe, Whitman believes, that Britain's voice is likely to be diminished but also in the US where, under President Barack Obama, enthusiasm for the "special relationship" has been cooler. "It is not clear why the US should pursue a privileged relationship with the UK over Europe when the UK is outside. We have sold ourselves as a bridge between Europe and the US. Why go through London when it can go straight to Paris or Berlin?"

Michael Calingaert, an expert at the US Brookings Institution on the EU and transatlantic relations, believes that Britain's influence will inevitably be diminished. "The notion that Britain was a bridge between the US and Europe was probably overstated somewhat. But now that Merkel and Sarkozy are running the show it is inevitable that Berlin and Paris will be more important [to Washington] than London. The US will look far less to the UK as an interlocutor."

But if these are the obvious challenges facing British diplomacy, by distancing itself from the core of Europe the UK may face more profound consequences. One may be its ability to play as significant a role as it does in other forums. Last week Liberal Democrat energy secretary Chris Huhne was in Durban as a senior member of the EU negotiating delegation. Further isolation from the mainstream could make it harder to claim such prominence.

Whatever the future, the United Kingdom looks suddenly smaller.

Question 7: can the UK return to the heart of Europe?

A return to the top table is not impossible, but highly unlikely while the current government remains in power, explains Political Editor Toby Helm

The answer is yes. But it is very difficult to see how Britain can do so under a government led by the current Conservatives. David Cameron has shown himself willing to put the demands of Eurosceptic backbenchers and the City above other EU leaders.

The sceptics have their tails up and many will redouble their efforts now. While they accept that their goal of repatriating powers is difficult for Cameron to achieve, they are likely to press the case for a referendum, arguing that the EU is a different club to the one the UK joined. Any backing off by Cameron from the hard line will be taken by the sceptics as betrayal and endanger his leadership.

Even if Cameron wanted to change direction and sign up to the new accord, it is difficult to see EU leaders agreeing to reopen talks. President Sarkozy and Chancellor Merkel are not in the mood to go back to the negotiating table – one that Merkel suggested Cameron did not appear interested in being at in the first place.

EU leaders have the euro to save and cannot spend time worrying about the UK. Cameron, too, seems content with isolation and the accolades of his party. The only point at which the dynamics could change is under a new British government with a genuine desire to be at the heart of Europe.