This record is a partial extract of the original cable. The full text of the original cable is not available.

UNCLAS SECTION 01 OF 05 FRANKFURT 008852 
 
SIPDIS 
 
STATE FOR EUR PDAS RIES, EB, EUR/AGS, AND EUR/ERA 
STATE PASS FEDERAL RESERVE BOARD 
STATE PASS NSC 
TREASURY FOR DAS SOBEL 
TREASURY ALSO FOR ICN COX, STUART 
PARIS ALSO FOR OECD 
TREASURY FOR OCC RUTLEDGE, MCMAHON 
 
E.O. 12958: N/A 
TAGS: ECON EFIN EUN
SUBJECT:  EU Stability and Growth Pact: Commission Wakes to 
Reality, Treads Fine Line Between Reluctant France and 
Robust Enforcers - Germany Next in Line 
 
Ref: (A) Frankfurt 06409; (B) Lisbon 1831 
 
T-IA-F-03-0056 
 
1.(SBU)  Summary:  "We wake from one dream into another 
dream," mused Emerson.  The European Commission has awoken 
from the dream that France would reduce its deficit below 3% 
of GDP in 2004, as recommended by Finance Ministers in June. 
The French budget plan provides for a deficit of 3.6%, at 
best.  The Commission is not satisfied.  Nonetheless, 
economic times are tough.  So the Commission has recommended 
to Ministers that France reduce its deficit below 3% in 
2005, but with an extra effort in 2004 to reduce its 
structural deficit by one percentage point rather than the 
0.7 percentage points contained in the French budget.  The 
Commission is treading a fine line between France, who only 
reluctantly plays along with what it probably regards as 
surreal Stability and Growth Pact (SGP) procedures, and the 
Netherlands and Austria who have called for robust 
enforcement of the SGP, including sanctions. 
 
2.(SBU)  Action on Germany is likely to follow.  The 
Commission staff is not pleased with implementation of 
measures promised by Germany last May.  The Commission's new 
forecast for Germany, to be released October 29, will show 
the German deficit also remaining above rather than below 3% 
of GDP in 2004, also contrary to EU Ministers' 
recommendation. 
 
3.(SBU)  Would giving France, and maybe Germany, an extra 
year mark the final nail in the coffin of the SGP?  German 
Finance Ministry officials bluntly confess they are "playing 
for time" since brighter economic prospects forecast for 
2005 make hitting the target more likely for them.  The 
Commission's realization of that reality, however, has not 
lessened its pressure.  Rather, the Commission staff seems 
to be pressing for more reforms in France and Germany, 
keeping Portugal on the hook for a sustainable deficit 
reduction, and upping public pressure on Italy that has 
slipped from its commitment to reduce its high debt.  If 
Ministers agree at their November 3-4 meeting in Brussels 
with something close to the Commission's recommendations on 
France, there could be more SGP and Commission in member 
states' budget coordination life rather than less.  Therein 
would lie yet another problem.  The outcome is far from 
clear. 
 
France: The Last Shall Be First 
 
4.(SBU)  EU Finance Ministers determined that France had an 
excessive deficit in June following earlier excessive 
deficit decisions on Germany and Portugal.  France's 
reluctance to accede to Ministers' recommendations, however, 
has propelled it to the role of trail blazer. Portugal moved 
(or sold) heaven and earth to get its deficit below 3% of 
GDP.  Germany, as founder and firm believer in the SGP, has 
talked a good game.  But France is France.  The French 
Finance Minister and others have been openly disdainful of 
the SGP deficit rules applied to The Hexagon.  Nonetheless, 
the GOF's 2004 budget announced at the end of September 
envisaged a more significant deficit reduction than mooted 
with the IMF staff last summer.  The structural deficit 
would be reduced by 0.7 percentage points, the nominal 
deficit would be 3.6% based on real growth of 1.7%.  On this 
basis the GOF met the October 3 deadline to report that it 
had taken appropriate measures to correct its deficit in 
accordance with EU Minister's recommendations four months 
earlier. 
 
5.(SBU)  The European Commission was not impressed.    On 
October 8 the Commission shot back with its recommendation 
to Ministers that "France has taken no effective action in 
response to the Council Recommendation."  The phasing should 
not be taken literally.  It is lifted directly out of 
Article 104c(8) of the Treaty, reflecting more legalese than 
reality.  In fact, the Commission explains that the GOF has 
taken some measures to mitigate the deficit in 2004.  These 
include reforming the pension system, increasing tobacco 
taxes, and raising the social contributions for the fund 
responsible for the payment of wages of workers in companies 
in bankruptcy.  In addition, the proposed reduction in the 
structural deficit by 0.7 percentage points was consistent 
with the Council's recommendation.  The GOF, however, let 
the 2003 budget slip away, in the Commission's view, racking 
up a 4% deficit.  This is contrary to what EU Finance 
Ministers had recommended. 
 
6.(SBU)  This "no effective action" assessment is the first 
ever under the SGP's excessive deficit procedures.  Portugal 
and Germany's reports passed Commission staff scrutiny. 
Dubbing its efforts as ineffective has propelled France from 
a follower in the excessive deficit procedure to a leader. 
Now what? 
 
Commission Walks Thin Line: Expedites Process and Asks for 
More, But Over Longer Time 
 
7.(SBU)  The Commission's assessment begs the question: "So 
what?"  If Ministers were to agree with the recommendation, 
what would happen next?  The Commission dropped the other 
shoe on October 21.  It issued a companion recommendation to 
Ministers of new measures for France to take in 2004.  This 
recommendation is in accord with Article 104c(9) of the 
Treaty which states that if a member states persists in 
failing to put into practice the Council's recommendations, 
the Council may decide to give notice to the member state to 
take measures within a specified time-limit to remedy the 
situation. 
 
8.(SBU)  Part of this recommendation is to postpone the 
target date to correct the excessive deficit to 2005.  This 
would be contrary to the Recommendation EU Ministers signed 
up to in June for France calling for correction by 2004 at 
the latest.  The letter of the law, Article 3(4) of Council 
Regulation (EC) No 1467/97 ("the regulation"), is more 
forgiving.  It states that the deadline for the correction 
of the excessive deficit "should be completed the year 
following its identification unless there are special 
circumstances."  While not citing any special circumstances, 
the Commission points out that the economic situation has 
deteriorated since June.  That deterioration would make the 
effort to bring the deficit below 4% in 2004 "significantly 
larger than envisaged." 
 
9.(SBU)  The Commission has proposed the following new 
measures: 
(1) Reduction in the cyclically-adjusted balance by one 
percentage point of GDP; 
(2) Another 0.5 percentage point reduction in the cyclically- 
adjusted balance in 2005 or whatever it takes to get the 
nominal deficit below 3%; 
(3) Any higher than expected revenue in 2004 to be allocated 
to deficit reduction; 
(4) Curbing the increase in health care spending is a 
possible measure to be included in any deficit reduction 
package, consistent with the Broad Economic Policy 
Guidelines that have been approved by Heads of Government 
and State. 
 
10.(SBU)  The Commission also recommends that France report 
to the Council once every six months, in April and October, 
over the next two years so the Council can monitor progress. 
The basis for requiring such reports in found in Article 
104c(9) of the Treaty that allows the Council to request 
reports in accordance with a specific timetable to examine 
adjustment efforts. 
 
11.(SBU)  On process, the Commission is seeking to expedite 
consideration of the French case.  Under the regulation, the 
Council is supposed to take measures under 104c(9) within 
one month of its assessment under 104c(8) that no effective 
action has been taken.  The Commission wants both to be 
considered at the November 4 Ecofin meeting.  In the view of 
Commission staff, the decision on 104c(8) should be "just a 
formality."  If Ministers comply and agree to recommend the 
new measures (or others) as suggested by the Commission, the 
Commission has suggested that France report back to the 
Council by December 15 on the measures it plans to take in 
2004 and 2005.  This also compresses the time frame 
envisaged in the regulation.  Article 6 permits at most two 
months between 104c(9) and the next step - sanctions.  Why 
the rush? 
 
12.(SBU)  Commission staff point out that Article 7 of the 
regulation requires that the Council's decision to impose 
sanctions be taken within 10 months of reporting dates for 
national accounts, e.g. from March 1 in this case.  Delaying 
the process could make the question of sanctions moot, at 
least this year.  By expediting the process, the prospect of 
sanctions provides some leverage. 
 
13.(SBU)  As noted in reftel, sanctions would be an 
admission of failure.  A senior German Finance official said 
they had been working to encourage France to make some 
additional efforts and to encourage the Commission to be 
more flexible.  He believes that "A conflict would be in no 
one's interest.  He interprets the Commission's latest move 
as "a tough line."  "There is still a gap," in his 
assessment, between the Commission and the French positions. 
 
14.(SBU)  Commission staff admit that they are walking a 
fine line.  Will Ministers accept the new recommendation? 
The German Finance Ministry expert who believes the 
Commission is too tough points to the larger budget 
adjustment (he would have preferred more emphasis on 
structural reforms) and aggressive procedures (resorting to 
Article 104(9) so quickly and calling for a firm plan by 
December and semi-annually reporting).  The Commission, in 
his view, is "putting its hands on national fiscal policy," 
something that, in his opinion, neither Germany nor France 
would accept. 
 
15.(SBU)  Will the Netherlands, Austria and Finland that 
have called for sanctions in the case of non-compliance go 
along with providing France an extra year to correct its 
deficit?  Dutch Finance Minister Zalm recently argued that 
the Commission should have proposed fining France and has 
threatened to stick to his plan to take the Commission to 
court, pending the outcome of the November 4 Ecofin meeting. 
Will France accept the recommendations?  And the intrusive 
reporting requirement?  Press reports suggest they have 
given the Commission's new approach a frosty response. 
Whatever happens could pave the way for action on Germany. 
 
Germany:  Slip, Slip, Slipping Away? 
 
16.(SBU)  Commission staff reports that they are 
disappointed with Germany's performance.  The measures that 
Germany had agreed to in its May report have proved 
ineffective in reducing the deficit has much as anticipated. 
Slower economic growth has widened the deficit, making 
adjustment efforts more difficult - as in the case of 
France.  Bringing the income tax cut forward from 2005 to 
2004 will create a much larger deficit than anticipated by 
the Commission last spring.  When the Commission releases 
its EU autumn forecast on October 29, the numbers for 
Germany in 2004 are likely to look roughly similar to those 
issued on October 21 by Germany's economic institutes: a 
deficit of around 3.5% with growth of 1.7%.  Even Finance 
Minister Eichel now has admitted that the deficit in 2004 
will exceed the 3% reference rate. 
 
17.(SBU)  Commission staff is preparing a new recommendation 
to Ministers for Germany that is likely to be taken up by 
Ministers at the December 15 Ecofin.  The content is being 
developed, but is likely to support reforms and subsidy cuts 
the German government is striving to get through the upper 
house of Parliament.  Since the prospect of Germany's 
deficit remaining above 3% next year are real, it would not 
be too much to imagine, as the German press has already 
begun to speculate based on Commission sources, that the 
Commission would accept that reality and call for the 
deficit to be well under 3% in 2005. 
 
18.(SBU)  German Finance Ministry officials will argue that 
(a) three years of stagnate growth are unusual; (b) they 
have significant structural reforms in the legislative 
process; and (c) bringing forward the income tax from 2005 
to 2004 will be good for German and EU economic growth and, 
technically, shouldn't count since it was already in 
Germany's stability plan for 2005.  That would shave a 
"virtual" 0.7 percentage points off the 2004 deficit.  As 
for getting the deficit under 3% in 2005, the Ministry's top 
economist confidently declared, "I am certain of it." 
 
19.(SBU)  Why can the Commission be less in a rush for 
Germany than for France?  Article 9 of the Regulation notes 
that the excessive deficit procedure shall be held "in 
abeyance" if the member state acts in accordance with the EU 
Finance Ministers' recommendations.  Since Germany seemed to 
be doing so, the 10 month clock was suspended. 
 
Portugal and Italy in the Wings 
 
20.(SBU)  The Commission continues to assess the budget 
situations of Portugal and Italy.  Even though the 
Portuguese, through extraordinary effort, reduced their 
deficit to 2.8% in 2002, the Commission has not recommended 
that the excessive deficit procedure be "abrogated." 
Rather, they want to make sure the deficit reduction is 
sustainable.  Given the slowdown in 2003's growth, it won't 
be. 
 
21.(SBU)  However, the GOP has indicated it will, again, use 
extraordinary measures to push the deficit down.  These 
include real estates sales, selling tax receivables to 
private investors (a deal being arranged by Citibank), and 
postal system transfers to the budget for pension 
obligations (Lisbon, septel).  The GOP's 2004 budget, based 
on a realistic real growth forecast of 1.1%, would deliver a 
planned deficit of 2.8% in 2004, in the Commission's 
assessment. The Commission's overall view on Portuguese 
budget developments will be contained in its October 29 
forecast. 
 
22.(SBU)  Italy has also attracted the Commission's 
attention.  Last year when the Council was debating ways to 
improve the operation of the SGP, they agreed that more 
attention should be given to the stock of debt.  So even 
though Italy has been able to skate under the 3% deficit 
value by adopting one-off measures, the Commission is 
looking for more robust action to reduce the debt.  In an 
October 2 statement, Commissioner Solbes opined that the 
path for deficit reduction in 2004 is "less ambitious" than 
envisaged in last year's stability program and in contrast 
with Finance Ministers' assessment that the "pace of debt 
reduction should be significantly faster." 
 
The ECB: A Difficult Moment 
 
23.(SBU)  ECB experts are monitoring developments.  They 
believe the Commission is acting in the EU's best interests, 
but also confess that this is a "difficult moment."  In its 
October Bulletin the ECB expressed "serious concerns" about 
recent fiscal policy developments.  The ECB wrote that it is 
"worrying" to see that not all countries have introduced 
sufficient consolidation measures. "It is fundamental that 
the credibility of the institutional underpinnings of the 
EMU be maintained." 
 
Comment 
 
24.(SBU)  Commission staff characterize their approach on 
France is "very delicate," with no certainty that Ministers 
or France will accept it.  France's initial public reaction, 
as recorded by the press, would seem to confirm their 
anxiety.  However, we tend to agree with the German Finance 
Ministry official's view that no one would benefit from a 
conflict, neither France, the smaller states, nor the EU. 
France would lose leverage in other major policy debates, 
such as in the constitution or budget; the Commission would 
lose its moral authority (by being perceived as either too 
strict or too loose); member states would lose the center 
piece for trying to coordinate fiscal policies, leaving the 
European Central Bank even less of an idea of how to 
incorporate fiscal policy into its monetary policy. 
Changing the SGP target, suggested by Italian President 
Berlusconi as recently as October 22, is not in the cards at 
present.  It would require an amendment to the Treaty, a 
process that would take too long to make a difference in the 
immediate case even if there were support to do so. 
 
25.(SBU)  All could benefit from a more assertive 
Commission.  Taking up the case of France and apparently not 
content to let Germany or Portugal easily off the hook 
without concrete evidence of sustainable deficit reduction 
could be useful.  As the Portuguese Finance Minister noted, 
the SGP provides an alibi for needed reforms and that budget 
discipline is good for growth (ref B).  Sending signals to 
Italy also could be useful, as high debt stock can play as 
much of a role in putting upward pressure on interest rates 
as rising deficits. 
 
26.(SBU)  If the case of France plays out more or less in 
line with the Commission's recommendation, an outcome that 
is by no means certain, there could be more rather than less 
of the SGP in member states' lives in the months to come. 
Maybe member states will have better budget performance 
under a watchful eye.  It is clear that they did not so 
while left to their own.   However, such intrusiveness would 
cause yet another problem for member states, giving the 
Commission more of a bully pulpit on national budgets.  Then 
again, it would be better if member states exercised budget 
discipline themselves - in good times and bad. 
 
27.(U) This cable has been coordinated with Embassies 
Berlin, the Hague, Lisbon, Rome, Paris, Dublin, Vienna, and 
USEU. 
 
28.(U)  POC: James Wallar, Treasury Representative, e-mail 
wallarjg2@state.gov; tel. 49-(69)-7535-2431, fax 49-(69)- 
7535-2238. 
 
BODDE