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UNCLAS SECTION 01 OF 05 FRANKFURT 008337 
 
SIPDIS 
 
SENSATIVE 
 
STATE FOR EUR PDAS RIES, EB, EUR/AGS, AND EUR/ERA 
STATE PASS FEDERAL RESERVE BOARD 
STATE PASS NSC 
TREASURY FOR DAS LEE 
TREASURY ALSO FOR ICN COX, HALL 
PARIS ALSO FOR OECD 
TREASURY FOR OCC RUTLEDGE, MCMAHON 
 
E.O. 12958: N/A 
TAGS: ECON EFIN EUN
SUBJECT: European Commission Proposes Changes to Stability 
Pact:  Rules and Reality 
 
 
T-IA-F-04-008 
 
This cable is sensitive but unclassified.  Not/not for 
Internet distribution. 
 
¶1.   (SBU) Summary:  On September 3 the European Commission 
  initiated a discussion of possible changes to the Stability 
  and Growth Pact (SGP).  The Commission is seeking to find a 
  balance between flexibility that accommodates individual 
  country circumstances and strict rules that instill 
  necessary budget discipline.  The initial reaction of 
  Finance Ministers was to welcome an examination of ways to 
  strengthen the SGP, but to rule out any changes to the 
  Treaty while keeping any regulatory changes to an absolute 
  minimum.  The discussion will continue at the November 
  Ecofin Council session. Any final outcome is unlikely until 
  the first half of next year. 
 
¶2.   (SBU) On balance the Commission's suggestions are 
  useful and arguably could be adopted   without changes to 
  the regulations. Agreeing to changes in implementation of 
  the SGP could provide the Commission a way out of the dead 
  end in which it has found itself since last November when 
  its interpretation of the rules differed from that of 
  Council's.   More rules, however, would not guarantee better 
  implementation of the SGP.  Key decisions on excessive 
  deficit procedures (EDP) still will be political and taken 
  by the Council.  In a match up of rules versus reality, 
  reality wins.  End Summary. 
 
Commission Launches Debate 
-------------------------- 
 
¶3.   (SBU) On September 3 the European Commission issued a 
  "Communication" that commenced a debate on possible changes 
  to the Stability and Growth Pact (SGP).  The Pact is 
  composed of provisions from the EU Treaty, Council 
  Regulations, and a Council Resolution.  The Commission 
  states that tensions have accumulated in the application of 
  the SGP leading to a "loss of credibility and ownership and 
  institutional uncertainty." 
 
¶4.   (SBU) The Commission's proposals are for a 
  "strengthened" SGP and a Code of Conduct containing specific 
  economic-analytical tools to allow consistency in budgetary 
  surveillance.  According to a senior Commission official, 
  the Commission is seeking to strike a balance between rules 
  that can take into account each country's unique economic 
  circumstances and those that are sufficiently strict to 
  instill necessary budgetary discipline. Another theme, 
  according to this official, is to place more emphasis on 
  "preventative" measures, e.g. taking steps to reduce 
  deficits in good economic times, rather than only 
  concentrating on "corrective' measures. 
 
Key Elements of Commission Proposals 
------------------------------------ 
 
¶5.   (SBU) The Commission proposes to (a) refocus the SGP; 
  (b) better coordinate budgetary policies; and (c) improve 
  enforcement. 
 
¶6.   (SBU) With respect to refocusing the SGP the Commission 
  suggests: 
 
           i.   Placing more focus on government debt and 
            sustainability.  The Commission suggests making the debt 
            criterion of the Treaty operational (e.g. initiate an 
            "excessive debt procedure" when the debt exceeds the 60% 
            reference value) and clarifying the basis on which to ass 
            a "satisfactory pace" of debt reduction, including an 
            assessment of debt sustainability that takes into account 
            pensions, contingent liabilities, and assets. 
ii.  Allowing for more country-specific circumstances in 
defining the medium-term deficit objective of "close to 
balance or in surplus."  A country with a higher debt level, 
for example, would be subject to a more stringent 
interpretation of the notion of "close to zero or in 
surplus" over the medium-term than a country with a lower 
debt level. 
iii. Considering economic circumstances and developments in 
implementation of the Excessive Deficit Procedure (EDP). 
One option would be to redefine the "exceptional 
circumstances" clause that can be invoked to avoid an EDP by 
adding the notion of "prolonged economic downturn" as such 
an "exceptional circumstance."  Another approach would be to 
allow country-specific deadlines for action rather than the 
standard ten months after the date new budget data is 
released, thereby seeking to better reflect a country's 
cyclical development and debt level. 
iv.  Ensuring earlier actions to correct inadequate 
budgetary developments.  Under this approach the Commission 
would issue early warnings directly to member states when 
deficits are close to 3% (a point on which Ministers have 
agreed in the Constitutional Treaty) but also in good times 
if a government is not moving close to balance or surplus. 
The Commission also could issue recommendations under the 
Broad Economic Policy Guidelines (BEPG). 
 
¶7.   (SBU) On coordination budgetary policies, the 
  Commission would like to reinforce the link between BEPG, 
  budget programs submitted under the SGP and national 
  budgetary processes.  BEPG address recommendations to member 
  states on structural policies, such as health care and 
  pension systems and labor and capital markets.  The 
  Commission believes that economic and budgetary policies 
  need to set the "right priorities toward economic reforms, 
  innovation, competitiveness and strengthening of private 
  investment and consumption, thereby contributing toward 
  achieving the economic objectives of the Lisbon strategy." 
 
¶8.   (SBU) The Commission suggests that Stability and 
  Convergence Programs should define the medium-term budget 
  strategy at the beginning of a country's budget cycle.  At 
  present all Stability and Convergence programs are submitted 
  to the Commission in early December, regardless of a 
  country's own budget cycle. Synchronizing national and EU 
  level budget exercises would allow a member state to reflect 
  the   Commission's and Council's assessments of its proposed 
  national budget as well as the BEPG's in its national 
  deliberations.  Such sequencing would increase the 
  interaction between European and national levels to include 
  national parliaments in the debate. 
 
¶9.   (SBU) With respect to enforcement, the Commission 
  suggests improving the quality, timeliness and reliability 
  of fiscal statistics, the effectiveness of peer pressure 
  (naming, shaming and blaming), and greater transparency and 
  accountability on budgetary policies (including reports to 
  the European Parliament and greater involvement of national 
  parliaments).  These would complement a change already 
  agreed to by Ministers in the context of the Constitutional 
  Treaty, namely that the Commission be authorized to send 
  early warnings directly to countries without securing 
  Ecofin's approval. 
 
Finance Minister's Take 
----------------------- 
 
¶10.  (SBU) At their informal meeting in the Netherlands on 
  September 10, EU Finance Ministers issued a short statement 
  reflecting on the Commission's ideas.  The thrust of these 
  comments is toward strengthening, or at least improving the 
  implementation of, the SGP.  Ministers ruled out changing 
  the Treaty (i.e. 3% deficit and 60% debt reference values to 
  remain) and want only minimum changes to the regulations, 
  "if necessary at all."  Specifically, the Ministers asked 
  the Economic and Finance Committee to work out elements on 
  the following issues: 
 
     ¶1.   Strengthening the preventative arm of the SGP by having 
       budget discipline in good times to gradually achieve 
       budgetary surpluses, practicing peer pressure, and having 
       transparent budget figures and growth assumptions. 
¶2.   Enhancing the focus on debt and its sustainability by 
having debt over the reference value diminish at a 
satisfactory pace, taking into account the future costs of 
aging and implications of pension reforms. 
¶3.   Drawing a distinction between measures taken and 
economic forecasting errors when assessing compliance with 
Council decisions; and 
¶4.   Having budgetary policies set the right priorities 
towards structural reforms, innovation, and competitiveness 
in support of the Lisbon agenda to promote economic growth 
and employment creation. 
 
Some Views: To Modify or Not to Modify 
-------------------------------------- 
 
¶11.  (SBU) A German Finance Ministry official noted that the 
  informal Ecofin seemed to concentrate on areas that would 
  strengthen the rules, an outcome he suspected was driven by 
  the Dutch Presidency that has taken a strict line in 
  implementing the SGP.  A Commission official explained that 
  the Ministers' statement reflects areas on which there was 
  consensus.  This official suspects that some member states 
  would support more flexibility.  According to a senior 
  Bundesbank official, some of the new member states' central 
  bankers and finance ministers are none too pleased with 
  contemplated changes to the rules that they have been 
  required to use in drawing up their medium-term budget 
  programs. 
 
¶12.  (SBU) Another German official speculated that the 
  Economic and Finance Committee would not suggest any changes 
  to the regulations.  This position was supported strongly by 
  European Central Bank President Trichet at his September 22 
  hearing before the European Parliament.   A senior 
  Bundesbank official, however, was not sanguine that this 
  position would hold.  The Dutch, Austrians and Nordics 
  continue to toe the line against changes, but Germany, once 
  the leader of this pack, is no more, in his view. 
 
¶13.  (SBU) Three points in the Commission's proposals would 
  require a change in regulations according to a Commission 
  official.  These would be to (a) modify the definition of 
  "exceptional circumstances;" (b) provide for another 
  timetable for sanctions to be taken rather than the 10 
  months from the date that new budget data is released; and 
  (c) modify the timetable to correct the excessive deficit to 
  reflect a country's circumstance rather than requiring it be 
  done "a year after its identification."  A senior Luxembourg 
  Finance Ministry official believed that some of these 
  changes would be necessary to bring more clarity in how the 
  SGP is being implemented.  In his view, these neither 
  strengthen the SGP nor weaken it. 
 
¶14.  (SBU) A French Finance Ministry official generally 
  supported the main ideas of the Commission's paper, but 
  cautioned that the details could prove to be tricky.  Tying 
  national budget cycles to the EU-level Stability Programs or 
  giving more weight to the BEPG are, in his view, unlikely. 
 
Next Steps 
---------- 
 
¶15.  (SBU) The Economic and Finance Committee will flesh out 
  Ministers' ideas with a view to having a first discussion at 
  the November Ecofin.  European Commission staff expect 
  discussions to roll into the next year.  After the Ecofin 
  Council has concluded its deliberations, the Commission must 
  present recommendations to the Council for approval.  A 
  Senior Luxembourg Finance Ministry official thought wrapping 
  up the exercise in the first half of next year would be 
  "fortunate."  He hopes they can conclude the work during the 
  Luxembourg Presidency. 
 
Observations 
------------ 
¶16.  (SBU) According to a senior German official, the 
  College of the European Commission agreed to taking the 
  Council to the European Court of Justice over the excessive 
  deficit cases of Germany and France provided that it also 
  developed ideas for improving implementation of the SGP. 
  This has positioned the Commission to devise new approaches 
  to implementing the SGP.  In doing so, it could provide a 
  way out of the dead end it has found itself by sticking to a 
  recommendation that the Council could not adopt last 
  November (see septel).  While this commitment was taken 
  while Commissioner Solbes was in charge of DG Economics and 
  Finance, the new Commissioner Alumina is more "politically 
  savvy," according to this German official, and wants to find 
  a compromise that member states can live with.  The 
  Commission has put its "cards on the table." 
 
¶17.  (SBU) We would agree with the Commission staff 
  observation that most of their suggestions and those of the 
  Finance Ministers could be implemented without any changes 
  in the regulations.  The Commission staff already examines 
  cyclically adjusted balances as part of their overall 
  assessment of a country's fiscal position.  We would also 
  argue that the "special circumstances" clause can be 
  interpreted to make allowances for the timing of the 
  adjustment path to correct the deficit.  The German Finance 
  Ministry has argued that the unforeseen, prolonged economic 
  slow done is such a "special circumstance."  On the other 
  hand, expanding the definition of "exceptional 
  circumstances" would allow countries to avoid any EDP and 
  more intense budget scrutiny. This would not be helpful. 
 
¶18.  (SBU) Putting more focus on debt would be a welcomed 
  change.  After all, financing costs are driven, in part, by 
  the stock of debt and its dynamics rather than the deficit 
  of a single year.  Seven of the Euro 12 (or nine of the EU 
  25) are over the 60% limit, three of the 12 are close to the 
  100% level (Italy, Greece and Belgium).  The 60% limit was 
  established in the 1990's when that was the average stock of 
  debt for the prospective euro area.  That number has gone up 
  to 70% in 2003.  In its latest World Economic Outlook, the 
  International Monetary Fund confirms that the EU has 
  demonstrated an "unsustainable deficit bias" since the 
  creation of the European Monetary Union. 
 
¶19.  (SBU) Subjecting member states to peer review when 
  budgets are in better shape also makes sense.  The authors 
  of the IMF report cited above note that a "key priority in 
  the reform of the SGP should be to enforce greater fiscal 
  restraint in good times" in light of the costs of aging 
  populations that loom larger and closer.  Deutsche Bank 
  Research has calculated that a one percentage point increase 
  in EU government deficits raises 10 year government bond 
  yields by 36 percentage points.  Rather than spending money 
  on deficit financing it might be better be spent easing 
  structural reforms or cutting taxes. 
 
¶20.  (SBU) Better forecasts and statistics (as in the case 
  of Portugal and Greece) are very important.  Uncritically 
  accepting national budget forecasts is nice, but unhelpful 
  in the budget surveillance process.  A little tough love 
  would be better. 
 
¶21.  (SBU) Providing better consistency between budget 
  proposals and structural reforms, innovation and competition 
  covered in the Broad Economic Policy Guidelines make sense. 
  The SGP should not be just a numbers game, but a discussion 
  of economic policies designed to promote growth and 
  employment.  Deficit spending does not mean the money is 
  spent wisely.  Promoting such consistency would bring EU 
  level macro efforts into the national arena, the purview of 
  member states - a move many member states are likely to 
  resist. 
 
¶22.    (SBU) One issue confronting the Commission is whether 
  the rules should be drafted to reflect economic reality or 
  whether it is implementation that is to reflect the reality. 
  Drafting more precise rules will not solve the issue of 
  political will.  That, or the absence thereof, still will 
  reside with the Council. 
 
¶23.  (U)This cable coordinated with Embassies Berlin, 
  Luxembourg, Paris, The Hague and USEU Brussels. 
 
¶24.  (U)POC: James Wallar, Treasury Representative, e-mail 
  wallarjg2@state.gov; tel. 49-(69)-7535-2431, fax 49-(69)- 
  7535-2238 
 
Bodde