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UNCLAS SECTION 01 OF 06 FRANKFURT 002435 
 
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, HULL 
PARIS ALSO FOR OECD 
TREASURY FOR OCC RUTLEDGE, MCMAHON 
 
E.O. 12958: N/A 
TAGS: ECON EFIN EUN
SUBJECT: Stability Pact Revision: Art Imitates Life 
 
 
T-IA-F-05-017 
 
This cable is sensitive but unclassified.  Not/not for 
Internet distribution. 
 
Stability Pact Revision: Art Imitates Life 
 
Ref: (a) Warsaw 1108; (b) Warsaw 1624 
 
¶1.   (SBU) Summary: Ecofin's report that was approved by the 
  European Council on improving the stability and growth pact 
  (SGP) is a vindication of the Council's application of the 
  SGP, not its demise.  While the Council had always 
  implicitly considered prolonged economic stagnation and 
  other relevant economic factors in assessing the existence 
  of an excessive deficit and adjustment path for its 
  correction, the proposals to revise the SGP explicitly 
  acknowledges them.  Countries that are close to the 3% 
  reference rate but temporarily running a higher deficit get 
  the benefit of the doubt.  Those running higher deficits 
  will not. 
 
¶2.   (SBU) The Commission, which had preferred a more rule- 
  based approach, is comfortable with the outcome and takes 
  solace in new provisions that the new provisions on 
  governance go beyond what they had thought they might get. 
  The European Central Bank (ECB) has publicly expressed its 
  "serious concern," but privately its officials are pleased 
  agreement was reached and that it does not stray from the 
  Treaty. The "minor miracle" of securing an agreement was 
  conjured by Prime Minister Juncker by asking Ministers to 
  agree to codify what they have been doing on a case-by-case 
  basis.  He captured the reality of the moment on paper. Art 
  of negotiation imitates real life. End Summary 
 
Council Report and Agreement: Next Steps 
---------------------------------------- 
 
¶3.   (SBU) On March 22 the European Council endorsed 
  Ecofin's report on "Improving the Implementation of the 
  Stability and Growth Pact."  As a German Finance Ministry 
  official pointed out, Heads of State were sure to approve 
  the deal as Prime Minister Junker had kept key Heads 
  informed during the Sunday negotiations.  The Commission 
  will use the report to prepare a package of proposed changes 
  in regulations and a Council Declaration for approval by the 
  European Council in June.  Although the report proposes five 
  amendments to existing Regulation 1467/97 (the regulation), 
  the Commission is examining whether more amendments might be 
  needed to put into effect the Council's reforms. 
 
Notable Changes 
--------------- 
 
¶4.   (SBU) The report presents changes to improve 
  governance, strengthen the preventive arm so governments can 
  avoid excessive deficits in bad economic times, and improve 
  implementation of the excessive deficit procedures (EDP). 
  In light of the wide-ranging views on the proposed changes, 
  it would be useful to spell out the changes and their 
  implications from current practice in some detail.  The most 
  significant changes are in the EDP that contains four of the 
  five proposed amendments to the regulation. 
 
Implementation of Excessive Deficit Procedures 
--------------------------------------------- - 
 
¶5.   (SBU) The Treaty specifies that the EC is to monitor 
  member states' budgets with a view to identifying "gross 
  errors," using as criteria whether the deficit has exceeded 
  the 3% reference value unless the excess over the reference 
  value is "only exceptional and temporary and the ratio 
  remains close to the reference value." "Exceptional and 
  temporary" are defined in the regulation.  "Exceptional" is 
  something outside the control of a member state that has a 
  major financial impact or is when there is a "severe 
  economic downturn." A "severe economic downturn" is defined 
  as an annual decline of real GDP of at least 2%. "Temporary" 
  means if the budget forecast provided by the EC indicates 
  that the deficit will fall below the reference value at the 
  end of the unusual event or severe economic downturn. 
¶6.   (SBU) The Council considered that the definition of 
  "severe economic downturn" was too restrictive.  Thus, they 
  suggest changing the regulation to have "exceptional" also 
  include an excessive deficit resulting from a "negative 
  growth rate or from the accumulated loss of output during a 
  protracted period of very low growth relative to potential 
  growth." 
 
¶7.   (SBU) A second amendment to the regulation would spell 
  out the meaning of "all other relevant factors. "  The 
  Treaty mandates the EC to take account of "all other 
  relevant factors" it its report to Council when it thinks a 
  deficit is excessive. This phrase is not defined in 
  regulation. 
 
¶8.   (SBU) This is the where the most apparent changes are 
  proposed for the regulation.   The Council suggests "all 
  other relevant factors" could reflect: (a) developments in 
  the medium-term economic position (in particular potential 
  growth, prevailing cyclical conditions, the implementation 
  of policies in the context of the Lisbon agenda and policies 
  to foster R&D and innovation); and (b) developments in the 
  medium term budget position (in particular, fiscal 
  consolidation efforts in good times, debt sustainability, 
  public investment and the overall quality of public 
  finances).  Additionally, due consideration is to be given 
  to "any other factors" which the member state concerned 
  thinks relevant, such as "budgetary efforts towards 
  increasing or maintaining at a high level financial 
  contributions to fostering international solidarity and to 
  achieving European policy goals, notably the unification of 
  Europe if it has a detrimental effect on the growth and 
  fiscal burden of a member state." 
 
¶9.   (SBU) There are two other proposed amendments in this 
  section. One would extend the deadlines for action after the 
  Council has determined that an excessive deficit exists. 
  Countries would be given six instead of four months to 
  present their plan to correct the excessive deficit, the 
  Council could take two instead of one month to decide 
  whether to adopt a recommendation under 104(9), the last 
  step before sanctions, and four months instead of two months 
  for the Council to decide that a member state has failed to 
  comply with it recommendations and to impose sanctions. 
 
¶10.  (SBU) The other proposed amendment would be to permit 
  the Council to make a recommendation under 104(7), the first 
  phase of an EDP, more than once and not necessarily moving 
  directly to 104(9), the last step before sanctions.  Such an 
  extension would be possible only if unexpected adverse 
  economic events had a major negative budget consequences and 
  the member state concerned had taken "effective action" to 
  correct the excessive deficit in compliance with the 
  Council's recommendation. 
 
Close to and Temporary: A Matter of Definition 
--------------------------------------------- - 
 
¶11.  (SBU) If all these "relevant factors" were to be "taken 
  into account" by automatically deducting them from the 
  deficit, no country would ever have an excessive deficit. 
  Juncker speculated that these special factors could amount 
  to 10-15% of GDP.  Rather, taking these factors into account 
  "must be fully conditional on the overarching principle" 
  that before doing so, the "excess over the reference value 
  is temporary and the deficit remains close to the reference 
  value." This firmly ties consideration of these other 
  factors to the Treaty's notion that deficits close to the 
  reference value and temporary are not to be considered 
  excessive.  "Temporary" is defined as mentioned above. For 
  "close to" the reference value is not defined.  Commission 
  experts, however, note that Juncker had mentioned that to 
  "close to" means a half a percentage point.  This will have 
  to be clarified in practice.  As far as the Commission is 
  concerned, they will consider these factors only if the 
  deficit is 3.5% or less. 
¶12.  (SBU) The notion that these special factors are not 
  automatically deducted is strengthened by the Council's 
  decision that while these factors can be taken into account 
  in the procedural steps leading to sanction, they should not 
  be considered in the Council's decision to abrogate an EDP. 
  Thus, once in an EDP a country would need to get the deficit 
  under 3% in order to avoid from having its budget policies 
  being subject to on-going EC and Council scrutiny. 
 
Other Provisions: Governance, Preventative Arm, Debt 
Sustainability 
--------------------------------------------- ------- 
 
¶13.  (SBU) A new section on governance clearly lays out the 
  responsibilities of the Commission and the Council and 
  contains provisions for (a) the horizontal review of budgets 
  to instill peer pressure, (b) involvement of national 
  Parliaments, and (c) using common forecast assumptions. 
  This section also contains provisions to improve statistics 
  and specifically considers imposing sanctions on a member 
  state for failing to report government data on a timely 
  basis.  Commission officials are generally pleased with this 
  section.  Initially, member states were not keen on a 
  governance section, but it became part of the package. 
 
¶14.  (SBU) The section on strengthening the preventative arm 
  concerns budgetary policy during good times.  The section 
  describes how a country should set its medium term budget 
  objective so its budget will be close to balance or 
  balanced.  Countries not yet having balanced budgets are to 
  make an adjustment of 0.5%, in cyclically adjusted terms, to 
  do so.  The 0.5% adjustment is not a "hard" obligation, 
  rather a "benchmark," something to aim towards. The 
  Commission has long-encouraged the use of such a benchmark. 
  None of these changes are to be incorporated in the 
  regulations. 
 
¶15.  (SBU) Structural reforms that have a direct long-term 
  cost savings and have a verifiable positive impact on the 
  long-term sustainability of public finances will be "taken 
  into account" in allowing a temporary deviation from a 
  member state's path toward achieving its medium term budget 
  objective.  The Council suggested that the idea of taking 
  such structural reforms into account should be reflected in 
  the regulations. 
 
¶16.  (SBU) On debt sustainability, there is little new.  The 
  provisions largely repeat those of the Treaty, i.e., that 
  the debt should be "sufficiently diminishing and approaching 
  the reference value at a satisfactory" pace.  It indicates 
  that the Council will formulate recommendations on debt 
  dynamics in its opinions on stability programs.  An earlier 
  version of the report had suggested that the Treaty 
  provisions be clarified in a regulation.  The Italians, 
  Belgians and Germans put a stop to that, according to a 
  Commission official. 
 
New States: Some Special Provisions on Pensions 
--------------------------------------------- -- 
 
¶17.  (SBU) A particularly interesting topic was the 
  treatment of new member states.  With generally low debt 
  levels and higher growth potentials, these countries could 
  run higher annual deficits on a sustainable basis, that is, 
  without driving up their debt stock.  The preventative arm 
  makes some allowance, indicating that a budget that is close 
  to balance might have a cyclically adjusted balance of -1% 
  of GDP if its debt is low and it has high potential growth. 
 
¶18.  (SBU) In the EDP section, "careful consideration" is to 
  be given to pension reforms that entail moving toward a 
  fully funded pillar from paygo systems.  This is another 
  issue of keen interest to new member states who are more 
  advanced in their reforms than others, such as Poland (Ref. 
  A), Hungary and Slovakia.  While such reforms can improve 
  public finances over time, short term transition costs put a 
  strain on budgets as governments continue to make pension 
  payments under the old system while some of the revenues are 
  channeled to the new one.  Such "careful consideration" is 
  to be exercised, again, if the excessive deficit is "close 
  to" the reference value of 3%. The Council suggests that 
  when it is deliberating whether to abrogate an EDP, 
  consideration should be given to the net cost of reform 
  during the initial five years, progressively declining from 
  100% of the net cost of the reforms to 20% in the fifth 
  year. Thus, a country that has a deficit close to 3%, with 
  the excess due to pension reform costs, will be given some 
  benefit of doubt, for five years. 
 
Translation Please: The More Things Change the More They 
Stay the Same 
--------------------------------------------- ----------- 
 
¶19.  (SBU) Expanding the meaning of "exceptional" and 
  larding on a list of  "all other relevant factors' give the 
  clear impression of that boring holes in the SGP.  However, 
  these are precisely arguments that Germany has been making 
  in the Council over the last two years as to why it does not 
  deserve to move to sanctions.  Rather than "gross errors" as 
  cited by the Treaty causing the excessive deficit, Germany 
  has argued that it has been economic stagnation and the high 
  costs of needed reforms (tax reductions, labor market 
  reforms) that have weighed it down.  In fact, Commission 
  staff have taken these factors into its account of the 
  German position, as had many member states.  While the 
  points about unification costs and contributions to the EU 
  budget had been vocalized by the Chancellor's office, these 
  always have been  "unspoken" considerations in the Council 
  deliberations. "How dare Greece vote against us when we are 
  supporting their budget through EU transfers," was a German 
  Finance Ministry official's quip.  The difference in the 
  Council's proposals from the past is that what was 
  implicitly taken into account now will be done explicitly. 
 
¶20.  (SBU) Changing the deadlines had been agreed by all 
  member states early in the Council's deliberations. 
  Application of the SGP for the first time revealed that the 
  existing deadlines did not give sufficient time for the 
  domestic budgetary process to give a considered response to 
  the Council's recommendations. 
 
¶21.  (SBU) Allowing more than one recommendation under 
  104(7) has been the Council's position since November 2003. 
  EC lawyers, however, did not agree.  This, in part, lead to 
  the blow-up between the Commission and the Council. The EC 
  was successful in the Council's report to have the two 
  conditions inserted for a country to take advantage of this 
  extension, i.e. unexpected adverse economic developments and 
  that the country had complied with the Council's 
  recommendations. 
 
¶22.  (SBU) Under the new rules, arguably Germany and France 
  would be treated just as they are now being treated under 
  the EDP.  The same for Greece and Hungary, both of which 
  have moved beyond the first level of recommendations.  Press 
  reports suggest that the Hungarian Finance Ministry is 
  pleased with the results on the pension, but they would not 
  have stopped the Council from making its recommendation 
  under 104(8) declaring that Hungary had not taken effective 
  action to reduce its deficit as previously recommended by 
  the Council.  Moreover, as all three are in EDP, the EC will 
  not take the "all other relevant factors" into account in 
  deciding whether to recommend abrogation of the proceedings. 
  At least in this case, 3% still means 3%. 
 
¶23.  (SBU) Some new member states believe that the new rules 
  can help speed up their adoption of the euro as the new 
  pension rules would allow them to show lower deficits than 
  usual.  While this could be the case for EDPs, EC officials 
  are quick to point out that the new rules do not apply to 
  the Masstricht criteria for joining the euro.  This, they 
  point out, is a separate issue. 
 
¶24.  (SBU) Do the new rules mean that German is given a pass 
  until 2006? Perhaps, if its deficit is only 3.2% in 2005. 
  But if the deficit pops back up to over 3.5% due to 
  unfinanced tax reform, it could likely be a different story. 
  For example, a Commission official notes that unification 
  costs could be taken into account, but are unlikely to be 
  given much weight because their increase would not be the 
  cause of the higher deficit as they are long-term 
  expenditures and, therefore, should be taken into account in 
  the government's medium term budget planning. 
 
ECB: The Thought Counts 
----------------------- 
 
¶25.  (SBU) The ECB quickly released a press release 
  expressing its "serious concern" about the changes proposed 
  by Ministers. It pledged to fulfill its role to ensure price 
  stability, a coded message that they will draw whatever 
  consequences that may arise from fiscal policy in setting 
  monetary policy.  An ECB official explained that they wanted 
  to send a signal to the markets so that inflationary 
  expectations stay firmly anchored to the ECB's monetary 
  policy. 
 
¶26.  (SBU) The ECB never has been happy with the debates on 
  the SGP in the headlines.  Disagreement over the SGP was 
  viewed in the bank as undermining one of the foundations of 
  European monetary union.  ECB officials didn't like the blow 
  up in November 2003 when the Commission and Council could 
  agree on recommendations for France and Germany, and didn't 
  think much of the Commission taking the Council to court. 
  The most positive aspect about the Council's report is that 
  it promises to put an end to the debates over the SGP, in 
  the view of one ECB official.  Another agreed that the new 
  rules would not change much; what remains important is 
  Finance Ministers' will to apply the rules. 
 
¶27.  (SBU) The ECB is no stranger to the importance of clear 
  quantitative benchmarks.  Price stability is defined as 
  annual increases in consumer prices of less than 2%, later 
  clarified that to "below but close to 2%."  The ECB's 
  reference value for the growth of M3 monetary aggregates is 
  4.5%.  The ECB generally gets high marks for its stewardship 
  of monetary policy, as reflected in low inflation and low 
  inflationary expectations.  And yet it has never achieved 
  its definition of price stability and has tolerated M3 
  growth well above the reference rate since 2001.  However, 
  it holds these targets clearly in mind - and uses them 
  effectively in its public discussions and to set its 
  monetary policy stance.  They would hope that Finance 
  Ministers do the same. 
 
Final Observation 
----------------- 
 
¶28.  (SBU) In the battle between discretionary application 
  of the SGP and rule-based approach, discretion has won.  The 
  SGP allows Finance Ministers make the final call, not the 
  Commission.  The Commission had been angling for a more rule- 
  based system that would give it more power.  However, one EC 
  official involved in the discussions assessed the new 
  provisions on EDP as "good," assessing measures rather than 
  just results. EC officials are disappointed that the details 
  on the preventative arm and debt are not to be included in 
  the regulation, but are pleased with the new provisions on 
  governance. 
 
¶29.  (SBU) The Treaty aims at correcting "gross errors," 
  giving plenty of leeway to take factors into account and 
  time to make the fix.  Only those who recklessly ignore the 
  warning signs and Council recommendations need to fear 
  sanctions. In the end, it depends on government's good faith 
  to exercise budget discipline.  The SGP may be a helpful 
  reminder of such discipline, but sound budget policies are 
  their own reward. 
 
¶30.  (SBU) Juncker's "minor miracle" was his ability to 
  capture on paper the state of the art of the application of 
  the SGP in real terms.  His miracle also had something to 
  due with the linkage of resolution of the SGP for Germany's 
  consideration of increasing its contributions to the EU 
  budget, in the view of one EC official Trading off 
  confirmation of the status quo for a possible increase in 
  Germany's contribution to the budget seems to be a 
  reasonable bargain. 
 
¶31.  (U) This message has been coordinated with US Embassies 
  Luxembourg, Berlin, Vienna and USEU. 
 
¶32.  (U) POC: James Wallar, Treasury Representative, e-mail 
  wallarjg2@state.gov; tel. 49-(69)-7535-2431, fax 49-(69)- 
  7535-2238 
 
Pasi