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UNCLAS SECTION 01 OF 05 FRANKFURT 004988 
 
SIPDIS 
 
SENSITIVE 
 
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 and Growth Pact:  Revived, Passes First 
Test 
 
 
T-IA-F-05-029 
 
This cable is sensitive but unclassified.  Not/not for 
Internet distribution. 
 
Ref: Frankfurt 2433 
 
  ¶1.   (SBU)  Summary: Even before modifications of the 
     Stability and Growth Pact (SGP) were adopted by the Council 
     on June 27, the European Commission (EC) had passed its 
     first test applying the "spirit" of the new rules to Italy 
     and Portugal.  The EC's recommendations that these countries 
     should be subject to Excessive Deficit Proceedings (EDP) is 
     likely to be accepted by the Ecofin Council on July 12 for 
     Italy and September or October for Portugal.  Applying what 
     popular wisdom perceived to be more lenient rules did not 
     allow Italy, with a deficit hovering around 3.1% of GDP, to 
     escape EDP.  Portugal's deficit of 6.2% was not even a close 
     call as the government gave up on one-off measures to reduce 
     the deficit.  A close reading of the staff reports suggests 
     that the EC has actually tightened its economic analysis, 
     shutting down arguments that deficits became excessive due 
     to exceptionally prolonged low economic growth or other 
     relevant factors like costly structural reforms or 
     investments. 
 
  ¶2.   (SBU)  The EC believes it has to press ahead to 
     demonstrate that the SGP functions.  The current EU 
     political crisis might give it a bit of a tailwind as member 
     states wish to show that EU and the Eurozone are not 
     paralyzed.  Offering countries an extra year to correct 
     their deficits should make the new SGP prescriptions more 
     palatable.  As before, the major cases of Germany and France 
     will demonstrate whether Finance Ministers have the 
     political will to follow the new rules.  But, for this 
     moment, the SGP looks revived.  End Summary. 
 
  New Rules Take Effect... 
  ------------------------ 
 
  ¶3.   (SBU)  Amendments to the regulations that form part of 
     the SGP were adopted by the Council on June 27.  These had 
     been proposed by the EC in April based upon Ecofin's report 
     to Heads of State in March on "Improving the Implementation 
     of the Stability and Growth Pact."  That report was agreed 
     after contentious negotiations. 
 
  ¶4.   (SBU)  As noted reftel, EC staff were principally 
     disappointed that Ecofin's admonishment for countries to 
     make adjustment to move their budgets to balance or close to 
     balance in good economic times did not find their way into 
     proposed amendments.  This was particularly disappointing as 
     Council members fought to include specific, hard fought 
     language of the Council report to make sure their own 
     concerns, e.g. German reunification costs, were covered. As 
     a result of this Council editing, the text  of the EC's 
     draft amendments, which were designed to be as short as 
     possible and suitable for legal text, became longer and less 
     legalistic. 
 
  ¶5.   (SBU)  European Parliament's Economic and Monetary 
     Affairs Committee (ECON) shared the EC's view on the need 
     for rules for adjustment during economic up-swings, but 
     amendments to this effect were voted down by the plenary on 
     the first reading.  Undeterred, ECON reasserted its position 
     and took it to a second reading where its proposal failed to 
     secure the necessary majority, losing 257 to 309 on June 23. 
     EC staff were comforted by the fact that they had allies in 
     the Parliament, but the new regulations, as modified by the 
     Council, were set for final approval. 
 
  ¶6.   (SBU)  EC staff also has been working on a code of 
     conduct that lays out the rules for application of the Pact 
     in more detail.  The Economic and Finance Committee will 
     discuss the EC's draft this week and the Council should 
     endorsed it shortly thereafter. 
 
  But EC Already Applied Their Spirit . 
  ------------------------------------- 
 
  ¶7.   (SBU)  Even before the Council's adoption of the 
     amendments, the EC applied the "spirit" of the modified 
     rules in the cases of Italy and Portugal.  On June 7 the EC 
     issued an assessment of Italy's budget situation in light of 
     Eurostat's May 23 revised figures showing Italy's deficit 
     had been 3.1% of GDP in 2003 and 2004.  On June 22 the EC 
     issued an assessment of Portugal's budget situation in light 
     of the new Portuguese government's updated stability 
     program.  Contrary to its predecessor, the new government 
     does not plan to use extraordinary measures to reduce its 
     deficit, but has pledged a gradual reduction from an 
     estimated 6.2% in 2005 to 2.8% in 2008. 
 
  In Unexpected Ways.. 
  -------------------- 
 
  ¶8.   (SBU)  Popular wisdom has been that the modifications 
     to the SGP would make any excessive deficit case nearly 
     impossible to make.  The deficit could be over 3% and 
     considered exceptional and temporary if caused by adverse 
     economic conditions like prolonged slow growth.  Moreover a 
     list of "all other relevant factors" could be cited, such as 
     structural reforms implemented under the Lisbon Agenda or 
     financial contributions to the EU budget, to avoid an EDP 
     proceeding.  According to this popular wisdom, the SGP was 
     history. 
 
  ¶9.   (SBU)  A close reading of the EC's report suggests that 
     popular wisdom did not have it quite right.  As explained by 
     an EC expert, to initiate an EDP, first the EC assesses 
     whether the deficit is close to 3% and whether the excess 
     over that reference value is exceptional (due to a severe 
     downturn or prolonged slowdown of the overall economy) and 
     temporary.  If the EC's assessment is that the deficit is 
     not close to 3% or it is not exceptional and temporary, it 
     can recommend the Council launch an EDP.  In taking that 
     step, the EC examines "all other relevant factors," which 
     also include cyclical conditions, consolidation efforts in 
     good times, and debt sustainability. 
 
  ¶10.  (SBU)  In the case of Italy, the EC report does not 
     comment on whether 3.1% is close to 3%.  The number, 
     however, does not leave much to the imagination.  The EC 
     report concludes that the deficit is not temporary.  As 
     noted above, Eurostat's revised numbers show a deficit of 
     3.1% for the last two years.  The EC's spring 2005 forecast 
     projects a deficit of 3.6% this year and 4.6% in 2006, both 
     likely to be higher in light of Italy's slowing economic 
     growth, according to another EC expert.  The EC report 
     observes that Italy's economic slowdown is not exceptional. 
     Yes, Italy's growth has been slower over the last decade 
     than before. However, EC staff point out that the slowdown 
     reflects structural weaknesses that have reduced Italy's 
     potential growth rate from 2.3-2.4% at the end of the 1980's 
     to "slightly above 1.5%." While Italy has grown less than 
     its potential for the last three years, the EC notes that 
     this output gap is not as large as those during other 
     economic recessions in the early 1980's and early 1990's. 
 
  ¶11.  (SBU)  What about the "other relevant factors?" Reforms 
     adopted in March to improve Italian competitiveness will 
     cost less than 0.1% of GDP, according to the EC's 
     assessment.    Expenditure on R&D and education remained 
     constant as a share of GDP and does not explain the deficit 
     increase.  The EC points out that: 1) the cyclically 
     adjusted deficit is likely to stay around 3.9%; 2) the 
     Italian government expanded the deficit rather than 
     shrinking it in good economic times; 3) the deficit had been 
     reduced by one-off measures which the government is phasing 
     out; and 4) the government's projection of deficits were 
     consistently lower because of overly optimistic economic 
     growth projections.  To top it off, the EC's close 
     examination of debt dynamics show that Italy's debt to GDP 
     of 106.5% of GDP (compared to the SGP reference value of 
     60%) is unlikely to be declining any time soon. 
 
  ¶12.  (SBU)  For Portugal the story was very similar.  The EC 
     states that a deficit of 6.2% is not close to 3%, an easy 
     call. The deficit is not temporary, under the GOP's own 
     assumptions of not falling under 3% until 2008.  And the 
     deficit is not due to exceptional circumstances, again 
     comparing Portugal's lower growth potential with output gaps 
     in previous recessions rather than just looking at its 
     recent poor economic growth.  With respect to other relevant 
     factors, the EC report gives Portugal little slack.  The 
     effect of recent structural reforms on the budget is 
     difficult to estimate, although expenditures in education 
     have increased continuously since the 1990's. But the 
     cyclically adjusted budget is not set to decline and the 
     government's reliance on one-off measures and overly 
     optimistic growth forecasts masked the reality that the debt 
     stock has increased from 53.4% of GDP in 2000 to a projected 
     67.5% in 2006. 
 
  ¶13.  (SBU)  One area where the modified rules appear to have 
     made a difference is in the time to correct the deficit. 
     Previously, the EC interpreted the SGP as requiring the 
     deficit to be corrected a year after its identification. 
     The EC will recommend that Italy be given until 2007 rather 
     than 2006 and Portugal to 2008 (on the assumption that the 
     2005 budget will be the first year over 3%), in line with 
     the government's program.  A senior EC official reported 
     that his was hotly debated within the EC.  Those favoring 
     strict adherence to the old interpretation argued that 
     crisis budgets are more successful when the reductions are 
     front-loaded rather than explaining painful adjustments year 
     after year. The other view was that an extra year took 
     better account of the politics of national budget cycles and 
     is a "bargaining chip" for the countries to accept EDP.  The 
     latter won. 
 
  ¶14.  (SBU)  An EC expert explained that the modified rules 
     provided an opportunity for the EC to change its 
     presentations to give a more economically robust 
     justification for recommending an EDP. The presentations for 
     both countries adhere to the same format and systematically 
     run through all the economic arguments that had been 
     included in the Ecofin report.  The EC gives consideration 
     to "all other relevant factors," then puts them aside as 
     they did not cause the deficit to become excessive.  As a 
     result, countries have a more difficult time rebutting the 
     EC case. 
 
  ¶15.  (SBU)  According to a senior EC official, the Economic 
     and Finance Committees showed little sympathy when the 
     Italians started to explain away their excessive deficit. 
     The EC's analysis had graphically shown how shoddy 
     statistical governance and a series of one-off measures were 
     used to hold the deficit under 3%.  Most member state 
     representatives were "fed up," accord to this official. 
 
  ¶16.  (SBU)  Most member states have not appreciated that the 
     EC will rarely find an excessive deficit to be temporary, 
     according to an EC expert.  When the EC makes budget 
     projections, it does so on the basis of no policy changes. 
     That is, unless there are policy changes, the deficit will 
     almost never be considered temporary. 
 
  ¶17.  (SBU)  Slow growth may be cited as a justification for 
     running slightly larger deficits. But there is a question as 
     to how slow growth should be defined. Basing slow growth on 
     the output gap was discussed early on by EC staff and 
     included in the Council's report. This point is that a 
     country could claim a prolonged economic slowdown, but if 
     prolonged for a sufficient time, growth potential drops 
     making a return to higher growth problematic and economic 
     forecasts based on the good old days overly optimistic. 
 
  But Germany and France Will Be Real Tests Again. 
  --------------------------------------------- --- 
 
  ¶18.  (SBU)  The EC's recommendation that Italy be subject to 
     an EDP was adopted by the full Commission June 29th and sent 
     to Ecofin for its endorsement at its July 12th meeting. 
     Since the Economic and Finance Committee accepted the EC's 
     report, EC staff are confident Ecofin will agree.  The 
     recommendation on Portugal will be considered by the 
     Economic and Finance Committee this week.  On July 12 Ecofin 
     will hear a report on the GOP's updated stability program, 
     but will not act on the EC's recommendation until its 
     meeting in September (unlikely as it is an informal meeting) 
     or October. 
 
  ¶19.  (SBU)  The EC is already preparing for the next cases 
     on Germany and France.  German Finance Minister Eichel has 
     admitted to Commissioner Alumnia that the deficit will be 
     over 3% in 2005 and likely again in 2006.  EC staff reckons 
     it will be around 3.5% this year.  France's announcement of 
     job creation measures and tax cuts do not bode well for a 
     deficit that is skirting 3%. 
 
  ¶20.  (SBU)  The EC could start action on either country at 
     any time, but the most likely opportunities will be after 
     the September 1 notification of likely budget outcomes or 
     the EC's autumn forecast due out November 12.  As Germany is 
     likely to have a national election in mid-September, EC 
     staff believes the German notification due on September 1 
     will be delayed. 
 
  ¶21.  (SBU)  Since Germany and France are already in EDP the 
     issue will be whether Ecofin should escalate proceedings to 
     104(9), the last step before sanctions, or repeat a 
     recommendation under 104(7).  Under the modified SGP rules, 
     a recommendation under 104(7) can be repeated provided 
     unexpected economic factors had caused the deficit not to 
     decline as projected even though the government had taken 
     effective action in line with the initial recommendation. 
     The   economic outturn is compared to what the EC had 
     projected for growth and the deficit. 
 
  ¶22.  (SBU)  In the assessment of a senior EC official, both 
     countries may experience weaker growth than initially 
     forecast. He believes that Germany could make a case that it 
     has taken effective actions, but, in his view, France could 
     not.  While he recalled that France was willing to accept a 
     recommendation under 104 (9) in November 2003, times have 
     changed, and he is not so sure that they would do so this 
     time. 
 
  Comment 
  ------------ 
 
  ¶23.  (SBU)  EC staff have surprised themselves with their 
     more robust economic analysis that cuts off many lines of 
     debate that could excuse a deficit higher than the 3% 
     reference value.  They believe the EU's political crisis has 
     strengthened the EC's resolve to press ahead and demonstrate 
     that the SGP has not been weakened.  Finance Ministers, in 
     this EC expert view, will be leery about challenging the EC 
     working with the freshly minted rules.  While the cases of 
     Italy and Portugal are set to proceed, as before, the cases 
     of German and France will demonstrate whether, in fact, 
     there is a new political will to make the SGP function in a 
     more robust, but economically rational, way. 
 
  ¶24.  (SBU)  The "extra year" for deficit correction is 
     likely to be perceived as slippage from previous 
     recommendations.  Two comments are in order.  First and 
     foremost the national political reality and the economic 
     policy mix of the country concerned will dictate how quickly 
     or sharply the deficit can be reduced.  Withdrawing 2% of 
     GDP can't be easy for any country and certainly was not 
     economically healthy for Portugal.  Second, the EC has 
     sometimes been guilty of a slight of hand by not always 
     promptly identifying a deficit as excessive, and thus 
     defacto granting an extra year.  This happened in the 
     previous case against Portugal when the EC's recommendation 
     slipped into January before the Council "identified" the 
     deficit, giving Portugal an extra year for correction.  The 
     point of the SGP is to push countries in the right direction 
     and give confidence that the government has or is getting 
     the budget situation under control. Deadlines imposed from 
     Brussels are less important than the substance of 
     government's fiscal decisions that may take more time and 
     local politicking. 
 
  ¶25.  (U) This report coordinated with USEU and Embassies 
     Lisbon, Rome, Paris, Berlin and Luxembourg. 
 
  ¶26.  (U) POC: James Wallar, Treasury Representative, e-mail 
     wallarjg2@state.gov; tel. 49-(69)-7535-2431, fax 49-(69)- 
     7535-2238 
 
Bodde