UNCLAS SECTION 01 OF 08 FRANKFURT 006409

SIPDIS

LONDON FOR HADDA
TREASURY FOR OASIA

E.O. 12958: N/A
TAGS: ECON EFIN EUN
SUBJECT: Stability and Growth Pact: Listerine Syndrome;
Striving to Do Good, Good Enough? Key Word -
Flexibility


T-IA-F-03-0040



1. Summary: "The taste people hate, twice a day."
Wretchedly-tasking Listerine's old advertising slogan
is akin to the criticism of the EU Stability and Growth
Pact (SGP): we don't like these rules, but we need
rules at least twice a year when budget results are
issued. When Europe was growing, budgets were not
under strain. The rules were tolerable. Slow growth
has changed all that. Calls for the SGP to be
suspended or modified, however, are likely to go
unheeded. Where does that leave this debate?


2. One way to approach the debate would be to
distinguish between the "letter" of the SGP and its
"spirit." The letter of the Pact is popularly
distilled into one number, the reference value that
deficits exceeding 3% of GDP are "excessive." If an
excessive deficit were not corrected in the year after
which it was identified, the member state concerned
could be subject to sanctions. The spirit of the Pact
essentially is that governments should work hard to
avoid any excessive deficit and, once it occurs, work
hard to get it back under control. Economies and
budgets, being less than clock-work like in their
predictability, often incur surprises or "exceptional"
or "special circumstances." Bad things happen.


3. At this writing, the outlook seems rather clear
that Portugal, Germany and France will not abide by
Ecofin's recommendations to bring their budgets under
3% value (for Germany and France in 2004) or keep them
there (Portugal in 2003). Sanctions, however, are not
automatic. Instead, a question EU Finance Ministers
will collectively decide is whether the member state
concerned is failing to take necessary corrective
action. This, necessarily, is a political as well as an
economic question.


4. Flexibility is the word of the day in the SGP
debate. Flexibility exists in the rules. Exercising
this flexibility responsibility will be a challenge for
the European Commission and Ecofin. Being flexible by

ignoring the rules is one thing. Being flexible by
taking into account measurable efforts to get the
structural deficit under control, including through
structural reforms, would be quite another. Such
efforts could mean brighter growth and budget
performance. That, after all, is the point of the SGP.
End Summary

SGP: Storm and Drang Amounting to Very Little


5. The SGP is getting its share of hits in the press.
As the euro area slogs through its third year of
sluggish economic growth, government budget deficits
are rising. Goldman Sachs estimates that for the euro
area these deficits will increase from 2.2% of GDP in
2002 to 2.7% in 2003. Portugal, Germany and France
have been found to have "excessive deficits," well
above the 3% of GDP reference value of the Treaty.
Ecofin has issued all three recommendations to reduce
their deficits below 3% and keep them there. Pro-
cyclical budget policy seems counter-intuitive.
Wouldn't tightening fiscal policy risk slowing an
already crawling economy? Calls for suspending the
SGP, revising it, or abolishing it seem to be a steady
diet of some financial journalists. They are likely to
amount to nothing.

SGP Rules: The Basics, Revisited


6. Many economists of the euro area agree that fiscal
rules are necessary for the European Monetary Union.
The basic argument is to contain the "spillover"
effects from a country with a high deficit and growing
debt on interest rates and, consequently, on the
financing costs of other countries in the union.
Higher interest rates could put pressure on the
European Central Bank (ECB) to lower rates, potentially
conflicting with its primary objective of maintaining
price stability. A framework of rules to coordinate
and discipline 12 national fiscal policies with a
single monetary policy is designed to avoid such
spillover effects.

7. Even Belgian economist Paul De Grauwe, often a
critic of the EMU, admits that some rules are
necessary. Nonetheless, in his "Economics of Monetary
Union" published in 2000 he criticized the SGP as being
"unbalanced" imposing strict rules at the expense of
flexibility. He points out that during the 1991-93
recession six EU countries had government deficits of
over 3% of GDP. So why impose such a strict rule if it
is bound to be broken? To do so risks breaking the
rules and diminishing the value of the pact.

8. Such criticism is, at least to date, misplaced.
This is the first time the excessive deficit procedures
(EDP) have been invoked. It is difficult to know
beforehand how they will be applied, particularly
during this period of prolonged economic slowdown.
Commented a senior Finance Ministry official who
participated in the drafting of the SGP, the authors
did not foresee such a long period of stagnation.

Why 3%?


9. 3% of GDP reference value seems to be a bit of a
rough rule. Yet it does have its logic. If trend real
economic growth were 3% (the high side of the euro
area's growth potential), inflation were 2% (the
European Central Bank's definition of price stability)
this would imply nominal growth trend of 5% per year
(which was the average nominal growth rate for the Eu-
15 during 1991-2000). If the stock of Euro area debt
were 60% of GDP (which it was for the Euro area 11
years ago when the basic rules were being written),
then a 3% of GDP government deficit would imply no
increase in the debt relative to GDP. That is, a
steady state.


10. The rough rule is even a bit rougher in reality.
As of 2002 the Euro 12 have a debt stock of 69% of GDP.
Nominal growth has been trending below 4%, likely to be
closer to 3% this year. The higher debt stock and
lower growth imply a deficit of around 2.7% to avoid a
further increase in debt as a share of GDP. For
countries with higher than average debt (Italy) and
average or below average growth (German), surpluses
would be in order to reach a sustainable level. Not
doing so can put pressure on interest rates and strain
on monetary policy, as noted above. No wonder small
countries that have moved close to budget surplus
during the cyclical upswing are displeased with the
larger countries that did not (France, Germany) or who
did not bring down their overall debt levels (Italy).
France is a special case: debt level around 60% and
growth rates around average.


11. The 3% reference value also is attractive because
it is relatively easy to explain and as transparent as
Eurostat can make it. More sophisticated measurements
of cyclically adjusted numbers are used by the
Commission to monitor trends. These lack clarity
(assumptions could vary) and simplicity.


12. The rules are unlikely to change. The recent
draft Treaty establishing a Constitution for Europe
incorporated the SGP rules, without substantive change.
Similarly, in its May 2003 Concluding Statement of its
Article IV consultations on the Euro Area Policies, the
IMF mission stated that the 3% limit "is and must
remain one of the key references values of the monetary
union." "An Agenda for a Growing Europe" issued by an
Independent High-Level Study Group chaired by Belgian
economist Andre Sapir in July 2003, argued that the 3%
of GDP upper limit should be kept to "steer fiscal
discipline." Nonetheless, there is another way to
approach the issue, namely, flexibly.

Need for Flexibility


13. De Grauwe's view on flexibility has become the
keyword of the day. Sapir's High Level Study Group
pleas for more differentiation in applying the SGP,
taking into account a country's debt level, and for
more flexibility in the case of severe cyclical
downturns. For the latter, the High Level Study Group
recommended changing the definition of the term
"exceptional circumstances" to be defined as simply a
negative annual growth rate rather than a 2 percent
decline. This would require a change in the Treaty.
Others, such as the ECB, argue that the SGP already has
sufficient flexibility. Which is correct?

Rules of the Game: Economists As Wanna-be Lawyers


14. To understand the debate, familiarity with the
rules of the game is helpful. This can be a chore.
The SGP is not one tidy document, but is composed of
Treaty Articles and Protocols and Council Regulations
and Resolutions. Article 104(2) of the Treaty states
that the Commission is to monitor member states'
budgetary situation and whether they comply with the 3%
reference value unless the excess over 3% is declining
close toward 3% or is "only exceptional and temporary."
Article 2(1) of Council Regulation (EC) No 1467/97
("the Council Regulation") defines "exceptional and
temporary" as resulting from an unusual event outside
the control of the member state concerned and which has
a major impact on the financial position of the general
government or when resulting from a severe economic
downturn. A severe economic downturn is exceptional
only if there is an annual fall of real GDP of at least
2%, according to Article 2(2).


15. Article 2(3) refines the point by allowing the
Commission to examine "other supporting evidence" that
would suggest an exceptional circumstance, even if the
decline is less than 2%. Such evidence includes the
abruptness of the downturn or the accumulated loss of
output relative to past trends. The Resolution of the
European Council on the SGP ("the Council Resolution")
further commits member states not to invoke the
benefits of Article 2(3) unless they are in a "severe
recession," further defined as an annual fall in real
GDP of at least 0.75%.


16. For Portugal, Germany and France, the Commission
considered whether exceptional circumstances were at
play and, at the time it was preparing its report,
decided in the negative. Thus, it issued a report that
these countries' deficits were excessive. Ecofin
agreed and issued recommendations to each of these
countries to "bring the situation to an end." As
provided for under the Council Regulation, Ecofin gave
the Member country concerned four months to take
effective action. Article 3(4) of the Council
Regulation states that the deadline for the correction
of the excessive deficit "should be completed in the
year following its identification unless there are
special circumstances." Under the Council Resolution,
member states have committed themselves to this action.
The phrase "special circumstances" is not defined
either in the Council Regulation or Council Resolution.


17. What happens if the deficit is not corrected?
Article 104(9) of the Treaty states that: "If a Member
State persists in failing to put into practice the
recommendations of the Council, the Council may decide
to give notice to the Member State to take, within a
specified time-limit, measures for the deficit
reduction which is judged necessary by the Council in
order to remedy the situation." If the Member State is
not implementing the recommendations or the measures
are inadequate, Ecofin is to take action, on the basis
of a recommendation from the Commission, either under
Article 104(9), that is give a (or another) notice or
under Article 104(11), resort to sanctions. Or if the
excessive deficit has not been corrected within the
time limits specified either in the initial EDP or a
notice issued under 104(9), Ecofin can again issue
another notice under 104(9) or move to sanctions.


18. Sanctions can be invoked "as long as a Member
State fails to comply with a decision taken in
accordance with" 104(9). Thus, a Member State would
have to "fail to put into practice the recommendations"
of Ecofin and would have to fail to comply with
recommendations in any follow-up notice. In short, be
incorrigible.
Sanctions: Deterrent or Admission of Failure?


19. For the record, sanctions themselves are also a
drawn out affair. When Ecofin takes a decision under
104(11) a non-interest-bearing deposit is to be
required. This would consist of a 0.2% of GDP fixed
component and a variable component of one-tenth of the
difference between the deficit as a percentage of GDP
and the 3% reference value. The total deposit cannot
exceed 0.5% of GDP.


20. The deposit is converted into a fine if two years
after the deposit was required the excessive deficit
had not been corrected. A German Finance Ministry
official admitted that just how the fine would be
imposed has not been thought through. "You see, when
we drafted these provisions, they were not meant to be
used, but to serve as a deterrent. "


21. Article 104(11) includes other possible measures:
require the member state concerned to publish
additional information before issuing bonds and
securities or invite the European Investment Bank to
reconsider its lending policy to the Member State
concerned.

Now we turn to the application of the rules to the
"live cases" of Portugal, Germany and France.

Portugal: Brightness Before the Burn Out?


22. In November 2002, Ecofin decided that Portugal's
2001 deficit of 4.1% was excessive. The Council's
recommendation called for (a) putting an end to the
excessive deficit as rapidly as possible (i.e. the year
following its identification, 2002); (b) implementing
budget plans for 2002 that would bring the deficit down
to 2.8%; and (c) implementing necessary measures to
ensure the 2003 budget is below 3%.


23. The GOP went through hell and high water to meet
(a) and (b). In the event, the deficit came in at
2.8%. In March 2003, however, the Council did not
"abrogate" their excessive deficit decision. Rather,
they wanted to assess the sustainability of the deficit
remaining below 3%. According to Commission officials,
prospects are not good.


24. Portugal's economy is contracting and the deficit
may well shoot up to 5% of GDP, according to Commission
experts. UBS Warburg suggests part of the contraction
was due to budget consolidation, between 0.7% to 1.3%.
In September Eurostat will give its assessment of the
budget outlook for 2003. The Commission is likely to
make an assessment either in September or shortly after
the final 2003 budget numbers are published in March

2004. The Commission is likely to make a report with
recommendations to Ecofin.


25. How might this case be handled by the Commission
and Ecofin? Under the "letter" of the rules, the
Commission is considering whether, in fact, there are
"special circumstances" given the decline in GDP. As
noted above, the phrase "special circumstances" under
the Council Regulation regarding the correction of the
deficit (Article 3(4)) is not defined. This contrasts
with the phrase "exceptional" under Article 2(3) of the
Council Regulation when the Commission makes its
initial assessment of whether a deficit is excessive.


26. With regard to the "spirit" of the rules, the GOP
probably can make a good case that they have complied
as much as possible with the Ecofin recommendations.
They pushed the deficit below 3% in 2002, as
recommended, and are committed to achieve a sustainable
deficit under the 3% reference value. Ecofin noted
that the GOP is moving to improve the collection and
processing of government data, reinforce mechanisms to
coordinate budgetary policy, and implement policies to
foster growth, employment and competitiveness.
Whatever the Commission and Ecofin do on Portugal will
set a precedent for the German and French cases to
follow.
Germany: Miss America on Your Arm or Egg in Your
Face


27. In January 2003 Ecofin determined that Germany had
an excessive deficit. They recommended that the German
government (a) put an end to the excessive deficit as
rapidly as possible in accordance with Council
Regulation Article 3(4) (i.e. the year after the
deficit was identified, 2004); and (b) implement their
budget plans for 2003 which, on the basis of German GDP
growth projections of 1.5% in 2003, aim at reducing the
deficit in 2003 to 2.75% of GDP by adopting budgetary
measures of 1% of GDP. Ecofin "noted" the commitment
of German authorities to implement structural reforms
and to reduce the underlying budgetary deficit by more
that 0.5% of GDP per year, with the exception of 2005
due to the introduction of income tax reforms.


28. The German government's budget plan for 2003
achieves a budget deficit reduction of almost 1%, in
structural terms, at least on paper. This plan passed
muster in the four month review of German budget
performance in May. However, the decline in growth,
probably close to zero this year, will help push the
deficit close to 4% in 2003. Under the "letter" of the
rules, the deficit need not be corrected until 2004.


29. Unfortunately, 2004 doesn't look much better.
Germany has announced that it will bring forward the
income tax cut scheduled for 2005 to January 2004, and
implement income tax cuts that had been postponed from
January 2003. Combined this would amount to a revenue
loss of around 1.3% of GDP, only part of which would
be financed through reduced expenditures. Goldman
Sachs estimates that the deficit will linger around 4%.


30. The German Finance Ministry differs. It hopes
that income tax cuts combined with structural reforms
and structural budget consolidation through subsidy
reductions will give a boost to economic growth to
around the Finance Ministry's assumption of 2%. This
should help push the deficit toward the 3% level.


31. This strategy is risky, in the view of a senior
ECB official. The income tax cuts may be pocketed by
politicians without making the important structural
reforms and subsidy cuts. Finance Ministry officials
admit that there are risks. It is a package deal - no
structural reforms or subsidy cuts - then no income tax
cuts in 2004. Success would be a "great step forward."
Failure would be "catastrophic," in the words of a
senior Finance Ministry official. Miss America on your
arm or egg on your face.


32. Under the SGP rules, German Finance Ministry
officials say they will argue "letter" and "spirit."
Like the case of the Portuguese, they will argue that
not realizing their assumed growth projections and the
prolonged economic stagnation are "special
circumstances" that have prevented correction of the
deficit by 2004. As noted above, this phrase is
undefined. German Finance Ministry officials hope the
Commission will exercise some discretion. German
Finance Ministry officials explain that they will keep
to the commitment of an average annual reduction of its
structural deficit of 0.5%, with a pause in 2004, due
to the income tax cuts, rather than in 2005 when these
cuts were originally scheduled to be implemented.


33. With respect to "spirit," Ministry officials say
they will point out that the government followed
Ecofin's recommendation to stick to their 2003
reduction plan, e.g. reduction of the structural
deficit by nearly 1%. Rather than boosting confidence,
as the Commission and ECB had suggested it might,
confidence languished. The announced program of
structural reforms and bringing forward the tax cuts
has provided the sweetener to push through subsidy cuts
envisaged in the budget consolidation program. The
idea of advancing the income tax cuts, they will argue,
is to bolster confidence while keeping their
commitments to Ecofin to cut the deficit over time and
undertake structural reforms. After all, getting below
the 3% reference value depends as much on the
denominator as the numerator, that is, on growth as
much as the absolute size of the deficit.


34. Commission officials privately are not convinced
by the "special circumstances" arguments. In a speech
in Berlin on July 1 European Commissioner Solbes was
"quite clear": "the Commission expects that Germany
will respect the EMU policy framework. A general
government deficit above 3% of GDP in 2004, for the
third year in a row, would be incompatible with our
common budgetary rules."

35. At the conclusion of the Fund's Article IV
Consultation with German authorities, the Fund mission
expressed support for the strategy of packaging
structural reforms, budget consolidation through
reduced expenditures, and advancing income tax cuts.
The mission conceded, however, that advancing the
income tax cuts "will make the fiscal arithmetic for
2004 difficult," and that getting below the 3%
reference value will "be a challenge" in 2004. But
overall, the mission sensed that "the prospect for
meaningful structural change is finally in the air. If
proposed reforms are implemented and fiscal
consolidation put on firmer ground, we are optimistic
that Germany's economy can put a long period of weak
performance behind it." Testimony on behalf of
Germany.


36. The first indications of the budget for 2004 will
be in the budget plan to be agreed by the end of this
year in Germany. If the budget plan has a deficit of
3% for 2004, perhaps with the help of "aggressive
assumptions" on growth and revenues, the first real
evidence of actual results will appear only in
September 2004 when Eurostat publishes its preliminary
estimates. Final figures for 2004 will be available
only in March 2005. On each of these dates, the
Commission could launch a report with recommendations
to Ecofin.

France: Unique, naturalement


37. In June Ecofin determined that France had an
excessive deficit. They recommended that the French
authorities (a) put an end to the excessive deficit as
rapidly as possible and by "2004 at the latest;" (b)
achieve a "significantly larger improvement in the
cyclically adjusted deficit in 2003 than currently
planned," and (c) implement measures to ensure that the
cumulative improvement in 2003-2004 is enough to bring
the nominal deficit "below 3% in 2004 at the latest."
Ecofin noted the commitment of French authorities to
ensure tighter control of expenditures and to achieve
pension reform.


38. As reported septel, this decision was not
supported unanimously, the Dutch and the Danes
dissenting. Ecofin had issued an "early warning" to
the French in January calling for "at least 0.5
percentage point of GDP" improvement in its cyclically-
adjusted budgetary position. In March the French
government's official forecast showed only a 0.1
percentage point improvement. It seemed that the
French had not taken to heart Ecofin's earlier
recommendation.


39. Reiterating the call for a 0.5 percentage point
cut in June when half the budget year was over seemed
unrealistic, according to Commission experts. Thus,
the formula was agreed that there should be an average
reduction of 0.5 percentage points annually over the
two years, 2003-2004. This suggests a one percentage
point cut in 2004. Moreover, Commission experts expect
the French deficit to be close to 4% of GDP in 2003.
Thus, a percentage point reduction in the deficit would
be necessary in 2004 in any case. Commission staff
consider such a deep cut problematic. German Finance
officials consider it the maximum possible.


40. The next step for France will come on October 3.
Under the SGP rules, this will be the four month
deadline by which time French authorities must explain
the measures they will take to comply with Ecofin's
recommendations. This will be a time of testing of
whether France is serious about respecting the SGP, at
least on paper.


41. German Finance Ministry officials, while quick to
emphasize their wonderful working relationship with
France, just as quickly distinguish their position on
the SGP from France's. They assert that they are
sticking by the rules, if not the letter at least the
spirit. In their view, France is doing neither.


42. The IMF also has supported the French Government's
basic economic strategy, in particular "the structural
orientation of policies and the intention to resume
fiscal adjustment." In its Article IV Consultation
Concluding Statement issued in June, the IMF mission
praised the legislation of the "key and difficult
milestone" of pension reform. The Fund notes that the
2003 deficit will be more than one percentage point
higher than planned and supports the objective of
reducing the underlying general government budget
deficit by 0.5 percentage points in 2004. Such a
modest reduction would not be in line with Ecofin's
recommendation.


43. The Fund mission goes on to point out that the
"credibility of the government's fiscal and economic
policy strategy hinges crucially on its ability to
reduce the share of public spending in GDP." Notably,
it points out that priority structural areas identified
by the government for reform (pension, health care,
reform of the state, and decentralization) will help
reduce expenditures as a share of GDP and "illustrate
the synergies between budgetary reform and possible
increases in potential growth." Here, as in the case
of Germany and Portugal, is the connection between
fiscal discipline, structural reforms and growth. An
argument that France is operating within the "spirit"
of the SGP. Moreover, France could argue that its past
growth rates and debt position suggest that its deficit
is sustainable - at least for a while - and not putting
pressure on the euro system.

Growth and the SGP


44. The stated objective of the SGP is "sound
government finances as a means of strengthening the
conditions for price stability and for strong
sustainable growth conducive to employment creation."
This suggests that discretionary fiscal policies should
be avoided so as not to burden monetary policy, and
foster low interest rates that are conducive to long-
term planning and investment. For most EU countries
this means cutting expenditures to achieve a more
sustainable level of debt or to avoid increased in debt
in order to ensure its sustainability when increased
expenditures become unavoidable due to aging
populations.


45. In its June 2003 report on "Public Finances in the
EMU," the Commission notes that budgetary consolidation
"often acts as a catalyst for structural reforms."
Structural reforms can boost growth and growth
potential. As the Commission notes in that report,
"the effect of budgetary consolidation on output could
be reinforced, and even positive, in the short-run if
fiscal consolidation is combined with structural reform
of factor and product markets and accompanied with an
accommodating monetary stance."


46. So that's the deal for growth: budget
consolidation, structural reform, accommodative
monetary policy. Interest rates are at record lows.
Pressure has grown for structural reforms due to budget
pressures. It would be more than a pity to relieve
that pressure now. No wonder Dutch Finance Minister
Zalm, noted for his tough stance on deficits, has
called for fines for France and Germany if they fail to
get their finances in order next year.


47. How could flexibility be applied without
sacrificing the rules? One point is that when Ecofin
made its recommendations for all three countries, the
Commission's and ECB's forecast was for much more
robust growth than has occurred. Thus, the rising
deficits could be due, in part, to cyclical factors.
In November 2002 the European Commission agreed to give
importance to cyclically adjusted budget balances in
its surveillance and ensure a cyclically-adjusted
budget position of at least 0.5% of GDP and more
emphasis on the quality of public expenditures that are
conducive to growth and employment.


48. The IMF Mission on Euro Area policies has praised
these measures. Specifically the Fund staff liked the
notion that countries with excessive deficits make
adjustments of at least 0.5% of GDP per year in
cyclically adjusted terms and that multi-year
consolidation plans should aim at curbing expenditures.
The Fund staff admits, however, that these steps will
not ensure deficits drop immediately below 3%.
Nonetheless, they argue that those countries that
follow these guidelines of "0.5 percent high quality
multi-year adjustment" should be "considered on a
sustainable path toward compliance with the Pact."
Striving to do good should be good enough.


49. Maintaining a judicious balance between enforcing
the letter of the SGP while safeguarding the spirit
will be the next challenge for the Commission and
Ecofin. No one said that coordinating 12 national
budgets during a prolonged economic downturn would be
easy.



50. This cable coordinated with Embassies Berlin,
Lisbon, Paris, Rome, the Hague and USEU Brussels.

(U) POC: James Wallar, Treasury Representative, e-mail
wallarjg2@state.gov; tel. 49-(69)-7535-2431, fax 49-
(69)-7535-2238.

Herrman