Stability Pact Revision: Art Imitates Life

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