Cablegate: Stability and Growth Pact: Revived, Passes First

This record is a partial extract of the original cable. The full text of the original cable is not available.

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

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