Cablegate: European Commission Proposes Changes to Stability

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 008337

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, HALL
PARIS ALSO FOR OECD
TREASURY FOR OCC RUTLEDGE, MCMAHON

E.O. 12958: N/A
TAGS: ECON EFIN EUN
SUBJECT: European Commission Proposes Changes to Stability
Pact: Rules and Reality

T-IA-F-04-008

This cable is sensitive but unclassified. Not/not for
Internet distribution.

1. (SBU) Summary: On September 3 the European Commission
initiated a discussion of possible changes to the Stability
and Growth Pact (SGP). The Commission is seeking to find a
balance between flexibility that accommodates individual
country circumstances and strict rules that instill
necessary budget discipline. The initial reaction of
Finance Ministers was to welcome an examination of ways to
strengthen the SGP, but to rule out any changes to the
Treaty while keeping any regulatory changes to an absolute
minimum. The discussion will continue at the November
Ecofin Council session. Any final outcome is unlikely until
the first half of next year.

2. (SBU) On balance the Commission's suggestions are
useful and arguably could be adopted without changes to
the regulations. Agreeing to changes in implementation of
the SGP could provide the Commission a way out of the dead
end in which it has found itself since last November when
its interpretation of the rules differed from that of
Council's. More rules, however, would not guarantee better
implementation of the SGP. Key decisions on excessive
deficit procedures (EDP) still will be political and taken
by the Council. In a match up of rules versus reality,
reality wins. End Summary.

Commission Launches Debate
--------------------------

3. (SBU) On September 3 the European Commission issued a
"Communication" that commenced a debate on possible changes
to the Stability and Growth Pact (SGP). The Pact is
composed of provisions from the EU Treaty, Council
Regulations, and a Council Resolution. The Commission
states that tensions have accumulated in the application of
the SGP leading to a "loss of credibility and ownership and
institutional uncertainty."

4. (SBU) The Commission's proposals are for a
"strengthened" SGP and a Code of Conduct containing specific
economic-analytical tools to allow consistency in budgetary
surveillance. According to a senior Commission official,
the Commission is seeking to strike a balance between rules
that can take into account each country's unique economic
circumstances and those that are sufficiently strict to
instill necessary budgetary discipline. Another theme,
according to this official, is to place more emphasis on
"preventative" measures, e.g. taking steps to reduce
deficits in good economic times, rather than only
concentrating on "corrective' measures.

Key Elements of Commission Proposals
------------------------------------

5. (SBU) The Commission proposes to (a) refocus the SGP;
(b) better coordinate budgetary policies; and (c) improve
enforcement.

6. (SBU) With respect to refocusing the SGP the Commission
suggests:

i. Placing more focus on government debt and
sustainability. The Commission suggests making the debt
criterion of the Treaty operational (e.g. initiate an
"excessive debt procedure" when the debt exceeds the 60%
reference value) and clarifying the basis on which to ass
a "satisfactory pace" of debt reduction, including an
assessment of debt sustainability that takes into account
pensions, contingent liabilities, and assets.
ii. Allowing for more country-specific circumstances in
defining the medium-term deficit objective of "close to
balance or in surplus." A country with a higher debt level,
for example, would be subject to a more stringent
interpretation of the notion of "close to zero or in
surplus" over the medium-term than a country with a lower
debt level.
iii. Considering economic circumstances and developments in
implementation of the Excessive Deficit Procedure (EDP).
One option would be to redefine the "exceptional
circumstances" clause that can be invoked to avoid an EDP by
adding the notion of "prolonged economic downturn" as such
an "exceptional circumstance." Another approach would be to
allow country-specific deadlines for action rather than the
standard ten months after the date new budget data is
released, thereby seeking to better reflect a country's
cyclical development and debt level.
iv. Ensuring earlier actions to correct inadequate
budgetary developments. Under this approach the Commission
would issue early warnings directly to member states when
deficits are close to 3% (a point on which Ministers have
agreed in the Constitutional Treaty) but also in good times
if a government is not moving close to balance or surplus.
The Commission also could issue recommendations under the
Broad Economic Policy Guidelines (BEPG).

7. (SBU) On coordination budgetary policies, the
Commission would like to reinforce the link between BEPG,
budget programs submitted under the SGP and national
budgetary processes. BEPG address recommendations to member
states on structural policies, such as health care and
pension systems and labor and capital markets. The
Commission believes that economic and budgetary policies
need to set the "right priorities toward economic reforms,
innovation, competitiveness and strengthening of private
investment and consumption, thereby contributing toward
achieving the economic objectives of the Lisbon strategy."

8. (SBU) The Commission suggests that Stability and
Convergence Programs should define the medium-term budget
strategy at the beginning of a country's budget cycle. At
present all Stability and Convergence programs are submitted
to the Commission in early December, regardless of a
country's own budget cycle. Synchronizing national and EU
level budget exercises would allow a member state to reflect
the Commission's and Council's assessments of its proposed
national budget as well as the BEPG's in its national
deliberations. Such sequencing would increase the
interaction between European and national levels to include
national parliaments in the debate.

9. (SBU) With respect to enforcement, the Commission
suggests improving the quality, timeliness and reliability
of fiscal statistics, the effectiveness of peer pressure
(naming, shaming and blaming), and greater transparency and
accountability on budgetary policies (including reports to
the European Parliament and greater involvement of national
parliaments). These would complement a change already
agreed to by Ministers in the context of the Constitutional
Treaty, namely that the Commission be authorized to send
early warnings directly to countries without securing
Ecofin's approval.

Finance Minister's Take
-----------------------

10. (SBU) At their informal meeting in the Netherlands on
September 10, EU Finance Ministers issued a short statement
reflecting on the Commission's ideas. The thrust of these
comments is toward strengthening, or at least improving the
implementation of, the SGP. Ministers ruled out changing
the Treaty (i.e. 3% deficit and 60% debt reference values to
remain) and want only minimum changes to the regulations,
"if necessary at all." Specifically, the Ministers asked
the Economic and Finance Committee to work out elements on
the following issues:

1. Strengthening the preventative arm of the SGP by having
budget discipline in good times to gradually achieve
budgetary surpluses, practicing peer pressure, and having
transparent budget figures and growth assumptions.
2. Enhancing the focus on debt and its sustainability by
having debt over the reference value diminish at a
satisfactory pace, taking into account the future costs of
aging and implications of pension reforms.
3. Drawing a distinction between measures taken and
economic forecasting errors when assessing compliance with
Council decisions; and
4. Having budgetary policies set the right priorities
towards structural reforms, innovation, and competitiveness
in support of the Lisbon agenda to promote economic growth
and employment creation.

Some Views: To Modify or Not to Modify
--------------------------------------

11. (SBU) A German Finance Ministry official noted that the
informal Ecofin seemed to concentrate on areas that would
strengthen the rules, an outcome he suspected was driven by
the Dutch Presidency that has taken a strict line in
implementing the SGP. A Commission official explained that
the Ministers' statement reflects areas on which there was
consensus. This official suspects that some member states
would support more flexibility. According to a senior
Bundesbank official, some of the new member states' central
bankers and finance ministers are none too pleased with
contemplated changes to the rules that they have been
required to use in drawing up their medium-term budget
programs.

12. (SBU) Another German official speculated that the
Economic and Finance Committee would not suggest any changes
to the regulations. This position was supported strongly by
European Central Bank President Trichet at his September 22
hearing before the European Parliament. A senior
Bundesbank official, however, was not sanguine that this
position would hold. The Dutch, Austrians and Nordics
continue to toe the line against changes, but Germany, once
the leader of this pack, is no more, in his view.

13. (SBU) Three points in the Commission's proposals would
require a change in regulations according to a Commission
official. These would be to (a) modify the definition of
"exceptional circumstances;" (b) provide for another
timetable for sanctions to be taken rather than the 10
months from the date that new budget data is released; and
(c) modify the timetable to correct the excessive deficit to
reflect a country's circumstance rather than requiring it be
done "a year after its identification." A senior Luxembourg
Finance Ministry official believed that some of these
changes would be necessary to bring more clarity in how the
SGP is being implemented. In his view, these neither
strengthen the SGP nor weaken it.

14. (SBU) A French Finance Ministry official generally
supported the main ideas of the Commission's paper, but
cautioned that the details could prove to be tricky. Tying
national budget cycles to the EU-level Stability Programs or
giving more weight to the BEPG are, in his view, unlikely.

Next Steps
----------

15. (SBU) The Economic and Finance Committee will flesh out
Ministers' ideas with a view to having a first discussion at
the November Ecofin. European Commission staff expect
discussions to roll into the next year. After the Ecofin
Council has concluded its deliberations, the Commission must
present recommendations to the Council for approval. A
Senior Luxembourg Finance Ministry official thought wrapping
up the exercise in the first half of next year would be
"fortunate." He hopes they can conclude the work during the
Luxembourg Presidency.

Observations
------------
16. (SBU) According to a senior German official, the
College of the European Commission agreed to taking the
Council to the European Court of Justice over the excessive
deficit cases of Germany and France provided that it also
developed ideas for improving implementation of the SGP.
This has positioned the Commission to devise new approaches
to implementing the SGP. In doing so, it could provide a
way out of the dead end it has found itself by sticking to a
recommendation that the Council could not adopt last
November (see septel). While this commitment was taken
while Commissioner Solbes was in charge of DG Economics and
Finance, the new Commissioner Alumina is more "politically
savvy," according to this German official, and wants to find
a compromise that member states can live with. The
Commission has put its "cards on the table."

17. (SBU) We would agree with the Commission staff
observation that most of their suggestions and those of the
Finance Ministers could be implemented without any changes
in the regulations. The Commission staff already examines
cyclically adjusted balances as part of their overall
assessment of a country's fiscal position. We would also
argue that the "special circumstances" clause can be
interpreted to make allowances for the timing of the
adjustment path to correct the deficit. The German Finance
Ministry has argued that the unforeseen, prolonged economic
slow done is such a "special circumstance." On the other
hand, expanding the definition of "exceptional
circumstances" would allow countries to avoid any EDP and
more intense budget scrutiny. This would not be helpful.

18. (SBU) Putting more focus on debt would be a welcomed
change. After all, financing costs are driven, in part, by
the stock of debt and its dynamics rather than the deficit
of a single year. Seven of the Euro 12 (or nine of the EU
25) are over the 60% limit, three of the 12 are close to the
100% level (Italy, Greece and Belgium). The 60% limit was
established in the 1990's when that was the average stock of
debt for the prospective euro area. That number has gone up
to 70% in 2003. In its latest World Economic Outlook, the
International Monetary Fund confirms that the EU has
demonstrated an "unsustainable deficit bias" since the
creation of the European Monetary Union.

19. (SBU) Subjecting member states to peer review when
budgets are in better shape also makes sense. The authors
of the IMF report cited above note that a "key priority in
the reform of the SGP should be to enforce greater fiscal
restraint in good times" in light of the costs of aging
populations that loom larger and closer. Deutsche Bank
Research has calculated that a one percentage point increase
in EU government deficits raises 10 year government bond
yields by 36 percentage points. Rather than spending money
on deficit financing it might be better be spent easing
structural reforms or cutting taxes.

20. (SBU) Better forecasts and statistics (as in the case
of Portugal and Greece) are very important. Uncritically
accepting national budget forecasts is nice, but unhelpful
in the budget surveillance process. A little tough love
would be better.

21. (SBU) Providing better consistency between budget
proposals and structural reforms, innovation and competition
covered in the Broad Economic Policy Guidelines make sense.
The SGP should not be just a numbers game, but a discussion
of economic policies designed to promote growth and
employment. Deficit spending does not mean the money is
spent wisely. Promoting such consistency would bring EU
level macro efforts into the national arena, the purview of
member states - a move many member states are likely to
resist.

22. (SBU) One issue confronting the Commission is whether
the rules should be drafted to reflect economic reality or
whether it is implementation that is to reflect the reality.
Drafting more precise rules will not solve the issue of
political will. That, or the absence thereof, still will
reside with the Council.

23. (U)This cable coordinated with Embassies Berlin,
Luxembourg, Paris, The Hague and USEU Brussels.

24. (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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