The Spanish Economy

Ouch

While many European countries have been able to weather the current crisis with a moderate increase in unemployment, the same has not been true for Spain. After a “Golden Decade” of steady convergence towards the rest of Europe in terms of employment and living standards, as well as fiscal balance, in a couple of years Spain has reverted to the pathological unemployment rates that prevailed between Franco’s death and the mid-nineties. Worse, the fiscal balance has deteriorated rapidly, making Spain a member of the infamous “PIIGS” club and suffering from high interest spreads on public debt, despite its credit record having been far more virtuous than that of other countries such as Italy, Greece, or Belgium.

What is going wrong? Are the markets unduly punishing the country or are they seeing weaknesses that the Golden Decade had hidden? We address those issues in a special chapter of the just-released EEAG Report on the European Economy .

We argue that the Golden Decade was largely unsustainable and that it did little to eliminate the structural handicaps of the Spanish economy. While the current fiscal crisis lends urgency to carrying out structural reforms, it will also mean that the timing of the budget-consolidating reforms will be unfortunate, since they will  be implemented during a macroeconomic contraction. This could have been avoided if Spanish policymakers had taken a more long-term view during the Golden Decade and implemented those reforms during the boom.

A number of adverse developments occurred during the booming years, which contributed to the severity of the current crisis. The country accumulated positive inflation differentials vis-à-vis the rest of the euro area, gradually harming competitiveness.  House prices grew faster than the economy, suggesting there was an asset bubble, as in the United States.  This in turn boosted both residential investment and consumption through their effect on household wealth. To the extent that house prices were too high, these two variables were also too high, and the collapse in the housing bubble is now leading to a rapid drop in these two components of GDP. In the end, very large trade deficits were due to both the persistent lack of competitiveness and the high level of domestic demand. As a result, the net foreign asset position of the country quickly deteriorated, making an adjustment unavoidable. Because of Spain's membership in the European Union and the euro area, these deficits could be financed by capital inflows at low interest rates, and they could not be mitigated by nominal exchange rate depreciation.

Most of the growth came from the construction sector and took the form of a reduction in unemployment. This occurred despite the fact that technical progress – measured by total factor productivity – remained quite low. As productivity is the only way to increase living standards in the long run, the expansion had to come to a stop once unemployment had fallen to a level where tensions on the labour market appeared again. Such tensions were eased by the fact that wage pressure was moderated by large immigration flows and that a large fraction of the jobs that were created were under temporary contracts. But  little was done to tackle the structural rigidities that plague the Spanish labour market, whose most salient symptom is the inability of wages to adjust in response to cyclical conditions.

The following Table from the 2011 Report illustrates how deadly this feature can be. Despite an almost 7-point increase in unemployment between 2008 and 2009, nominal wages in Spain nevertheless managed to grow by 3.7%. The bargaining system in Spain allows insiders to shelter themselves from outside competition when setting wages. The two-tier structure of the Spanish labour market, whereby a third of the employed are under short-term contracts,  makes this feature worse because when setting wages, workers with permanent contracts know that workers with temporary contracts will be the ones who will lose their jobs first as a result of wage increases.

Lack of response of wage increases to unemployment

Source: Bank of Spain (2009) Annual Report

Because these rigidities are still there, it looks like the Golden Decade is an anomaly and the country is reverting to its “normal” regime of pathologically high unemployment.

To exit this bleak situation, policymakers must act on two fronts:  wage bargaining and productivity.

The level at which wage bargaining takes place (that is, the sectoral level) is inappropriate. An intermediate level of wage-setting, along with low coordination, delivers high and persistent unemployment at the aggregate level. Ideally, wage formation should be decentralised at the firm level. An interesting proposal ² in that direction was made in 2009 by 100  economists. This proposal allows for agreements at the firm level to supersede any sectoral agreement, for example, if the lower level agreement implied lower wage growth than the sectoral one. Thus, sectoral agreements would only define a default option in the case that bargaining does not take place at the company level.

As long as productivity growth remains low, there is little hope for an improvement in living standards and, since the trade balance needs to be restored, the adjustment in the external sector must be achieved through a real exchange rate depreciation,  implying a reduction in real wages. Furthermore, such a depreciation is long and costly to achieve in the context of European Monetary Union. To exit this conundrum, Spain needs a set of measures to improve productivity and to promote growth and exports. Here, rather than a big reform, many interventions are needed, because the root of the evil lies in the myriad regulations that conspire to deliver a bleak performance.  To mention but a few issues:

• There are many rigidities in the process of entry and exit in industry, including the dysfunctional commercial rental market or the protection of declining firms with subsidies. In education and R&D a change in organisation and incentives in the bureaucratic structures is needed. Schools need more autonomy to compete for students and teachers, with more transparency on performance. In higher education, the universities should have autonomy to select professors and students, with public financing based on results; they must charge fees closer to the real costs and develop a system of scholarships to foster equal opportunity.
• Competition should be fostered in services (implementing the EU Services Directive) to lower costs and induce faster adoption of information technology. This may be particularly important in a sector such as retailing. In regulated sectors like energy, an opportunity must be given for market forces to act. At present the maze of subsidies and regulations induces an extremely high inefficiency and distorted use of energy sources.

The bursting of the real state bubble has left scars in Spain, and the level of indebtedness of the private sector, which is external in an important proportion, suggests that internal demand that was largely stimulated by capital imports will not be an engine of growth for some time. Achieving the needed real exchange rate depreciation in the absence of structural reforms will be a long and painful process. The price to be paid will be stagnant growth and, if wages remain as inflexible as at present, a high level of unemployment for years. To mitigate the pain that undoubtedly will come with this process, structural reforms will be key ingredients of any successful adjustment package. The better and more radical they are, the shorter will be the period of slump that Spain will have to endure. The success of the labour market reforms Germany implemented in 2004 to allow for more downward flexibility of wages when it was caught in a similarly painful real depreciation crisis shows that such reforms eventually pay off.

• Download Chapter 4, "Spain", of the EEAG Report on the European Economy 2011 (pdf, 1.7 MB)

• CESifo Working Papers published in the past three months