BBA Thesis

SPAIN’S ECONOMY AND THEIR ABILITY

TO OVERCOME THE CURRENT

ECONOMIC CRISIS

A Thesis

Presented to the Faculty of European University

In Partial Fulfilment of the Requirements for the Degree:

Bachelor in Science of Business Administration

By: Adham Robin

July 2013

Table of Contents

Executive Summary and Introduction..................................................................................................3

Industrialisation....................................................................................................................................6 The Spanish Civil War and its Aftermath............................................................................................7

The Regime of Francisco Franco.........................................................................................................7 1960’s, 1970’s................................................................................................................................8

Oil Crisis...............................................................................................................................................8

The Crisis of the 1990’s.....................................................................................................................10 The ‘Golden Decade’, 1995-2007......................................................................................................11

Spain, its Subprime Mortgage Crisis and Housing Bubble of 2007-2008.........................................13 The Double-Dip Recession..........................................................................................................16

Recent Political Parties in Power.......................................................................................................19

The Aznar Government...............................................................................................................19 The Zapatero Government..........................................................................................................20

European Union Integration...............................................................................................................22 The Single Currency, The Euro..........................................................................................................23 European Integration - Constraints.....................................................................................................24

Should Spain pull out the Euro...........................................................................................................25 Spain’s Financial Bailout………………….......................................................................................25

Current Situation: A Serious Structural Problem...............................................................................26 General Indicators....................................................................................................................27 Technology.........................................................................................................................................28

Competitiveness of Markets...............................................................................................................30 Research and Development................................................................................................................31

Labour Productivity............................................................................................................................32 Education: Current State, Reforms and Suggestions..........................................................................34 Unemployment...................................................................................................................................39

Labour Reforms........................................................................................................................43 Export Sector......................................................................................................................................45

Financial/Banking Reforms................................................................................................................49 The Need of Regional Convergence..................................................................................................50 Pension System...................................................................................................................................51

Conclusions........................................................................................................................................52 Bibliography.......................................................................................................................................58

Executive Summary

In the course of this thesis an attempt was made to evaluate the state of the Spanish economy, the

effects of the current crisis on the economy, and the country’s potential for recovery.

This thesis will be structured around an analytical framework based on the production function

described as followed:

Y = Af {L, K, H, N}, where Y represents the amount of goods and services produced, L is labour,

K is capital, H is human capital and N is the natural resources in the economy. A, or TFP (Total

Factor Productivity), represents levels of technology and shifts the production function up or down

for any given amount of the factors of production.1

The production function determines the amount companies are capable of producing, or in other

words, the quantity of goods and services that a country can offer to the market.

If the production function is divided by the amount of labourers in the economy, the end result is

the output per worker function, or productivity: Y/L = Af {1, K/L, H/L, N/L}.

A country’s standard of living depends on its ability to produce goods and services, and a rapid

accumulation of the factors of production and ensuring that these factors are employed as

effectively as possible is essential for an economy to grow and living standards to increase.

The significant events in the past that has affected the production and growth potential of Spain are

analysed in order to have a better understanding of the strengths and weaknesses of the country’s

economy. The politics put in place by previous governments are also analysed as the

mismanagement of the economy has had a pivotal role in creating the structural problems that has

held Spain in such a deep and prolonged recession.

Spain’s current situation is then analysed in order to evaluate the effects the crisis has had on the

country’s economy. The efforts made by the current government in the form of labour, banking and

pension reforms, and the effects they have had so far, are also analysed.

The recovery of the Spanish economy depends on several factors: the stability of the financial

system, the reduction of unit labour costs to increase competitiveness, and moreover, gains from the

export sector, the loosening of credit, job creation, unemployment rates and last but not least, the

effectiveness of the educational system. In light of all the data analysed, the Spanish economy is

expected to flat line in 2014, and experience a period of growth and true recovery only in the

following years, 2015 and 2016.

1 Total Factor Productivity (TFP) can be taken as a measure of an economy’s long-term technological change or technological dynamism

Foreseeably, furthering the scope of these priority economic policy measures will allow a gradual

recovery in internal and external confidence, will lead to the normalisation of the funding of the

economy, and will lay the foundations for resuming economic growth in the medium to long-term.

Introduction

The modernisation of the Spanish economy has occurred during the last two centuries (19th and

20th century), although with more intensity during the second half of the 20th century. The study of

the factors that increased or decreased economic growth during this period can help explain the

current situation of the Spanish economy. Although past situations do not always occur again, the

knowledge of the factors that had increased or decreased Spanish production, productivity and

competitiveness in the past can be used to improve the Spanish economy and may help to avoid

repeating the same mistakes. This period will be described and analysed as this was when the

Spanish economy converged with the rest of its European neighbours, within a process that started

with the industrial revolution at the end of the 19th century and culminated with Spain’s entry into

the European Union at the end of the 20th century.

The Spanish economy has enjoyed a long period of growth from 1994 to 2007, with extensive job

creation. From 1994 to 2007, the labour market had seen an increase in employment from 13.3 to

20.6 million workers. The great moderation period in Spain led to historically low interest rates and

an expansion of credit facilities, which helped to sustain an intense and prolonged period of both

private consumption and investment growth. Spain managed also to reduce public debt to levels of

around 30%, and turned public deficits into surpluses.

Throughout this expansionary process the labour force increased considerably due to sustained

immigration flows. This rapid growth has been far from healthy and throughout this period the

economy has developed some imbalances that help to explain the depth of the recession. First and

foremost, while the Spanish economy was growing faster than most countries in Europe,

productivity growth was almost non-existent. Moreover, the sector composition of production was

heavily biased to relatively low productivity sectors (mainly real estate construction and services).

Since the beginning of the century, Spanish real state prices have increased, contributing heavily to

the increase in the levels of debt amongst many households financing mortgages and consumption

credits. The specialisation in goods with low value-added per worker, the limits to competition and

the pressure of domestic demand drove prices upwards generating persistent positive inflation that

decreased competitiveness relative to other trade partners. Finally, although the process of growth

has been very successful over the last fifteen years, the base on which the economy is founded is far

from perfect.

The monetary and fiscal policies put in place by the Spanish government have played a role in

creating and prolonging the current crisis. GDP, employment, private consumption, labour costs,

inflation, government deficit, debt ratios, risk premium rates, credit growth, the impact of fiscal

policies and the role of monetary policies will be discussed in order to shed light on Spain’s

economic situation to date and analyse whether or not they have the ability to overcome the current

economic crisis.

Further on will be considered the recent efforts of the government to overcome the country’s

difficult situation and the success they have had in improving the production function. The

economic situation that Spain faces today will be analysed in depth, and the conclusion will try to

estimate whether or not Spain has the ability to overcome the current crisis, and if so, in what time

period this can be expected to occur.

In continuation will be discussed briefly the significant events prior to the current crisis that started

in 2008 that have affected the factors of production. These will include the late industrialisation of

Spain, the Civil War and the Regime of Franco, the 1990’s crisis and the Spanish ‘Golden Decade’.

Industrialisation

Spain was a primarily a rural, agrarian society, from the 16th century until the early 20th century, as

its industrialisation was delayed compared to other Western European countries.

During the second half of the 19th century, Spain was experiencing high growth rates. Foreign

investment came in from France and Britain, used in railway networks and coal mines. The inflow

of capital (K) allowed the rate of investment to rise, breaking the link between investment and

domestic savings, contributing to more rapid growth.

Furthermore, the investments promoted the introduction of new technologies (A). Together with

these positive elements derived from foreign investments, other institutional changes promoted

economic growth in the second half of the 19th century. National transportation and

communications system strengthened as railway networks and telegraph mileage were completed,

together with the creation of a Central Bank in 1874 that allowed cheap movement of capital across

the country, facilitating the integration of the national capital market.

It was indeed only in the 1920’s that the manufacturing output exceeded the agricultural output.

The regime of Miguel Primo De Rivera, from 1920 to 1930, laid the foundation for the Spanish

industrialisation. A program presented as "economic reconstruction" during World War 1 was

initiated, which included the nationalisation of railways and changes in legislation in regard to

railways and mining, extensive budgeting for public works, the creation of an agricultural credit

organisation and a program of reforestation, as well as the organisation of agronomic services.

The necessary infrastructure for development, mainly roads and railroads, were built. This period

saw the beginning of industrialisation as private companies invested in machinery, textile in

Catalonia and metallurgy in the Basque Country. Analysing this through the production function,

this foreign investment led to a significant increase in capital (K). Also, during the second half of

the 19th century, a process of urbanisation started to take place as people were attracted into towns

and cities in search of jobs, which led to a significant increase in labour (L). Regional migrations

rose appreciably during that century, mainly from the countryside to the cities, showing a trend

similar to that of other countries in Southern Europe2. However, these all were processes that were

put to a hold during the Spanish Civil War.

2 http://www.country-data.com/cgi-bin/query/r-12983.html

The Spanish Civil War and its Aftermath

The Spanish Civil War, which began in 1936, was a three-year struggle that represented a time of

extreme protectionism leading to economic stagnation. The war was a huge burden financed by the

sale of treasury bonds, the use of gold reserves from the Bank of Spain, and foreign aid from

Germany and Italy under Hitler and Mussolini, respectively (Harrison, 1985).

The conflict had debilitating and lasting consequences, seeing the national income decreased by

more than a quarter (Harrison, 1985) and the government exhausted most of its reserves. Referring

to the production function, the amount of capital (K) in terms of liquid assets was largely reduced.

The infrastructure of both industry and agriculture was damaged, decreasing productivity from 1939

onwards substantially. As a result, economic progress was halted during this period.

By 1939 the Republican forces were defeated, the civil war was over, and Francisco Franco took

control of the country.

The Regime of Francisco Franco

Economic policy changed considerably over the years that Franco remained in power (1939-75)3.

During the regime’s early years, a set of anti-market policies were put in place, that largely resulted

in high inflation rates, the development of black-markets, and a reduction in international trade.

However, in the1950s, the most extreme interventionist policies (protectionist measures) were

relaxed while the Spanish economy benefited from an agreement with the US government (mainly

military and technological aids)4. In 1959 the Liberalisation and Stabilisation Plan was presented.

The plan opened the way to a new institutional design that incited free-market allocation of

resources and allowed Spain to accelerate its growth and catch up with the rest of Western Europe.

These reforming programs included measures that favoured free trade, macroeconomic policies to

reduce inflation and the size of the fiscal imbalances, and other reforms including ones to protect

private property rights.

The 1959 Plan marked the beginning of a new era in the Spanish economy as the country entered a

process of economic liberalisation and international market integration. Firstly, inflation was

reduced, public spending was better controlled, and the issue of new public debt limited. Secondly,

domestic markets were partly liberalised by reducing regulations and simplifying administrative

procedures. And lastly, a liberalisation of foreign trade was implemented and foreign investment

3 Francisco Franco Bahmonde was a Spanish military leader and statesman who ruled as the dictator of Spain from 1936 until his death 4 http://countrystudies.us/spain/24.htm

was encouraged. The tariffs, quotas and special trades where not eliminated (not until 1973, when

liberalised trade reached 80%), but were largely reduced.5

As a result, K (capital) increased as foreign capital investment grew sevenfold between 1958 and

1960, and the uses of N (natural resources) increase as the annual inrush of tourists began to rise

rapidly. As these measure little by little converted Spain's economic structure into a more ‘free-

market’ economy, the country entered the greatest cycle of industrialisation and prosperity of its

history.6

1960’s, 1970’s

A dramatic period of growth and modernisation during the 1960s and the early 1970s occurred due

to Franco’s regime and the policies put in place. Spain benefited from a relatively free-market

economic structure and much foreign aid (mainly from the US). Furthermore, agricultural and

industrial productivity were greatly increased with technological advances and mechanisation (A).

Analysing this through the production formula, the fact that the economy opened up led to tourism

that brought in foreign cash, increasing N (natural resources), as this tourism was based on the

Spanish Mediterranean weather and beaches. Tourism is an important factor in increasing

production and GDP, as it has spill over effects on transport, commerce, construction,

accommodation and food and beverage industries amongst others, and helped reduce

unemployment and replace activities that had lost their competitive advantage, such as the

agricultural sector. International capital (K) is also involved in the tourism sector in the form of

direct foreign investment in infrastructure and services (hotels, tour operators, transport, etc.).

Increased tourism particularly affected less developed regions of Spain such as Andalusia, acting as

a means to distribute development away from industrial centres and contribute to a process of

convergence. In this sense, tourism acted as an instrument for regional development and as a means

of reducing economic disparities, and due to the spill over effect of this industry, was very rapid in

impacting this region’s economy.

These reforms laid a firm political foundation for the economic integration of Spain, the free

mobility of L (labour) and K (capital), and were the base for economic growth in the country during

the second half of the century.

The oil shocks of 1973 and 1979 coincided with the end of Franco's regime and the transition to

democracy7. Structural inefficiencies were inherited from the Franco era, which with the oil supply

shocks of the 1970s let to mass disinvestment, inflation, and job destruction. Only after the

5 http://e-archivo.uc3m.es/bitstream/10016/6987/1/wp_10-02.pdf 6 http://countrystudies.us/spain/51.htm 7 http://www.upo.es/econ/seminars/Montanes_20oct08.pdf

establishment of democracy in 1977 were adjustment measures introduced with the ‘Moncloa

Agreements’ 8, a set of structural reforms and economic policy measures. Among the agreement’s

main features were fiscal reforms, a new exchange rate for the peseta, trade liberalisation, and

finally an income policy to moderate increases in nominal wages. A long-run period of economic

adjustments and reforms ensued to completely remove the anti-market policies from the Franco era.

Figure 1. Spanish Gross Domestic Product (GDP) Annual Comparison from 1959 until 1973

Oil Crisis 1970’s, 1980‘s

Because of the failure to adjust to the drastically changed economic environment brought on by the

two oil price shocks of the 1970s, Spain was confronted with plummeting productivity, an

explosive increase in wages from 1974 to 1976, and a reversal of migration trends as a result of the

economic slump throughout Western Europe, in which more migrants were leaving Spain than

entering it (losses in labour [L] and human capital [H]). All these factors, together with high

unemployment, led Spain to enter a long period of recession. During this period, the production

function was significantly affected. When an increase in relative oil prices occurs, the amount of oil

used decreases more than 10% 9. The reduction in the use of oil determines the capital response due

to the complementarity of both inputs in the production function so that as capital decreases, so

does the number of hours worked. As a result, the decrease in the productive inputs translated into

an output decrease (decreased GDP growth).

8 http://www.eurofound.europa.eu/emire/SPAIN/MONCLOAPACTSOF1977-ES.htm 9 http://webs.uvigo.es/bmanzano/research/EJ.pdf

The Crisis of the 1990s

In the early 1990s, the rate of growth of the Spanish GDP began to slow from an annual rate of

5.1% in 1988, to a 2.5% in 1991, a 0.9% in 1992, and hit a low of -1% in 1993 (see Figure 2).

Figure 2. Spanish Gross Domestic Product (GDP) Annual Comparison from 1980 until 2012

Source: http://countryeconomy.com/gdp/spain

This deceleration of growth can be attributed to the allocation of funds to consumer goods

particularly in industry. Throughout the 1990s, secondary-sector industries used inefficient and out-

of-date business models, and relied on the Spanish government to minimise global competition

through its protectionist measures. The Spanish government had invested into importing foreign

goods and services, rather than in domestic industries, and as a consequence consumers increased

their purchases of foreign goods. Meanwhile, Spanish exports decreased, resulting in a larger trade

deficit.

The appearance of the Partido Popular10 in 1996 and the policies implemented reversed this

downwards trend in annual growth in GDP, and the following period, between 1997 until 2007 was

led to be called by the European Advisory Group, the Spanish “Golden Decade” (EEAG, 2011).

10 A conservative, liberal, right-wing Spanish political party re-founded in 1989 as the People’s Party (Partido Popular or PP)

The ‘Golden Decade’, 1997-2007

This period is very important to analyse because the measures and policies taken by the government

helped to worsen the effects of the subprime mortgage crisis of 2007-2008 on the Spanish economy.

In the mid 1990‘s, Spain started a new process of economic growth that was characterised for its

fiscal stability and employment incentives. In 1999, Spain integrated in the euro zone, which led to

an environment of low interest that in turn led to the expansion of the construction sector and

demand of goods and services through the provision of credit. In this period, the economy was

strong and Spanish labourers returned to the country from neighbouring countries (France and

Portugal), increasing L (labour) in the production function. These factors are what led the average

GDP annual growth from 2000 to 2007 to average 3.6% (shown by Figure 3)11.

Figure 3. Spanish GDP Growth 2000-2007

Year GDP(%)

2000 5.0

2001 3.7

2002 2.7

2003 3.1

2004 3.3

2005 3.6

2006 4.1

2007 3.5

Source: Own elaboration, with data from:

http://data.worldbank.org/indicator/NY.GDP.MKTP.KD.ZG?page=1

The fall in interest rates has resulted in a credit boom that allowed an increase in long term

mortgages (20 years or more), for which the financial institutions accelerated the supply of credit

for the construction sector. This led to an increase in the price of houses that prompted massive real

estate investment and a substantial inflow of resources by German banks. This in turn led to a huge

increase in foreign debt by Spanish banks, but also meant a large increase in K (capital) available

for investments.

11 http://www.fedesarrollo.org.co/wp-content/uploads/2013/05/Crisis-de-paro-en-Españolpaña-E_Lor%C3%ADa-C_Libreros-E_Salas-pp.-135-152-C.-E.-Diciembre-2012_Web.pdf

It can be said that for the period between 1995-2007, the economic boom was concentrated in

labour-intensive sectors with little technological potential. Both the construction and services

sectors helped create thousands of jobs, incorporating manual labour with no qualification

requirements from abroad, made up mostly of immigrants with Latin-American origins.

In this context, there was a focus on low specialised jobs with seasonal contracts (this is the type of

contracting that can lead to many being left without a job, depending on how well the economy is

doing12), which in the short term helped reduce drastically unemployment rates that during the 90s

were around 20%. For its part, the availability of lowly qualified, lowly specialised labour, through

seasonal contracting, led to specialisation in sectors of the economy that are labour-intensive and of

low added value, such as the construction industry.

However, the construction sector was the leading sector for growth and in large part is responsible

for the large reductions in unemployment rates between 1995 and 2006, as there is a clear

relationship between the growth of the construction sector and unemployment rates in Spain. In

other words, economic growth and employment rates are very dependent on the health of the

construction sector, as it is the leading sector in terms of growth for the country. This dependence is

at the source of the present challenges faced by the government; the challenge of fundamentally

changing the economic structure of the country.

12 http://ccec.revues.org/3212

Spain, the Subprime Mortgage Crisis and Housing Bubble of 2007-2008

The U.S. subprime mortgage crisis was a set of events that led to a financial crisis that began in

2007-2008. This crisis was characterised by a rise in subprime mortgage13 defaults (partly due to

the credit boom mentioned earlier that led to a sudden rise in easy credit and subprime mortgage

supply), and the resulting decline of securities backed by such mortgages. Several major financial

institutions collapsed in September of 2008, such as the bankruptcy of the Lehman Brothers

investment firm, which caused a significant disruption in the flow of credit to businesses and

consumers, and was the beginning of the current economic and financial crisis.14

Spain can be said to have had a significant role in the subprime mortgage crisis of 2007-2008,

mainly due to the issuing of 40-year loan products. Banks were readily giving out long-term

mortgage products at very low interest rates, which led much of the houses bought to be financed

through these subprime mortgages (see Figure 4).

Figure 4.

Unemployment rose more than double from 8.6% in the fourth quarter of 2007, to 19.3% by

September of 2009 (Banco de España, 2007), mainly due to Spain’s construction sector decline

from 2007 to 2009 (see Figure 5).

13 Very low credit rating, high risk, high interest rate loans (also called junk loans) 14 http://www.stat.unc.edu/faculty/cji/fys/2012/Subprime%20mortgage%20crisis.pdf

Figure 5.

Source: http://www.ine.es/jaxi/tabla.do?path=/t07/a081/e01/l1/&file=03002.px&type=pcaxis&L=1

A related theory for the causes behind the current Spanish crisis is that the entrance of Spain into

the European Monetary Union led to low interest rates which in turn led to over-investment in

construction and helped the creation of the housing bubble that was doomed to burst15. What is

clear is the Spanish economy was particularly reliant upon construction, and that the effects of the

bursting of the housing bubble was more damaging for Spain than for other Europe countries. From

2003 to 2006, demand for credit in the construction and housing sectors far exceeded all others, and

Spain had the largest construction sector amongst the EU countries. Until the start of the crisis, the

Spanish construction sector was booming, reaching a 10% share of national GDP in 2006, twice the

average figure for the EU, employing 2.9 million people (13% of the labour force). At its peak in

2007, the construction sector accounted for 16% of GDP and 12% of Spanish jobs16. During the

period, the growth of this industry was the driving force behind the Spanish economic growth. Until

2007, Spain recorded higher new home constructions per year completed than France, Germany and

Italy combined17. As a result, the Spanish hosing market experienced strong and constant growth

over the period exposed by Figure 6. In the face of the oversupply and oversize of the sector, rising

interest rates and stricter lending conditions due to the emerging global financial crisis, Spain’s

construction industry collapsed in 2007. Many firms were forced to exit the sector, and the effects

15 European Economic Advisory Group (EEAG) 2011 Report: ies.fsv.cuni.cz/default/file/download/id/22599 16 http://www.realinstitutoelcano.org/wps/portal/rielcano_eng/Content?WCM_GLOBAL_CONTEXT=/elcano/elcano_in/zonas_in/powell_pain_spain_europe_trouble_oct12 17 http://epp.eurostat.ec.europa.eu/cache/ITY_OFFPUB/KS-SF-10-007/EN/KS-SF-10-007-EN.PDF

this sharp decline in construction had on Spain was magnified by the extent to which they were

reliant on this industry.

Figure 6. Spanish Housing Prices 1995-2007

To further illustrate the crisis of the Spanish market, retail sales were down by almost 50% from

2007 to 2011, and investments in houses as well as house prices shot down, as shown by Figure 7

and Figure 8.

Figure 7. Retail Sales Volume, 2000-2011

Source: http://www.tradingeconomics.com/spain/retail-sales-annual

Figure 8. Investment in Houses and House Prices in Spain

Source: https://rwer.wordpress.com/2012/03/08/retail-sales-in-europe-2000-2011-5-graphs/

The Double-Dip Recession

Although the economy seemed to slightly recover in 2010, it went in late 2011 into a second

recession. This period is characterised for its climate of uncertainty, difficult financial conditions,

the inefficiency of the labour market, the decline in disposable income and the fall in financial and

non-financial wealth reducing household spending, in terms both of consumption and residential

investment.

All these factors, present since the start of the crisis, bore down on private and public sector

demand. Also, the abrupt decline in the saving ratio since the start of the crisis reflects the

difficulties of household spending being sustained in the long or even medium term, in a context

where the level of household debt must fall.

The following subject is on the Spanish banks, in particular Bankia. These banks which the IMF

pronounced "highly competitive, well-capitalised and profitable" before the 2008 crash, and which

"would be able to absorb losses from large adverse shocks without systemic distress”, were then on

the brink of collapse.

Figure 9. Supply and Demand

Source: Own elaboration

When there is a crisis, creditors become fearful and loose confidence. In Spain, this fearfulness led

to a shift in the supply of credit in Spain (Figure 9, from S1 to S2). What this means is that for

every given amount of credit, creditors demand a slightly higher interest rate. The fact that credit

was made much more difficult to acquire due to this drop in creditor confidence, significantly

reduced capital (K) available. The crisis also reduced potential output in the short and medium term

through a decline in investments. This in turn affected Total Factor Productivity (A) as investments

in research and development were cut. TFP (A) drivers, such as physical investment, R&D and

innovation, also suffer in a recession like this from shifts in attitudes towards risk, resulting from

tighter credit conditions and an increase in the cost of capital.

Furthermore, the need of the Spanish government of restructuring the economy and financing the

collapsed banking sector has led to huge inflows of aid from the Eurozone institutions to help Spain

recover. This further burdening of Spain with debt was accentuated by the rising interest rates18 for

their debt.

The most immediate effect that a crisis can have on potential output is through its adverse impact on

investment and the ensuing slower capital accumulation (K).

Strong cyclical reduction in investment rates in the downturn phase negatively affects the stock of

capital and causes a downward shift in potential output. Recessions may also have a long lasting

impact on capital accumulation if associated with a rise in perceived uncertainty, which in this case

it is.

In regard to the labour supply (L), a sluggish adjustment in prices and wages as well as a slow

adaptation to the sectorial reallocation process occurring in the economy has led to temporary

increase in the NAIRU (Non-accelerating Inflation Rate of Unemployment, the ‘natural rate’, or

‘structural rate’ of unemployment). Unemployment has been accompanied by an increase in long-

18 http://www.tradingeconomics.com/spain/government-bond-yield

term unemployment, which is particularly important in some countries, including those that have

been hit the most by the financial and construction sector crisis such as Spain. Long-term

unemployment plays a key role in the NAIRU. Workers who have been unemployed for some time

tend to become less attractive to employers. Not only the human capital of the unemployed

diminishes over time, but also, as a result of recruitment costs, prospective employees are

frequently evaluated on the basis of frequency and duration of their periods of unemployment.

Moreover, job search may also diminish as the unemployed lose contact with the labour market and

awareness of job offers.

It can be argued that the long-term unemployment spells caused by the crisis has caused to some

extent a permanent destruction in human capital, leading to an irreversible rise in the structural

unemployment rate (NAIRU), further decreasing the potential output level.

A crisis can have important implications for both the level and growth rate of TFP, which can

materialise through a number of channels. The post-crisis evolution in TFP is the main determinant

of whether the economy comes out of the crisis successfully or fails to achieve a full recovery.

The present downturn appears to be provoking a "one-off" downward shift in the level of

technology (A), or TFP. Some industries, for example financial services, construction and motor

vehicles, are likely to experience lasting reductions in the level of their activities as a result of the

crisis. In addition, these industry shifts, reflecting a permanent reallocation in the economy, may

impact on TFP growth itself via a compositional effect. A slow process of industrial restructuring,

caused either by credit constraints or by entrenched structural rigidities, both of which are the case

in Spain, can reduce the level and growth rate of TFP.

The delayed treatments of 'toxic' assets and the restructuring of the banking sector, made worse by

the inefficient state aids to institutions such as Bankia, has created tight credit constraints especially

on liquidity-constrained, but potentially profitable, start-ups or small and medium enterprises with a

large innovative capacity and promising growth prospects.

Recent Political Parties in Power

Under the framework established by the constitution of 1978, Spain is established as a social and

democratic state, and its power is thus given to its people, with a form of parliamentary monarchy

government.19

Spain has a multi-party system at both the national and regional level. Nationally there are two

dominant political parties (the left-wing PSOE and right-wing PP) 20, although some autonomous

communities like Catalonia and the Basque Country have strong regional parties.

Governments can heavily influence the national economy. They have a lot of power over business

activity and can pass laws that can affect them in many ways (through economic policies: fiscal,

monetary, and supply side policies). The governments that have been in power since 2000 (Aznar

and Zapatero) are essential to analyse as the policies and mismanagement of the economy have had

a great impact and are one of the reasons for why Spain is having such a touch time recovering from

the crisis.

The Aznar Government (PP)

Jose Maria Aznar was elected President for the term 1996-2000 and re-elected for the period of

2000-2004.

The Aznar Government in their first term maintained previous commitment to join the European

Union’s single currency and was willing to take risks in order to meet the requirements for

membership. A period of privatisations also followed after the previous PSOE government had

nationalised parts of the economy.

After having to suffer the effects of the 1990’s crisis, in 1999, the European Union introduced the

euro, leading to a period of steady economic growth and falling unemployment.

Throughout his two terms as President, Aznar led an important process of economic and social

reform. Various liberalisation and competition promoting processes were introduced, leading to the

creation of almost 5 million jobs. GDP grew every year by more than 2%, at an average of 3.4%.

However, it can be argued that the Aznar government coincides with the start of the easy credit, the

construction boom and real estate bubble, and has helped in large part in making the foundations for

a weak and fragile economy susceptible to booms and busts.

The Zapatero Government (PSOE)

19 http://www.legislationline.org/countries/country/2 20 PSOE (Partido Socialista Obrero Español, or Spanish Socialist Working Party), PP (Partido Popular, or People’s Party)

José Luis Rodríguez Zapatero, part of the Spanish Socialist Workers Party, took charge in 2004

until 2012. Zapatero inherited of a country in an economic boom, with a still relatively low

unemployment rate, but with an important public debt.

Zapatero’s policies between 2004 and 2008 were marked more by continuity with previous

administrations than by change. Zapatero did do efforts to promote a new social agenda and

transform Spanish socialism, however his policies were characterised at best by incoherence and at

worst by largely unrealised commitments. An example of such was the implementation of a tax

reduction in 2008 that was taken back a year later, which caused much confusion.21

Until March of 2008, at the start of his second term, Zapatero did not make any significant market

or labour reforms. Although the government promised that they were a necessity to modernise the

Spanish economy and avoid dependency on the construction sector, there is little to show for it.

And then the crisis began. Zapatero at first denied the existence of a crisis in Spain, stating that the

so-called crisis was pure catastrophism, praising the growth that the country had been experiencing

and assuring that growth in GDP and increases in employment would continue.

Not without the pressure of its European partners (who’s impact will be discussed later), Spain

began to make a series of very unpopular adjustments. Zapatero’s economic policies in 2010

consisted of cuts in social expenditure in response to the pressures from the EU, including

adjustments such as spending cuts and reforms of the pension system, labour market and the

financial sector 22. The labour reform of 2010 was the most polemical of all, as it resulted in mass

firing in order to reduce labour costs, which were becoming unnecessary due to the decreasing

aggregate demand. However, these measure were ineffective in turning around the rising trend of

unemployment and bring about a sustained recovery.

The government did not manage to structurally reform the economy, failing to decrease its

dependence on the construction sector, and failing to generate confidence in the unity of the

country.

Zapatero left with a record unemployment at the time of nearly 5 million people (29/4/2011), and

the downgrading of Spain by Standard and Poor’s Rating Services in October of that year, due to

high debt, high unemployment and unfinished labour reforms, and the fact that Zapatero’s legacy

would be a burden for the years of recovery yet to come.

In Zapatero’s defence, his dilemma was that of all social-democratic parties in power. Social

democracy can function effectively in times of economic growth. However, during economic crises,

21 http://blogs.lse.ac.uk/europpblog/2012/04/22/book-review-spains-second-transition-the-socialist-government-of-jose-luis-rodriguez-zapatero/ 22 http://globalopinion.pl/2012/03/the-economic-policy-of-the-new-spanish-government/

social-democratic governments cannot so easily draw out the social benefits on which their identity

and legitimacy largely rest.

Current Government

Partido Popular. Mariano Rajoy Brey, leader of the People’s Party, was elected President the for the

2012-2016 period. The policies and reforms put in place by Rajoy, and the effectiveness they have

had in addressing the pressing issues of the Spanish economy will be discussed in the next few

chapters.

European Union Integration

The peseta suffered many devaluations between 1992 and 1994, creating upward inflationary

pressure, while the public finances were weakened by the 1990’s recession, also lead to very high

unemployment rates. Spain was viewed as a relatively large country within the European Union,

with a recurring tendency for imbalances, thus making them a dubious candidate to join the creation

of a common currency.

Spain entered into the European Community (EC) in 1986, and the European integration helped

Spain to develop and grow its economy. The EC was focused on creating a single market inside

Europe, in order to allow for the free movement of goods, services, and people throughout the

members, and take the subsequent steps in the direction of full economic integration.23

Spain’s entry into the EC meant huge opportunities for economic development and growth.

Spain was predominantly made up of many small firms with low levels of technology. The EC

shifted Spain’s focus from its traditional major industries such as textiles, clothing, and food, to

more advanced technologically intensive businesses focused on global trade (increasing the level of

technology [A]), and made Spain to adapt to more modern practices. As a result, Spain was seen as

an ideal location to do business, and many mergers took place in the following decade. The entry in

the EU increased foreign investment and helped modernise Spanish firms. However, the

restructuring of the economy also made obsolete some capital vintages that had an adverse effect on

capital accumulation (K).

In 1989, Spain’s currency, the peseta, was entered into the Exchange Rate of Mechanism of the

European Monetary System, which gave the EC power over the currency while at the same time

controlling Spain’s price stability.24

In 1992, under the Maastricht Treaty the European Community became the European Union (EU),

and the Cohesion Fund was created in order to tackle regional disparity25. The bill stated that 15.1

billion euros would be dispersed among the four cohesion countries: Spain, Greece, Portugal, and

Ireland 26 to help with project funding, on which Spain relied heavily. The credit that was allocated

to Spain meant a huge increase in the K (capital) available for investments in infrastructure and

research and development (which in turn led in later years to the increase in the level of technology

[A] available).

23 http://aei.pitt.edu/32455/ 24 http://digitalcommons.salve.edu/cgi/viewcontent.cgi?article=1006&context=pell_theses 25 http://www.esfondi.lv/page.php?id=954 26 The cohesion countries were those members with weaker economies who needed financial help from the European Union.

In 1993, the European Union successfully removed all border barriers allowing for the free

movement of people, goods, and services throughout the EU member states27. This free movement

of people meant that it was made much easier for workers to migrate to Spain to find work,

increasing the amount of L (labour) available, and the quality of the labour available (H-human

capital). No longer would the country rely on just Spanish labour, as it then had access to more and

better qualified labour (H) from the other member states of the Union.

The EU in 1997 passed the Stability and Growth Pact to facilitate free trade, realising that the best

way to do this was with a common currency28. Following this (a topic that will be developed in

contiunation), the ‘Euro’ was released to international financial institutions in 1999.

In 2004, the admittance of 10 new, less economically developed members into the EU, lead to a

shift in the distribution of the cohesion funding. The new proposal greatly influenced Spain, as the

amount of EU funding to the country was expected to be cut in half (from 1% to 0.5% of GDP).

This change in cohesion funding is not expected to get better for Spain in the future since the

European Union will most likely continue to offer membership to countries with economies much

weaker than Spain, which will decrease Spain’s financial aid even further. This meant that from this

period on, the K (capital) made available by the credit given by the Union was largely reduced.

Before its integration, Spain was largely reliant on local production of low value goods, and was a

lower income member state that was much behind its European neighbours. The evidence discussed

supports the fact that the Spanish economy has been strengthened in terms of labour (L), human

capital (H), and capital (K), as well as technology advances (A) as a result of its admission into the

Union and the received funding.

The Single Currency, The Euro

On the 1st of January 2002 the currency was officially placed into circulation. The EU exercised

some leniency with phasing out previous currencies and allowed member states to set their own

date when each country’s currency would no longer be accepted. Spaniards were given until June of

that year to change their pesetas into euros. The creation of a single currency placed more pressure

on Spain to maintain economic growth since any pause would result in political and economic

consequences that would strain the government’s finances.

Openness to trade and investment have had important effects on productivity growth both through

knowledge transfers and their effects on labour efficiency. The ability to trade enables a country to

27 http://europa.eu/legislation_summaries/internal_market/single_market_for_goods/free_movement_goods_general_framework/index_en.htm 28 http://ec.europa.eu/economy_finance/economic_governance/sgp/index_en.htm

specialise in more efficient production processes that raises aggregate growth. There is also

evidence that increases in competition brought about by the removal of barriers to trade and

investment, which increases L (labour), H (human capital) and K (capital), has helped raise the

output of Spain. This is because more often than not, increased competition forces company’s to cut

costs and become more efficient in order to remain competitive in a global market. Spain may even

be the country that benefited the most from the Euro and from the economic reforms that were

required to usher it in. However, this integration has not come without constraints, which will now

be developed in the following chapter.

European Union Integration - Constraints

The replacement of the volatile peseta with the much more stable Euro, lowered borrowing costs

dramatically. Although this has helped in developing the economy, it has largely contributed to the

amount of borrowing made by Spain and its financial institutions (largely increasing the country’s

debt-to-GDP ratio).

A high government debt-to-GDP ratio29 can be very detrimental to an economy. Government debt

impacts economic growth including private saving, public investment, productivity, and long-term

interest rates. The debt Spain incurred through loans from the ECB (European Central Bank) from

the 1970s clearly has had an adverse effect on its economic growth.

There are many theories about the impact of debt on growth. Many state the impact of sustaining a

government debt-to-GDP ratio of 90% or beyond has a very harmful impact on long term growth,

although the negative growth effects of high debt may already be felt around the 70 to 80% of GDP

level. Additionally, there is strong evidence that the annual change of the public debt ratio and debt-

to-GDP ratio are negatively correlated with per-capita GDP growth. 30 The areas that high debt-to-

GDP ratios affect the most are private saving, public investment, workforce productivity and

sovereign long-term interest rates. From a policy perspective, this indicates that debt reduction is

necessary in order to sustain longer term economic growth. 31

Spain has an alarming debt-to-GDP ratio, recorded at 88.2% in the first quarter of 2013, with a 15.2

point increase compared to the same quarter last year 32.

All these constraints have been developed around, and cannot be detached from, Spain’s integration

to the European Union and the Eurozone.

29 Government debt as a percent of GDP, also known as debt-to-GDP ratio, is the amount of national debt a country has in percentage of its Gross Domestic Product. 30 http://www.bis.org/publ/othp16.pdf 31 http://www.ecb.int/pub/pdf/scpwps/ecbwp1237.pdf 32 http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-22072013-AP/EN/2-22072013-AP-EN.PDF

Should Spain Pull Out the Euro?

Some sources states that Spain’s only hope is to leave the Euro and urges a return to the old ‘peseta’

currency. It is argued that due to the structure of the Eurozone, the member countries cannot

undertake fiscal or monetary stimulus policies, loosing the power to devalue their currency, and the

possibility of financial restructuring. This means that in the middle of a crisis, Spain has very

limited policy space. Due to this, it is true that Spain could benefit from leaving the Eurozone, as

they would regain the power of conducting monetary policies and controlling the supply of money

in circulation33.

However, what is sure is that exiting the Euro would also have disastrous effects on the economy’s

potential for recovery. Apart from the extremely complex procedure necessary to reverse the

process and return to the old currency, leaving the Euro would mean a huge outflow of investors

from the country as risk premiums would rise. Also, abandoning the Euro would cause the other

members to interpret it as a sign of disdain and political consequences could follow. The possible

devaluation of the currency would also lead to capital outflows as families and firms would leave to

try to avoid the losses.

In conclusion, the Euro has played an important role in driving growth in Europe since its

introduction, delivering unprecedented price stability, boosting trade between its members, and in

turn increasing competition, productivity and growth. Safeguarding the euro is essential for

Europe’s long-term growth. No plan for growth will have real force until the present uncertainties

around the euro are resolved. Labour markets reforms, by increasing convergence and adjustment

capacity between national economies, can, alongside institutional reform to increase financial, fiscal

and economic integration, help strengthen and safeguard the euro, as well as boosting employment

and growth. In recent months, Spain has made important progress in taking forward such reforms.

Spain’s Financial Bailout

With too many toxic assets, Spain's banks had to be recapitalised. But the state, with a smothered

economy, was struggling to raise funds. Refusing a full state bailout, and the consequences that that

would incur in terms of loss of sovereignty and increases in debt, a financial bailout was carried out.

In late 2011, the ECB announced that 39.5 billion euros in aid was approved for Spanish banks,

paid into Spain’s bank rescue fund (Frob)34. Although this amount is far less than many private-

sector analysts believe is necessary (some economists believe the eventual needs could be two or

33 http://www.telegraph.co.uk/finance/comment/jeremy-warner/9572359/Spain-must-leave-the-euro.html 34 Fondo de Reestructuración Ordenada Bancaria (Frob), or the Fund for the Orderly Restructuring of the Banking Sector; Spain’s banking bailout and reconstruction program

three times that amount)35, intervention by the European Central Bank eased market pressure on

Spanish debt and bond yields. During the last 12 months, Spain’s 10-year government bond yield

declined 1.29%, currently recorded at 4.54%36.

Current Situation: A Serious Structural Problem

During the 1990s and early 2000s, Spain enjoyed rapid economic growth. Spain is now the 5th

largest EU economy. In particular, the rapid economic growth encouraged a boom in property, and

that has caused some deep structural problems.

In 2008, Spain was badly affected by the global credit crisis. The Spanish property market collapsed

leading to a deep recession that they are still currently struggling to recover from.

There are positive and negative aspects to Spain’s economic growth over the years. Although it has

sustained a very high growth and created many jobs over the past decade, there are several aspects

that are worrying from a structural point of view:

1) For over twenty years it has gradually been losing relative productivity37 , and is currently 181st

out of 191 in current account balance comparisons38, although there has recently been significant

productivity improvements due to successful labour market reforms

2) Due to the construction boom and the jobs that were created as a consequence, Spain is suffering

large distortions in its labour market and has led to specialisation in sectors with low added value

3) Moreover, there is a great need to improve the educational system; Spain has the OECD’s

highest percentage of pupils who repeat a year 39.

The current situation of Spain will now be analysed. Education, employment, and the financial

situation of Spain will be analysed one by one to find out Spain’s competitive position and current

strength and weaknesses in order to finally conclude whether or not Spain has the potential to

overcome the current economic crisis.

To start off with, Figure 10 shows general indicators of the Spanish economy, to give a general

overview before going more into detail.

35 http://www.ft.com/intl/cms/s/0/77b62ae4-3d8d-11e2-9f35-00144feabdc0.html#axzz2YUXDL0Uz 36 http://www.investing.com/rates-bonds/spain-10-year-bond-yield 37 http://fernando-eneldisparadero.blogspot.com.es/2012/03/economia-espana-productividad-y.html 38 https://www.cia.gov/library/publications/the-world-factbook/rankorder/2187rank.html 39 http://news-spain.euroresidentes.com/2006/09/schooling-in-spain.html

Figure 10. General Indicators for Spain’s Economy

The Spanish economy contracted by 0.5% in the first quarter of 2013 from the previous period

when it retreated by 0.8%. On a year-ago basis, real GDP fell by 2%, following a 1.9% decrease.

Domestic demand subtracted 4.9% points from annual growth, while net exports contributed 2.9%

points. 40 The recent weak results of the Spanish economy prompted the government to lower its

forecast for 2013 from a 0.5% contraction to a 1.3% drop and revise the deficit targets up to 2016.

Moody’s Analytics predicts GDP will shrink by 1.5% this year.

40 http://www.tradingeconomics.com/spain/indicators

Meanwhile, Spain's unemployment rate fell for the first time in two years to 26.3% in the second

quarter of 2013 from 27.2% in the first three months of the year. The jobless rate had been climbing

almost continuously since the second quarter of 2007, when it stood at 8%. With the economy in a

double-dip recession, unemployment will likely continue to be under pressure in the coming

quarters, and high joblessness will make it hard for the government to achieve its fiscal deficit

targets. 41

Technology

Improvements in technology can reduce the cost of producing goods and services. Improvements in

technology are crucial as they can result in a lower number of required inputs per unit in terms of

human and physical capital.

Technological improvements can include: replacement of people with automated processes,

improvements in sources of power, improvements in telecommunications and transport, and better

access to, and processing of, natural resources. New product design and development, through

research and development, can be a crucial factor in the survival of a company and affects the

ability to compete in the marketplace.

Technological levels are the most important of all factors in the production function, as it shifts the

entire production function up or down for any given amount of the other factors of production. For

these reasons, technology in Spain is essential to analyse in order to have a better understanding of

where it stands respective to its European neighbours

Spain is ranked 38th in the World Economic Forum’s Networked Readiness Index (NRI), which

measures the propensity for countries to exploit the opportunities offered by information and

communications technology. 42

Spain has been stuck, mainly due to the boom in the construction sector, in low added value, high

labour and low technology intensive sectors of the industry. However, there are some positive

aspects to take into account. Thanks to the EU integration and the funds that were allocated to the

country, Spain has been able to develop some high-tech industries. An example of such, Spain is the

largest user of desalination technology in the Western world. Technological development and

excellence of Spanish companies can be seen in several other important industries, such as wind

energy, infrastructures, high-speed rail, aerospace, industrial machinery, biotechnology and

41 http://www.economy.com/dismal/outlook/country.aspx?geo=IESP 42 http://www3.weforum.org/docs/GITR/2013/GITR_OverallRankings_2013.pdf

renewable energy. Renewable energy in Spain represented 12.7% of total energy generation in

2009, and an overall 23% of Spain's electricity was generated from wind and solar in 2010.43

Spain seems to be committed to becoming a leader in innovation and generating advanced solutions

in the industries of aerospace, renewable energies, water treatment, rail, biotechnology, industrial

machinery and civil engineering. The country seems determined to deepen and intensify its

productive specialisation in industries that depend on technology and innovation, which is a very

good sign for the long term recovery and sustainability of the economy.

43 http://www.billingsnews.com/index.php/commentary/3991-renewable-theology-vs-economic-reality-part-2

Competitiveness of Markets

One of the most important characteristics of the economic expansion experienced by the Spanish

economy before the current crisis was the gradual loss of competitiveness as measured, for

example, by the growth of unit labour costs relative to the average for the euro area countries (see

Figure 11).

Figure 11.

Competitive success is a reflection of the good domestic behaviour of an economy, and therefore

the only meaningful concept of competitiveness at a national level is national productivity.

Competitiveness can be defined as a set of institutions, policies and factors that determine the level

of productivity of a country (productivity function).

The goal of increasing peoples’ income could be achieved with a combination of different factors,

and competitiveness is one of them. One country is more competitive if it simply has more factors

that increase its ability to sustain its level of income and its potential to grow in the future.

Therefore, improving competitiveness is an essential objective to stimulate growth. This is where

supply side policies (focus on incentives, enterprise, technology, mobility, flexibility and

efficiency) and structural reform policies, especially labour reforms, come into play.

Also there is a huge need of improving the effectiveness and efficiency of public spending and

resource allocation. For example, public money should not be spent on building airports that no one

uses and on roads that nobody takes. An example of such wasteful spending is the Castellón

Airport, built at a current cost of 150 million euros, officially opened in March 2011, but has still

not received a single flight. 44

Research and Development

Moreover, to ensure growth in competitiveness in the medium to long term, investments in

education, innovation and R&D will be crucial. It is evident that for achieving long term

economics growth, the amount of R&D (Research and Development) is highly important, although

the direct effect is difficult to measure because of lag.

Sources that support this statement include Griliches (1986) who concluded that federal R&D in

industry has a positive effect on productivity, and Lehr and Lichtenberg (1998) who showed it

possible to determine how new technologies improves the productivity of government agencies.

The development of new technologies or processes directly leads to improved sustainable growth

through the increasing economic efficiency and number of employees (mechanisation for example

far reduces labour needs, in turn reducing costs and increasing productivity).

Investments in R&D as a percentage of GDP in the year 2011 in Spain was 1.33%, much lower than

the OEDC average of 2.38% 45. This stresses the importance of increasing investments in this

sector. The strengthening of the scientific and technical base of the labour force is essential to

improve productivity and in turn the international competitiveness of the country. Moreover,

investments in R&D are crucial for innovation and the development of new technologies that

increase A (technology levels), the most important factor of production. Ways in which R&D can

be leveraged is through government investments in federal and university research programs, or by

making grants available for university scientists in order to incite students to follow this line of

study.

44 http://www.airportwatch.org.uk/?p=2872 45 http://www.oecd-ilibrary.org/science-and-technology/gross-domestic-expenditure-on-r-d_2075843x-table1

Labour Productivity

Figure 12. Real Gross Value Added, Employment, and Labour Productivity

Source: http://www.oecd-

ilibrary.org/docserver/download/5k9777lqshs5.pdf?expires=1373829071&id=id&accname=guest&checksum=2B89A87E99ED3F86

95D38F2986141FD6

Figure 13. Labour Productivity Gaps of Spain with Respect to Selected Countries

Source:

http://www.oecd-

ilibrary.org/docserver/download/5k9777lqshs5.pdf?expires=1373829071&id=id&accname=guest&checksu

m=2B89A87E99ED3F8695D38F2986141FD6

Figure 12 plots Real Gross Value Added, Employment, and Labour Productivity.

Figure 13 plots the productivity gap of Spain compared to the U.S., France, Germany and the

OECD area using constant prices and constant purchasing power parities.

The total working hours per week in Spain is of 38.4, higher than the European average of 37.446.

The problem is therefore not how many hours Spaniards work, but more precisely how efficiently

they work. This clearly problematic issue has not been properly addressed, despite being discussed

at length by Spanish political parties. It is imperative that this issue be properly tackled, as it may

very well be the key to Spain’s economic recovery.

Spain´s work culture and practices set Spaniards apart from the rest of Europe, that is to say, the

way the people think, organise themselves and work.

An example of such culture is the fact that Spanish workers are the ones who call in sick the most in

the EU 47. Moreover, in Spain there is a yet-to-be-measured but enormous underground economy

(‘black’ market), with a very large number of workers who collect both unemployment benefits and

a regular salary, as well as tax evading. Moreover, traditionally, the Spanish workday was

characterised by ‘la siesta’, an extended lunch break, usually lasting three to four hours, during

which the workers returned home for a substantial lunch and quick power nap. This emerged out of

the agricultural lifestyle once typical to Spain. Although over the years the economy began to shift

and employment moved to industrial jobs, the tradition remained. This is a problem as economists

have stated that the ‘siesta’ places a strain on the country’s ability to compete in the global

marketplace.

Spain’s work culture is surely not solely to blame, but can be said to be to some extent a barrier to

increases in productivity. Education is the only tool that can be used to change such work culture,

although trying to change a nation’s culture may take generations, at best.

However, the recent labour market reforms, which will be developed later on, have helped increase

the productivity of the labour force. As can be seen by Figure 14, Spain is actually the only country

of the selected countries that record higher labour productivity annual percentage change in the

2008-2012 period than in the pre-crisis, 2003-2007 period.

46 http://www.guardian.co.uk/news/datablog/2011/dec/08/europe-working-hours 47 http://spanish.martinvarsavsky.net/general/el-rol-nocivo-de-los-medicos-espanoles-en-las-relaciones-laborales.html

Figure 14.

Education: Current State, Reforms and Suggestions

There is a huge need to improve the performance of the educational system. Education is a key

element in increasing H (human capital) in Spain. The process of continually seeking more

education keeps the mind active and working hard, improves the ability to learn anything (cognitive

skills) and opens the mind up to new ideas, and these are all qualities that can increase the H

(human capital) of an economy.

In comparative terms, according to the latest PISA report48 in which Spain ranks in the following

list for reading, mathematics and science literacy skills, it is clear there is much room for

improvement.

As illustrated in Figure 15, in all areas, Spain is below the US and the OEDC average, and the fact

that the educational ministry’s budget has been cut a total of 14% between 2012 and 2013 is a real

concern for the ability of the government to improve this situation. These cuts have led university

tuition fees to increase, have led to larger class sizes, fewer grants for graduate studies, and much

more.49

48 The Programme for International Student Assessment (PISA) is a worldwide study made by the OECD for 15-year-old school pupils' scholastic performance on mathematics, science, and reading 49 http://www.aljazeera.com/news/europe/2013/05/201359192955857931.html

Figure 15. PISA Report: Reading literacy, Mathematics and Science literacy

Source: http://nces.ed.gov/pubs2011/2011004.pdf

Figure 16. Share of population aged 18-24 who leaves high school and do not continue with

other education or training (percentage)

As can be seen in the Figure 16, in Spain, more than 20 per cent of youth aged 18 to 24 leave school

with at most lower secondary education and not in further education or training (early school drop

out), which is more than twice the EU-27 average 50. Leaving school early to enter a weak job

market can have long-lasting consequences. There is a heightened risk that young workers will exit

50 http://epp.eurostat.ec.europa.eu/statistics_explained/index.php?title=File:Youth_education_attainment_level_and_early_leavers_from_education_and_training,_2006_and_2011_(1)_(%25).png&filetimestamp=20121001110139

the labour market entirely if they encounter difficulty finding employment 51. Moreover, long

periods of unemployment, without training or education, can lead to poverty and skill erosion, both

of which have consequences for potential future earnings and thus future growth (as discussed

earlier, this can affect the NAIRU, the natural unemployment rate, and have long lasting effects).

What there needs to be is an urgent remodelling of the whole educational system, because such

levels of failure, drop outs and youth unemployment is simply not sustainable, in a time when

unemployment in those ages between 16 to 24 is over 57%, and more than 20% of Spanish students

drop out of school early 52.

The political party of Rajoy has been making some reforms recently. These include policies that

tries to tackle the drop-out issue, obligating students to start choosing preferred subjects at age of

12, and either a vocational or academic course of study at the age of 15. This curriculum change

includes a reduction of optional subjects and the elimination of full syllabuses, such as the Bachelor

of Arts’ degree, while increasing the academic weighting of mathematics, sciences and reading

understanding (the only subjects assessed in the PISA reports).

However, the worker unions, as well as a recent PISA report, argue that this will create inequality

between students; separating students early according to their socio-economic circumstances and

this will not help drop out rates, on the contrary it may increase early school leavings 53.

On the bright side, according to the LOMCE54, students will be evaluated after each stage of their

education through external evaluation centres, which will help to value externally the efficiency of

the system and promote effort and competitiveness.

The point is that the efforts done to date to improve the quality of the educational system are simply

not enough. In fact, the educational reform has in fact deteriorated the system and can be considered

to be a long term economic disaster for Spain. In essence, it seeks to more closely monitor students

through further standardised tests, to condition schools' funds based on success in decreasing

dropout rates, and to more efficiently redirect students toward academic or technical careers. This in

itself is not the underlying problem, which lies in the severe spending cuts.

Since 2009, Spain has cut over 6.7 billion euros from its education spending and expects more cuts

into the future, decreasing investment from 5% of the GDP in 2010 to a predicted 4% of GDP by

51 http://www.ilo.org/empelm/pubs/WCMS_143349/lang--en/index.htm 52 http://www.thelocal.es/20130519/spain-government-approves-crisis-education-reform 53 http://www.ei-ie.org/en/news/news_details/2455 54 The Organic Law for the Improvement of Education Quality, or Ley Orgánica para la Mejora de la Calidad Educativa (LOMCE), is an education reform presented in May of 2013

2015. The cuts are equivalent to around a 15% decrease in resources for education, even as student

numbers have increased by more than 5%, translating into more students per teacher. 55

Moreover, Spain has cut teachers’ wages considerably, increased university fees by 66%, and cut 50

million euros worth of budget for scholarships.56 Although these measures may be necessary, such

cuts not only decreases the quality of education and but also makes it more difficult to access.

What the educational reform could involve to increase the quality of the Spanish educational level

is firstly to transfer funds from the inefficient and oversized higher education system (Spain has as

many university students as countries with a much larger population, such as Germany or France) to

the public primary and secondary education system, a stage of education in which Spain has a

significant deficit with respect to more developed countries.

Moreover, increasing the number of public child-care places could be a measure to take into

account. This is one of the most efficient ways of assigning public expenditure on education, as it

offers the best relative returns and in many cases is self-financing over the long term.

William Dickens and Charles Baschnagel in 2008, used models to estimate the long-run effects of

these early childhood program investments. The authors find that implementing proven programs

for children would increase job growth and earnings, as well as boost future GDP and in turn

government revenues through higher tax revenues 57. However, as costs begin accumulating

immediately, while fiscal benefits come mainly later, the government must be patient and have

more a long term focus in order to benefit from such programs.

As well as an increase in public investment in pre-school child-care, there needs to be an increase in

the total amount of teaching (outside of school). Test shows that success or failure at school

depends on what is learned at school, but also how the holidays are spent.

In a country like Spain, expanding out-of-school educational offerings and extending the teaching

year (which in Spain totals just 175 days, compared with 240 days in Japan, for instance), would be

measures that could also improve educational performance and as a result also facilitate women’s

inclusion in the workforce. 58

55 http://www.csmonitor.com/World/Europe/2013/0517/Spain-s-controversial-educational-reform-Will-the-Green-Tide-wash-it-away 56 http://educationincrisis.net/blog/item/894-austerity-and-education-reforms-in-spain-moving-far-away-from-international-excellence 57 http://www.readynation.org/docs/researchproject_dickens_bartik_200802_brief.pdf 58 http://www.oecd-ilibrary.org/docserver/download/9612041ec027.pdf?expires=1373234046&id=id&accname=guest&checksum=CFF4B078F246E540FAA8E941328AE09B

Unemployment

Unemployment was last recorded at 26.26% (see Figure 17) of the population in Q2 of 2013, down

from 27.3% in Q1. Although this figure represents nearly 6 million unemployed workers, it is the

first time in two years that the unemployment rate has gone down. Although this may indicate that

the worst of the country’s economic slump may be over, this decrease in unemployment is mainly

due to a strong tourist season, which is a seasonal factor. Moreover, most of these new jobs are

mostly temporary jobs.

Figure 17.

An important issue related to this unemployment rate are short-term contracts. Short-term contracts

that are beneficial in times of prosperity but are easily reversible in times of crises, leading to

rapidly increasing unemployment.

The temporary employment rate in Spain even exceeded 30% in the year 2000 as illustrates Figure

18.

Temporal contracting, when the crisis hit, led to many being left without a job, since the cost of

firing is very small in this case. Since the decrease in national and global demand since 2007, the

rate at which people were fired increased dramatically. One of the main factors of the increase in

unemployment in Spain was the difference in costs of firing between the different kinds of contracts

59, and the fact that so much of the workforce was employed under temporal contractual terms.

The boom of temporary employment in Spain is mainly due to the demand-side, due to the dramatic

growth in the size of the secondary sector. Demand-side interpretations of temporary employment

establish a link between the rate of temporary employment and the size of the secondary sector of

the economy. Yet labour market outcomes are not only defined by demand factors, but also by

59 http://www.iae.csic.es/investigatorsMaterial/a9297120238archivoPdf65174.pdf

supply side factors, by the institutional regulatory framework, as well as by the general economic

context.

Figure 18. Rate of Temporary Employment in Selected OECD60 Countries, 2000.

Source: OECD (2002: ch. III)

In relation to the supply side factors, an increase in temporary employment is more likely to occur

when the leading employment sectors require high levels of L (labour), and when the education of

the workforce is low, demonstrated by the relationship between rate of temporary employment and

level of education. 61

All these factors have influenced both employer and employee strategies in the labour market,

including, crucially, the type of contractual terms offered, and are the reasons for which Spain have

had such high temporal employment rates.

The duality of the Spanish labour market is characterised by workers on open-ended contracts, who

are entitled to generous severance pay, and temporary workers on low salaries, who are cheap and

easy to fire. For that reason the latter are usually the first to be let go during an economic downturn,

which explains the recent surges in unemployment in the Spanish economy. This is exactly the

problem that the labour reform is supposed to address, but has not, as will be discussed further on.

The large number of workers on temporary contracts is one of the big problems in the Spanish

labour market. Temporary workers account for over 25% of all employees in Spain, compared with

an average in the OECD of 12%. The percentage is even higher amongst young people. 62

60The Organisation for Economic Co-operation and Development (OECD), made up of 34 countries, was founded in 1961 with the goal of stimulating economic progress and world trade 61 http://www.march.es/ceacs/publicaciones/working/archivos/2004_212.pdf 62 http://elpais.com/elpais/2012/03/05/inenglish/1330952298_341418.html

The fact that most of the employment was concentrated in the construction sector, boomed by the

real-estate bubble, meant that when that bubble burst at the start of the crisis of 2007/2008, many

construction companies went out of business and as a result many workers were left without a job.

As can be seen by Figure 19, unemployment rate rose sharply to 26% of the labour force in 2012

Q4, and this unfavourable rate can be said to have had very adverse effects on structural

unemployment 63. This can be explained simply by the fact that workers that are out of work have

been for a long period of time, and the longer a worker is unemployed, the less attractive they

become to employers and therefore less likely they are of finding employment.

The most recent figures show that the number of temporary contracts converted to permanent

positions fell more than 10% in May of this year compared to the same month last year.

Figure 19.

The nation’s youth is locked out of the permanent jobs and the first to be fired from temporary jobs.

As a result of this temporal employment issue, in May of 2013, youth unemployment was recorded

at over 56% (see Figure 20).

63Structural unemployment is a type of unemployment where, at a given wage, the quantity of labor supplied exceeds the quantity of labor demanded, because there is a fundamental mismatch between the number of people who want to work and the number of jobs that are available.

Figure 20. Spain’s Youth Unemployment Rate

Source: http://ycharts.com/indicators/spain_youth_unemployment_rate_lfs

The fact that educated youth cannot find work will make them look for jobs outside of Spain, and

start a trend that is worrying as this will lead to loss of talent and skilled workers inside the country.

From the beginning of 2012 to the end of March, some 365,000 Spaniards between the ages of 16

and 29 have left the country, according to the National Statistics Institute.

The loss of young people with university studies represents the loss of one of the key elements for

growth, H (human capital), and must be one of the centres of focus of the labour reforms.

Another important issue in having high numbers of workers on temporary contracts is that this

reduces productivity, as employers tend to invest less in training them.

One way to encourage employers to take on more workers on a permanent basis could be to make

social security contributions higher for temporary employees, in fact making it more costly and as a

result less attractive to contract employees under temporal conditions.

The main tool to tackle unemployment is a labour reform. In continuation will be discussed the

labour reforms put in place and their effectiveness.

Labour Reforms

There have been several labour market reforms over the past few years:

- Royal Decree 10/2010 on urgent measure to reform labour market

- Royal Decree 7/2011 on urgent measure to reform collective bargaining

- Royal Decree 11/2011 on urgent measure to promote youth employment

- Royal Decree 3/2012 on urgent measure to reform labour market

Labour market reform of 2012 gave the employer power to modify working conditions, salary, or

work environments, without agreement; in the public sector it enables collective redundancies,

which led to mass firing.

Rajoy is emulating the policies Germany put in place a decade ago to reinvigorate its economy. The

easing of firing laws and cut backs on jobless benefits, puts pressure on the unemployed to seek

work. Also, as a result of the newfound freedom to hire and fire, Spain’s labour costs have been

falling (as seen in Figure 21)

Figure 21. Unit Labour Costs

Source:

http://sdw.ecb.europa.eu/quickview.do?SERIES_KEY=119.ESA.Q.ES.Y.1000.UNLACO.0000.TTTT.D.N.I

Labour market reforms can actually feed through to economic performance relatively quickly.

Reforms that lowered the cost of laying off workers in Spain are showing in the form of increased

foreign investment. Spain received a total of 28,415 million euros of foreign direct investment in

2011, 18.4% more than in 2010, according to data from the Foreign Investment Registry of the

Ministry of Economy and Competitiveness, placing it 15th among the world's economies in terms

of FDI received in 2011.64

64 http://marcaespana.es/en/economia-empresa/internacionalizacion/destacados/76/spain-an-attractive-destination-for-foreign-investment

The fact is that the measures introduced reduced both public and private sector wage costs and in

turn increased workplace productivity that helped firms become more competitive. By limiting

possible wage claims and negotiating flexible working conditions, companies in the car industry for

example have become more competitive and boosted their exports as a result.

However, the controversy of reducing costs of firing to reduce labour costs is that the labour reform

does not tackle the issue of unemployment. Temporal employment contracts, although they reduce

labour costs as it is less expensive to fire a temporary employee than a permanent one, makes the

destruction of employment much easier and makes it harder for workers to find stable employment,

which could push qualified employees to look for work outside of the country.

The fact is the reform barely addresses the problem of the high incidence of short-term hiring due to

temporal contracts. The new regulations revive a previous ban on extending temporary contracts

that was temporarily lifted, limiting the period to 24 months starting next year. However, companies

can easily find a way around this law by simply regularly changing a temporal employee’s duties or

post.

The youth unemployment, which is to some extent a result of the issues of temporal contracting, has

reached 56% and is also an important issue the labour reform should tackle. There is, above all, an

urgent need to quickly address this youth unemployment. Apart from inciting companies to offer

more long term contracts, labour market reforms needs should be at the centre of education,

including improving the quality and image of apprenticeships, in order to make learning that

combines both school and workplace based elements more widely used in Spain.

Improving skills and increasing occupational mobility are measure the government could take to

decrease unemployment in the medium to long term. Such policies should provide the unemployed

with the skills they need to find re-employment and the proper incentives to find work. Structural

unemployment is the result of workers being occupationally immobile, therefore improvements in

education and training will increase the human capital of these workers, and therefore give them a

better chance of taking the new jobs that become available in the economy.

Moreover, a benefit reform could be done to reduce the real value of unemployment benefits, which

should increase the incentive to take a job. The government could also put in place employment

subsidy programs, in which subsidies are given to firms that take on the long-term unemployed to

reduce the trend of structural unemployment.

Export Sector

Exports play an important role in the Spanish economy (as in any economy), influencing the level

of economic growth, employment and the balance of payments.

The share of exports-to-GDP ratio in Spain is below 25% (second lowest in the Union), very low in

comparison with the EU average of about 40%. Moreover, the share of high value-added export

products of total exports, at 48% in 2010, is much lower in Spain than in other European neighbours

(Germany and Italy, 72% and 68% respectively).

However, since the start of the crisis, there has been two factors that have brought consistently good

news for Spain's economy. The first is tourism, the second are exports. The latest figures show that

during the first half of this year, exports rose 8% compared to the same period last year, particularly

to emerging markets such as India, while the trade deficit has come down by around two-thirds.

Figure 23 illustrates this growth in the Spanish export sector.

Figure 23. Spanish Exports, Annual percentage change

Source: Thomson Reuters Datastream; IMF

This data should be celebrated for macroeconomic reasons, because the size of the trade deficit

(approximately 10% of GDP) was one of the main characteristics of the recession in Spain, and has

been reducing as a result of the increase in the export sector, as illustrates Figure 24. The

government is also claiming that the rise in Spain's exports is down to the increasingly competitive

prices firms can offer, thanks to the government's labour reforms and the effect they have had in

bringing down salary costs.

Figure 24. Spanish Current Account Deficit, as a percentage of GDP

Source: Thomson Reuters DataStream; IMF

Just as important as the macroeconomic element of this data is the microeconomic aspect. If Spain

is exporting more, it's because Spanish companies are exporting more and are doing so much better,

which represents a great achievement in the context of the battle against the recession. Above all

else, it shows that at least one part of the Spanish economy can hold its own in the face of

competition from medium and large companies on the global market. And they are doing so in a

context of falling subsidies from the government. For countless Spanish companies, and for the

national economy as a whole, exports have emerged as the one bright spot in a country suffering

from extremely high unemployment rates and a plummeting demand from consumers, corporations

and the government alike. Shipments of construction materials, car parts, Rioja wine, textiles,

machinery and complex software are all booming, amid claims that Spain’s only hope of recovery

is to export itself out of the crisis.

This trend, which reflects the efforts being made by Spanish businesses to survive in the midst of a

very complicated situation, by opening up in new markets or consolidating their presence in others,

is often reflected in companies with a domestic reach, thanks to the adoption of best practices and

management styles that allow for innovation, which is a very positive point to be taken into

account.

This recent data shows that Spain has indeed gained ground in world markets. Exports are now

growing even faster than shipments from Germany, Europe’s economic powerhouse. According to

the latest forecast by the European Commission, exports from Spain will grow by 4.1% this year,

the biggest increase of any country in the EU 65.

65 http://www.ft.com/intl/cms/s/0/a68310b4-b8b5-11e2-a6ae-00144feabdc0.html#axzz2czmVYtlD

In summary, the Spanish economy has managed to swiftly redirect its production output away from

the stagnant domestic market and toward the international community, where the potential for

growth is much larger. As a result, the trade balance has been significantly improving since the start

of the crisis, as can be seen by Figure 25.

So, what lies ahead for the export sector? The figures show that the labour reform has prevented

wage levels from rising along with inflation. This means that the Spanish workforce is not only

more competitive, but also more flexible. This will ensure that the number of Spanish products and

services worldwide will continue to grow.

An important factor to note is the fabric of Spanish export production, which is famed for its low

elasticity. Spain’s exports have proved to be inelastic, unlike the exports of many emerging

economies. If Spanish exports are deconstructed, it can be seen that they are far more similar in

structure to German exports than those of a country like China. This is important as it means that

Spanish exports will not only continue to grow, but they will also not be subject to much volatility.

As a consequence of all the above points, Spain is increasingly attracting more direct foreign

investment.

Figure 25.

funding real estate promotion, solar energy parks or leveraged acquisitions. It is now aimed at new

industrial activity with export capacity, particularly in the automobile sector. It will result in more

Higher foreign investment, which in turn means more jobs, will help the Spanish GDP to start

growing again in 2014 and help to bring unemployment levels down.

However, caution must be taken. The vast majority of Spanish companies, accounting for the

majority of jobs, simply lack the size, the products, the expertise and the financial muscle to

compete abroad. BNP Paribas, a famous French bank, complained about this “duality of the Spanish

economy” in a recent research report. The bank’s conclusion: “Spain’s export base is still too small

to offset the drop in demand” 66. There is still crucial work to be done to ensure the positive trend

continues.

Continued diversification will be a key factor to further leverage gains from the export sector.

Further gains could be achieved by continuing to diversify the export sector, in terms of number of

products, product range, and markets.

Industrialised exports products should be promoted. Encouraging the development of sectors that

are more intensive in the use of technology would be an important step towards the sustainable

development of the export sector.

Expanding the export base for Spanish goods and services could also open new markets.

Diversifying its foreign trade relationships, especially with emerging economies, could open up

new opportunities for Spain.

Policies aimed at promoting exports will be essential to be put in place. The most important being:

i) Adequate price incentives through a competitive real exchange rate and low levels of anti-export

bias arising from import protection.

ii) Improving physical infrastructure (e.g. roads, power supplies) and social infrastructure (e.g.

equality of education).

iii) Access to credit for exporters, either for investment or export trade financing, at favourable

interest rates 67.

Policies must also balance the need for growth with the need to consider environmental challenges.

This can be achieved by promoting CO2 reduction within firms or sectors that experience strong

growth. Alternately, supporting low-carbon industries that have the potential to be productive and

innovative, for example the electrical and optical equipment industry (which has the potential to

achieve both objectives).

In order to carry on exporting it needs a lot more mid-sized companies, not small ones. Spanish

companies are, however, mainly small rather than mid-sized. That is why it is vital to implement

state policies that foster the consolidation of Spain’s SMEs (Small and Medium Enterprises).

Moreover, Spain is still experiencing pressing problems where bank loans are concerned, and said

problems are not going to go away for a long time. It is therefore essential that non-banking sources

of funding be made available to Spain’s exporters to enable them to keep growing.

66 http://economic-research.bnpparibas.com/Views/DisplayPublication.aspx?type=document&IdPdf=22137 67 http://www.ilo.org/wcmsp5/groups/public/---dgreports/---dcomm/documents/publication/wcms_189821.pdf

Financial/Banking Reforms

The state of the banking sector at the start of the crisis meant that a clean up, recapitalisation and

restructuring of the banking system had to be done.

Royal Decree-Laws 2/2012 and 18/2012 laid down a swift and transparent process of cleaning up

potential capital losses associated with real estate assets, raising the levels of specific and general

provisions. Subsequently, a detailed and rigorous stress test was conducted to evaluate the capacity

of each individual bank to withstand reasonably extreme situations involving a further heightening

of difficulties. Once the capital requirements to shore up each bank had been identified in this way,

the following step of the strategy consisted of designing a mechanism and specific conditions for

the recapitalisation and restructuring of the banks in question, and for the orderly resolution of those

that were not viable. In parallel, procedures were set in place for the segregation and transfer out of

banks under restructuring of assets and real estate loans.

As a result of all these measures and, to a lesser extent, the sale of assets and other actions, the total

net exposure (after applying provisions) of the bank balance sheets to the real-estate sector had been

reduced in 2012 by 127 billion euros, as can be seen in Figure 22.

Figure 22.

The banking sector has a key role in the elimination of unsold new homes. On the one hand, due the

large number of properties that at this time it has in its portfolio, it should lead the process of price

adjustment, which is still incomplete. On the other hand, when the current credit rationing in the

wholesale markets is reduced, it should relax the conditions for granting loans, even guaranteeing

certain standards of creditworthiness.

Pension System

In order to meet the future challenges, it is essential to ensure the viability of the social protection

system in the context of a rapidly ageing population. The sustainability of the pension system has

been one of the main concerns of institutions across Europe, as well as the Spanish government,

since the financial crisis began. A reform of the Spanish pension system was not, however, put into

law until March 2011.

The main aspects of the agreement on pensions, incorporated in Law 27/2011, included increasing

the retirement age from 65 to 67 years.

There will also be an increase from 15 to 25 years of social security contributions taken to

determine the regulatory base of the pension. Also, the legal age of early retirement will rise from

61 to 63 years. These measures are all significant steps towards enhancing the long-term

sustainability of Spain’s public finances, although Spain should not stop there and should intensify

its pension reforms in order to fix the country’s troubled public finances.

The effect of raising the retirement age is positive and may be significant: by raising the retirement

age the average period during which individuals contribute to the system is gradually extended and

the average period over which they draw a pension is shortened. Until both factors stabilise, this

will raise the tax revenue growth rate and reduce expenditure.

Despite these changes, Spain is under a lot of pressure to fix the imbalances in its economy as the

high unemployment rates put a strain on social security funds. An ageing population and low birth

rates have also added to Spain’s problems, and there is need for broader changes to make the

pension system more sustainable.

The number of people contributing to state pensions has fallen to its lowest level in a decade after

nearly 6 million Spaniards lost their jobs and stopped paying into the system, which supports 9

million pensioners. 68

There are several options that the government could consider. Firstly, a ceiling or cap could be

placed that would prevent pensions rising more than 0.25% above inflation. Secondly, the pension

plans could be linked to life expectancy. Although there is more than one way to achieve this, the

two main ways are: automatically increasing pensionable age as people live longer, or automatically

lowering pension replacement rates as people live longer.

Such a policy has both economic and political attractions. It is only reasonable that people pay more

or less depending on how long they are expected to live. The automaticity of adjustments means

that governments no longer face nasty surprises in pension financing when life-expectancy

projections change. Increasing life expectancy provides a neat and logical justification for cutting

68 http://www.reuters.com/article/2013/09/02/spain-pensions-idUSL6N0GY39520130902

future benefits that may be politically more palatable for the public than alternative reforms that

would also reduce pensions.

The Need of Regional Convergence

Although this is a point is not talked often about during economic discussions, Spain’s regional

structure emerges as a factor in explaining some of the economy’s structural issues. In fact, the

development of autonomous regions has represented an obstacle to the creation of a single market

and has taken Spain in the opposite direction to what Europe is trying to achieve.

According to a study made by the Spanish Competition Court, the majority of regions within Spain

did not have barriers to trade in 1996, but 14 out of the 17 have implemented such measures since

then 69. The main argument against trade barriers is that they usually result in higher prices for

consumers inside the country implementing such measures. In other words, the benefits lie only for

the industries and people with jobs within these industries that the tariffs and quotas protect.

In a context in which Spain is rapidly losing international competitiveness, this is an issue that

needs to be looked at in more detail. It can be said that the development of Spain’s autonomous

regions represents a structural obstacle to growth.

Firstly, it creates a significant obstacle to geographical mobility through the raising of the language

barriers in certain regions (including Castellano, Catalan, Aragones, Gallego and many other

variants). Also, linguistic diversity categorises education too much, preventing, for example, the

implementation of a program of standard tests with which to compare results and assign resources

efficiently, and perhaps explains the very low scores for reading obtained in the PISA tests

previously analysed. There is also a lack of policy coordination among regions, and all these are

serious obstacles to economic growth.

Moreover, it makes efficient consolidation of the banking system difficult. Such difficulties can be

found for example in savings-bank mergers, and raises doubts about the governance of some of

these institutions (for example, Bankia).

69 Tribunal de Defensa de la Competencia, 2003

Conclusions

Spain is facing serious structural problems, since the rapid economic growth of the past decade was

based on unstable foundations. To overcome the current situation it is necessary to break the vicious

circle of low economic growth, high unemployment and elevated debt. Besides a broad program of

fiscal consolidation (including cuts in education), which began in 2010, the authorities have

promoted various economic reforms in some sectors and markets. Although results have fallen

somewhat short of expectations, recent months has seen the export sector grow significantly due to

the labour productivity gained from the labour market reforms. A successful exit strategy for the

current situation needs, on the one hand, to deepen the reforms launched so far and, on the other, to

extend the reformist agenda to other areas, such as education, as a way of guaranteeing further

increases in growth potential in the longer term.

The two key sectors that led to the creation of the crisis in the country and the extent of its impact

on the economy, real estate and banking, should stabilise. The high exposure of banking to

construction and real estate activities (through the massive volumes of credit granted) was the

means of transmission of the housing crisis into the banking industry. The consequence of this

contagion is that the Spanish banks have faced serious solvency problems since the start of the

crisis, until recently. The banking sector has a key role in the stock elimination that should lead the

process of price adjustment that is still incomplete, and moreover, when the current credit

difficulties in the wholesale markets are reduced, loans will be more easily granted, increasing the

amount of K (capital) available to the economy. The reforms carried out so far to correct the system

have seen their benefits. Although the banking system is now significantly stronger, the

normalisation of the banking sector will take some time. Despite the extensive reforms carried out,

there are reasonable doubts about whether the measures implemented will be sufficient to address

the imbalances accumulated during the pre-crisis period. Because of these doubts, markets continue

without fully relying on the health of the Spanish banking industry for the time being, due to its still

too high exposure to real estate and the large volume of potentially problematic assets.

Concerning the export sector, it is necessary to adopt measures that may enhance the services sector

and some tradable sectors. In this model, exports have an absolutely fundamental role. Although the

lack of domestic demand has already been offset by the dynamics of foreign demand, adequate

measures should be taken in order to further increase competitiveness. The subsequent gain in

competitiveness would help to increase exports, and in the longer term also contribute to job

creation (and unemployment reduction), which in turn would then contribute to the recovery of

household incomes.

Concerning the labour market, the reforms put in place has moderated wage growth and reduced

unit labour costs and recently have already had a significant impact on labour productivity. This has

improved competitiveness, which has in turn led exports to perform strongly and the current

account to swing into a surplus. The labour market reform can therefore be said to have been very

successful but only in part. In the medium term, further increases in competitiveness will require

more investment in education and R&D.

Figure 26. Unit Labour costs

As illustrated Figure 26, labour costs have increased since the year 2000 more than the unit labour

costs of Germany, creating the now large competitive gap that the labour reforms are trying to

tackle. Reducing costs of labour is the only way of regaining the competitiveness lost since the year

2000.

Figure 27.

Figure 27 illustrate the unemployment rates in the Asian crisis in the 1970’s, and the effects of

internal and external devaluation. As Spain is part of the Euro they do not have the capacity to

manipulate their exchange rates in order to devalue their currency. The only tool that Spain has is to

internally devaluate their labour market in order to increase competitiveness. This in the short term

increases unemployment as labour becomes cheaper to fire and hire. However, in the longer term,

as is seen by Figure 27, unemployment is reduced. As the labour force become more competitive,

the export sector grows and in turn this increased economic activity has a knock on effect on the

unemployment rates. This is the what has been done so far and quite successfully, although more

efforts are yet to be done to close the competitive gap that is so crucial in order to compete in the

global marketplace.

Also, insufficient progress has been made in reducing the damaging divide between permanent and

temporary contracts. The probability of finding a permanent job remains too low and that of losing

a temporary job too high.

The focus should be on a pro-jobs strategy that allows the economy to grow and hire. More tools

should be available to help the unemployed find jobs through training and placement programs.

To decrease levels of temporality in the Spanish labour market it is necessary to introduce a single

employment contract. This type of contract will promote the creation of stable jobs and the

accumulation of H (human capital), and it will simultaneously ensure that wages are set in

accordance to the evolution of productivity.

Concerning the pension system, the reforms made aimed at increasing the retirement age and

increasing the years of social security contributions required have been crucial yet insufficient

reforms. In order to meet the future challenges of rapidly ageing population, it is of outmost

importance to ensure the viability of the pension system. A ceiling or cap should be placed that

would prevent pensions rising more than 0.25% above inflation. Secondly, the pension plans should

be linked to life expectancy, as it is in most European countries. The two main ways of achieving

this are by either automatically increasing pensionable age as people live longer, or automatically

lowering pension replacement rates as people live longer. Such a reform would have significant

effects on the viability and sustainability in the long term of the pension system.

However, caution must be taken in order not to put too much stress on particularly low-income

workers, as cutting their already low benefits as life expectancy increases might risk a resurgence of

old-age poverty.

Education. This is the key to eliminate gender inequality, to reduce poverty, to maintain a

sustainable planet, to prevent needless deaths and illness, and to foster peace. Moreover, in a

knowledge economy, education is the new currency by which nations maintain economic

competitiveness and global prosperity. Education today is inseparable from the development of H

(human capital). This understanding that education is the new driver of economic growth and

human development is the reason for which Spain should focus on improving the quality of its

educational system. The issue is that those in school perform badly in international testing. As

illustrated by the PISA report (Figure 15), there are large deficiencies in students relative to other

OEDC countries in terms of reading, mathematics and science skills. Spain must ensure more

youths complete high school, and universities turn out graduates with needed skills if it wants to

slash its high unemployment rate and increase the country’s human capital. Measures to reduce the

high number of students who drop out of schooling must urgently be put in place.

Also, early childhood program should be invested in. Implementing such programs for children is

proven to increase job growth and earnings in the long term, and has very high returns on

investments compared to other programs. Expanding out-of-school educational offerings and

extending the teaching year are also measure that Spain should consider if the educational system is

to be improved.

Following the crisis of the 1970s in Spain, it took longer than a decade to recover a decent rate of

growth and robust job creation. In view of the structural problems highlighted in this thesis, it is

necessary to consider the consequences of a repetition of this scenario. The prospect of a “lost

decade” could put in doubt the capacity of the Spanish economy to undertake the necessary

structural reforms.

To conclude, this thesis evaluates the multiple structural problems of the Spanish economy. In the

absence of the necessary structural reforms, the economic outlook could be similar to that of the

long and slow recovery from the crisis of the 1970-80 period.

However, after five years of deep recession, there are at last reasons to believe that the worst may

be over, and that the beginning of a slow recovery may not be far away. Such reasons include the

effective financial reforms that have stabilised the banking system, and the labour reforms that have

led to a boom in exports due to an increase in competitiveness.

If the reforms are intensified, together with European stability of the euro and the good pace of

exports, job creation could start to be seen at the end of the year 2014, and will be the stepping

stone for economic recovery in the short term.

Although most experts agree (i.e. IMF forecasts) that 2013 will end with an economic decline, they

also predict that the economy will flatten out in 2014, and this is amongst the most pessimistic of

forecasts. According to data compiled by the Funcas think-tank, economists surveyed are predicting

average growth in 2014 for Spain of 0.7%, while the Spanish government is expecting 0.5%, the

Bank of Spain 0.6%, and the European Commission 0.9%.

In order to quantify relatively accurately when the Spanish economy will start to recover, it is

important to consider Figures 27 and 28.

Figure 28 shows the decrease in credit available in the Spanish economy since the start of the crisis.

Credit is crucial for economic growth, as business investment in productivity enhancing technology

and equipment requires borrowing. And this is simple economics; a decrease in money supply leads

to a decrease in economic growth. Only through an increase in the money supply will the economy

be able to recover.

Figure 28.

Figure 26 is also very important to consider. Over the period of economic growth, the labour unit

costs have shot up, way above Germany. If competitiveness at the level of the year 2000 is to be

regained, the current trend of reducing labour costs needs to continue. According to the Nomura

Research Institute, this target will be reached not before late 2016. Only when the economy has got

going again thanks to the competitiveness gains of reduced labour costs, thanks to the reforms put

in place, will job creation start to take place. The structural unemployment of Spain due to the low

skills and education of the Spanish workers may also contribute to the time lag between when jobs

are created, and the time unemployment rates start to drop.

In light of all this, the Spanish economy is expected to flat-line in 2014, and a period of growth and

true recovery will only be experienced in the following years, 2015 and 2016.

Considering the financial system is kept stable, the necessary labour reforms are put in place to

reduce the still alarming unemployment rate, the sustainability of the pension system is ensured, the

quality of the educational system is improved, gains from the export sector are leveraged, credit is

loosened, and unit labour costs continue to drop and competitiveness continues to rise, then Spain

may be looking at a slow but sure recovery from the current recession.

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