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Lift the ban on Spanish labour reform

Reviving the Spanish economy will require more that macroeconomic stimulus. This column says a sizeable reallocation of labour, brought about by increased labour market flexibility, is the only responsible course of action.

Remarkable events are taking place in the Spanish economy, even by the standards of the current world recession. Last year output grew quite fast, at 3.7%, whereas in the third quarter of this year output has fallen at an annualised rate of 0.8% and household consumption at a startling 4% rate, and GDP should drop 0.9% in 2009 according to the OECD forecast.

The Spanish government has responded to the slowdown by implementing various stimulus measures, officially estimated as amounting to 2% of GDP, and if liquidity injections are included, to 3.7%. A new package will soon be announced. It has also taken steps to ease constraints on bank’s supply of credit.

However, the government may be running out of firepower, since the budget deficit may end up close to 3% of GDP this year –down from a 2% surplus in 2007. Moreover, like with the global financial crisis, stimulating demand is only part of the task at hand. Another key set of policies concerns structural reforms, where little progress has been made.

The labour market

The long boom in the Spanish economy that started in 1996, with average annual growth of 3.7%, was crucially fed by construction. Now, on top of worldwide shocks, Spain is suffering a home-grown housing bust. Housing starts are down by 56% compared to one year ago and by 75% compared to two years ago.

Employment has accordingly fallen by 0.8% over the past year, with job growth in services partly compensating a 13% employment drop in construction. Since the latter industry still comprises 11.6% of employment –compared to, say, 6.7% in Germany or 8.5% in the UK – there is more labour shedding to come. In just one year the unemployment rate has soared from 8% to 11.3% of the labour force and the IMF forecasts a figure of 14.7% for 2009.

Again, some compensating measures have been adopted, mainly subsidies for hiring unemployed workers with family burdens under permanent contracts. They will probably not be very effective. Over the last decade the government has devoted about 0.3% of GDP annually to subsidies for hiring under permanent labour contracts, without much to show for it.

Looking ahead

With a current account deficit of 10% of GDP, to pull itself out of the slump Spain sorely needs to gain competitiveness – as Olivier Blanchard wrote last year.1 Within EMU devaluations are no longer possible, and competitiveness has to be earned the hard way. Since 1995, despite wage moderation (real wages have fallen by 0.5% per year), Spain has seen a 30% increase in its relative unit labour costs vis-à-vis the euro area, due to a dismal productivity record (total factor productivity has fallen by 0.1% annually). Increasing productivity will require, among other things, a sizeable reallocation of labour from inefficient firms that mushroomed during the boom to more efficient ones in industries where there is demand.

All these requirements point towards raising labour market flexibility. Indeed, as Giuseppe Bertola has recently pointed out, both increasing openness and EMU raise the employment cost of labour market rigidity and have led to some labour market deregulation in EMU countries.2 On top of those two forces, Spain has strongly felt a third one: immigrants currently comprise 16% of the labour force, up from 1.3% in 1996.

Looking at the medium term, we should recall that over the period 1980-2007 the (OECD-standardised) average unemployment rate was 14%, with much higher figures for females and young workers. The main reason lies with the unemployment-prone nature of Spanish labour institutions, so deregulation would also help on this front.3

Labour market reforms

What reforms could be implemented to achieve those goals? Here are a few examples.

(a) In mid-1970s Spain had very high firing costs inherited from the Franco regime. To reduce them, fixed-term labour contracts were introduced in 1984, creating a dual labour market: about one-third of employees are on such contracts (vis-à-vis 15% in the EU-15). The evidence shows that those contracts are not stepping stones to permanent jobs. Thus, while better than the preceding regime on various counts, the two-tier system has also caused problems,4 such as excess job turnover (the ratio of annual contracts signed to the labour force was 92% in 2007) and a decrease in productivity growth,5 with a neutral or slightly positive effect on employment.

A sensible reform would close the gap between the firing costs of permanent and temporary contracts introducing gradual job protection. New hires would take place under a single permanent contract with severance pay that increases smoothly as workers accumulate job tenure.6 The system should be calibrated so that average severance pay for a given tenure level (e.g. 10 years) became lower than currently, since labour courts could be involved in the dismissal, whereas in the case of temporary contracts they cannot. Clearly, more radical reforms should also be entertained.

(b) Wage levels agreed at the industry level, between the two major labour unions and one employers’ association, are binding floors for all firms in the industry. Unions have shown wage restraint, presumably due to increasing openness, immigration, and fixed-term contracts. However, there is very little dispersion in bargained wage growth across industries to accommodate industry-specific needs. Thus the reform should aim at decentralising the wage setting process.

(c) Both the need for more worker protection against higher uncertainty as a result of increased openness/EMU and the now popular “flexicurity” approach suggest raising the generosity of unemployment benefits while reducing employment protection. However, strict enforcement of availability to work and efficient job search assistance would also be required, and these are far from assured.

These proposals are not so new (or bold). One can find similar ones in a report on Spanish unemployment by a set of highly reputed economists in 1995.7 Indeed, labour economics is one of the most developed areas in Spanish academia, so that economists could help in designing the reform.

Lift the ban on labour reform

With unemployment increasing so fast, one would expect the Spanish public to be hotly debating labour market reform now, as it did many times in the past. On the contrary, there is hardly any discussion at all. Why? Because the public responds to expectations of viability and the government has completely ruled out any labour reform ever since the general election last March.

But there has been a sea-change from that time and so the current dire prospects may have created an opportunity for a national agreement on labour reform. There is no time to waste, since government bargaining with employers and labour unions on such a thorny issue would surely take a while. It is time to lift the ban on labour market reform in Spain. It may not be a popular course of action, but it is the only responsible one.

1 Financial Times Economists’ Forum, blogs.ft.com, 27-3-2007.
2 G. Bertola (2008), “Labour Markets in EMU – What Has Changed and What Needs to Change”, CEPR Discussion Paper 7049.
3 S. Bentolila and J.F. Jimeno (2006), “Spanish Unemployment: The End of the Wild Ride?”, in M. Werding (ed.), Structural Unemployment in Western Europe. Reasons and Remedies, MIT Press.
4 J. Dolado, C. Garcia-Serrano, and J.F. Jimeno (2002), “Drawing Lessons from the Boom of Temporary Jobs in Spain”, Economic Journal.
5 In general increasing labor market flexibility raises productivity, but the evidence suggests that doing it through fixed-term contracts does not; see A. Bassanini et al. (2008), “Job Protection Legislation and Productivity Growth in OECD Countries”, IZA Discussion Paper 3555.
6 S. Bentolila, J. Dolado, and J.F. Jimeno (2008), “Two-Tier Employment Protection Reforms: The Spanish Experience”, CESifo DICE Report 4/2008.
7 O. Blanchard et al. (1995), Spanish Unemployment: Is There a Solution?, CEPR, London.


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