Spain: Stop the blame game and get on with solving the big issues

As I mentioned in Why the Spanish housing bubble was partly Germany's fault the housing bubble in Spain was somewhat an effect of the European Central Bank keeping interest rates too low for too long. Well, there is nothing wrong with that conclusion, but the general development in Spain is not just a consequence of low interest rates. There's more to the story.

In any economy there are a number of levers you can push and pull to change the direction and speed limit of an economy. But Spanish authorities basically did little of that.

Missed opportunity during last two decades
If an economy is moving too fast, given a number of constraints, then politicians and governments alike have at least one easy lever to pull – the speed at which the public sector leads this growth.

In chart 1 you see that public sector growth was lower than overall economic growth up until just before 2000. There were some immediate targets to adhere to in order for Spain to join the Eurozone and adopt its common currency and initially there was some form of discipline. It only took a few years however before this failed.

Looking closer at the developments since 2002 and up to 2010: There was massive growth in the public sector, which was much higher than in the overall economy, i.e. the red line is above the blue. Instead of cooling down the economy the government had the pedal to the metal!

Where did the adverse effects show up?
Chart 2 shows different indexes of salary development going back to 1999. Looking at Real Earnings excl. Agriculture and comparing to the time when public sector growth took off, it is apparent that real earnings rocketed. Just look at 2001-2002 where real earnings rose from index 80 to 90, which consitutes a more than 12 percent increase. From then on earnings just kept on flying high.

Construction salaries soar while sector crumbles
Looking at the other time series for salaries in Construction, Industry and Service it is relatively clear that rigidities exist in the Spanish labour market. How can salaries in construction continue to trend higher when this sector is basically going down the tubes?

Add to this that industrial salaries are also under huge pressure (here salaries have also risen significantly since the onset of the financial crisis in 2008). For Service though there has been a more acceptable development. It has witnessed a much lower growth trend since 2008. What is behind this greater flexibility I can only guess at, but the botom line is the rest of the economy should figure out how to get more of the same salary development as in the service sector. Sensible and gradual salary increases are vital for Spain, and even more so now.

If salaries continue to rise more than productivity then in the end Spanish products will not sell as their competitiveness will decline. See chart 3 which clearly shows some of the effects. (Here I have indexed Unit Labour Cost developments in Spain and Germany to the same level in 1992.) Until 1996 the developments in both countries were much alike and the Spanish trade deficit was steady. Then in the ensuing period Spain lost to Germany and this became fairly quickly evident in the trade balance.

These numbers are quite serious as the trade deficit is in billions of euros per month! It is clear that the different Spanish governments have failed to take care of Spain's interests in the long run.

What all this mess amounts to
If a country is not competitive then over time it will borrow money every year. If this continues over a long period then it becomes a problem and this is where we are now.

Look at the current account in chart 4, which shows that services (tourism) is the big positive for Spain, and note that from chart 2 salaries in this sector have been on a much better path, which seems to have had an effect as the level is much higher in the latter years.

On the goods front there has been an improvement but it is still in negative territory, and it will probably take years before it turns positive. There are large transfers as there is a huge chunk of debt where interest payments have to be made.

Chart 4 spans a short timeframe, just to give an idea of what Spain is actually fighting against. Going to chart 5 it paints an unfortunately grim picture of decades of governments mismanaging the country.

Chart 5 shows us that the aggregated current account deficit has been developing negatively since the early 1990s. In the period up to 1998 the aggregate dissaving was stable, which was when Spain entered the Eurozone and then the party began. Spain has dissaved an aggregate EUR 650 bn over a period of 12 years. This is a massive number, and it should never have come to this.

Get on with it
Politicians should have rained in the public sector to leave room for the private sector to flourish and the rigid labour market should have been reformed to become more flexible. So yes the ECB rates were too low while the German economy was in a poor state, but Spain's authorities should have taken this into account and adjusted fiscal policy accordingly. The job ahead is massive and this is what should be kept in mind. Just throwing pennies at Spanish banks does not solve the bigger issues. Premier Minister Rajoy should begin to solve these first and use less time on the blame game.