EVERY member of the eurozone has weaknesses that limit its potential. Spain seems to contain a continent’s-worth of frailties in just one country. Like Ireland, its consumers are weighed down by huge mortgage debts. Spain has a rigid system for setting wages, also a source of inefficiency in Greece and Portugal. The attempt to free up Spain’s jobs market by allowing temporary work contracts has reduced incentives to train workers, holding back productivity. That is true also of Italy. And, like all these countries, Spain has steadily lost cost competitiveness against the euro zone’s “core” countries, centred around Germany. As a member of the euro, it cannot address that problem by devaluing the currency.

Politicians in Spain have woken only recently to the need for reform. The wage system demands it most urgently. Pay is set centrally through a complex system of agreements across regions and industries. That means wages adjust only slowly to changes in business conditions. Despite a deep recession and zero inflation, pay growth averaged 3% last year, according to the OECD. That helps explain why Spain’s jobless rate shot up so quickly; it now stands at 19.5%. In Britain, by contrast, though the recession was equally savage, firms could limit pay; they therefore did not have to shed as many jobs, and unemployment rose less steeply.

Rigid wage-setting alone cannot account for Spain’s poor productivity growth. In the euro’s first ten years, output per worker rose by an average of 0.2% a year. In some years it fell even as wages grew quickly, which chipped away at Spain’s cost competitiveness (see chart). Part of the blame lies with Spain’s “two-tier” jobs market. In the top tier around two-thirds of the workforce are permanent employees who are costly to fire. When firms cannot shed workers easily, they become reluctant to hire them at all, which pushes up unemployment. Spain’s response in the mid-1990s was to allow the spread of temporary contracts for newer recruits. That gave the economy some flexibility and helped create jobs. But it also tilted the country towards unskilled sorts of work, where productivity is low. And since “insiders” in the top tier are too expensive to sack, most job losses in Spain have been borne by temporary workers, usually the young and migrants. Spain’s government is looking at ways to address this, perhaps by promoting a contract that limits firing costs to 33 days’ pay for each year worked—still remarkably generous.

The government says it will also press for reform of the wage-bargaining system in the next six months. That will prove tricky. Both businesses and unions have big bureaucracies tied to today’s set-up. The government may not push too hard, either. It does not believe that wage cuts are necessary to restore competitiveness and to reduce unemployment, the accepted wisdom in places like Ireland and, latterly, Greece. “The prime minister is not telling the country that Spain needs to adjust and that we are poorer than we had thought,” laments one economist. Indeed, on February 9th, an agreement between businesses and unions was announced that set wage growth at 1-2.5% in 2011-12.

This lack of urgency could count against Spain because of another of its frailties. Its households are loaded down with mortgage debt, a legacy of its long housing boom. As in Ireland, the interest rates on most of these mortgages are variable, linked to the rates on offer to banks in short-term money markets. For most of the past year, the European Central Bank (ECB) has made vast quantities of cash available to euro-zone banks at a fixed rate of 1%, which in turn has pushed down mortgage rates. That has helped hard-pressed homeowners in Ireland and Spain.

One worry is that the ECB might start to increase interest rates before Spain has carried out the necessary reforms. If so, Spain’s householders would find their wages falling just as the interest cost on their debts is rising, prolonging the economy’s slump. That risk seems fairly low, at least for a while (see article). Even the thrifty countries at the euro zone’s core are struggling to grow, so there is little pressure on the ECB to act soon. But monetary policy will not stay so loose for ever, so the wise course is to enact reforms quickly.

The government seems keener to point out that things are not so bad. Spain “is not Greece”, says Elena Salgado, the finance minister. “At no time will we need the support of Europe. In fact, we could be part of the support for Greece, if necessary.” Spain’s public finances are in a less bad state, thanks to discipline during its boom. But if its economy cannot grow, Spain’s debt burden will loom that much larger.

Source: Economist.com, Feb 11th 2010