MILAN – The Spanish economy is beginning to attract investors’ attention – and not only because asset prices are depressed in the current climate (arguably implying a good buy for longer-term, value investors). While there are huge problems that must still be overcome, there is also a clear sense on the ground that the economy has passed a turning point, roughly at the start of this year.
To skeptics, green shoots of recovery will not bloom without access to the credit spigot, which is still clogged by balance-sheet damage in many banks. But, though the road back to full employment and sustainable growth will not be built overnight, progress on it may be faster than most observers expect.
It is easy to get lost in the details of recovery patterns, so a sound framework for assessing potential growth helps. In fact, the Spanish economy is a classic case of a defective growth pattern followed by a predictable, policy-assisted recovery that is driven (with a delay) mostly by the tradable sector.
Prior to the crisis, Spain’s economy relied on demand created by a leveraged real-estate bubble – a pattern not dissimilar in some respects to that in the United States. Thus, both growth and employment came at the expense of the tradable side of the economy. Unit labor costs rose steadily relative to Germany – not only in Spain but also in all of southern Europe, and in France – in the decade beginning in 2000, following the euro’s introduction.
The crisis struck domestic demand, and the tradable sector was incapacitated, because the rapid rise in relative unit labor costs, combined with an over-valued euro, had undermined competitiveness. Moreover, the crisis-related damage to banks’ balance sheets constrained demand by severely limiting household credit and lending to small and medium-size businesses.
Spain was not in an enviable position. The rapid deterioration of fiscal position after the crisis made any substantial countercyclical response impossible, while regulatory constraints limited the economy’s structural flexibility.
The path to recovery, though difficult and lengthy, has been relatively clear and specific. First, unit labor costs needed to decline toward productivity levels to restore competitiveness – a painful process without the exchange-rate mechanism. In fact, there has been substantial post-crisis re-convergence toward German levels.
Second, both capital and labor needed to flow to the tradable sector, where demand constraints can be relaxed as relative productivity converges. Like many other southern European countries, however, labor-market and other rigidities dramatically reduced the speed and increased the costs of structural economic adjustment, resulting in lower levels of growth and employment, especially for young people and first-time job-seekers.
But Spanish policymakers and business leaders appeared to grasp the nature of the pre-crisis economic imbalances – and the importance of the tradable sector as a recovery engine. Recognizing that the economy could not benefit from a partial restoration of competitiveness without structural shifts, the government passed a significant labor-market reform in the spring of 2013. It was controversial, because, like all such measures, it rescinded certain kinds of protections for workers. But the ultimate protection is growing employment. With a lag, the reform now appears to be bearing fruit.
Indeed, though domestic investment is constrained by credit availability, major European and Latin American multinationals have begun investing in the Spanish economy, attracted partly by its enhanced competitive posture and structural flexibility, and, on a slightly longer time horizon, by a recovery in domestic demand. Private equity is flowing in as well, not only because the valuations are attractive, but also because potential growth in Spain now seems within reach.
Though Spain and Italy are similarly depressed in terms of current growth and employment, especially for the young, two significant differences stand out. One is that, unlike Spain, Italy has experienced relatively little convergence of unit labor costs with productivity. That restricts the potential of the tradable part of the economy as a growth engine.
The second difference is that labor-market reform and market liberalization in Italy remain on the to-do list for Prime Minister Matteo Renzi’s new government. If Italy is to take advantage of the growth potential on the tradable side of the economy, following through is crucial – just as it was for Spain. There is no chance in either country that domestic demand alone will support sustained growth in the short to medium term. Moreover, both countries need growth-oriented policies to help with deleveraging.
As Spain’s experience has shown, though structural flexibility is difficult to achieve politically, it is essential for strong economic performance. One reason is that rebalancing is needed when a defective growth pattern distorts the economy’s structure, particularly the balance between the tradable and non-tradable sectors. Another is that technological and global market forces are imposing structural change on all advanced economies, even those that are not unbalanced. Built-in rigidities impede adaptation and adversely affect growth and employment.
Generally, the successful economies in the past three decades have been those that adopted reforms and policies aimed at increasing structural adaptability: one thinks of the US after Ronald Reagan, the United Kingdom after Margaret Thatcher, Germany after Gerhard Schröder, and China after Deng Xiaoping. Spain appears to be in the early stages of restoring a balanced and sustainable growth pattern. One hopes that others will soon follow its example.