Reasonably Thinking

Causal Forces to Spain’s Economic Disengagement

Spain no longer enjoys the economic boom of the previous decade.  Instead, the country’s landscape is tainted with twenty-five years worth of excess housing supply, continuous struggles to enhance productivity, and arduous banking regulations.  The supply of credit is limited, unemployment ascends toward 30%, and black market activity is substantial.  These symptoms reveal the artificial nature of the past boom and provide challenges and opportunities for Spain.

Spain’s economic problems are primarily rooted in structural impediments to enhancing productivity.  First, the caja system of regional banks encouraged political corruption.  Local politicians utilized bank funds in an unprofessional and shortsighted manner to provide jobs, which had limited usefulness, along with inflated wages.  Political interference further diminishes productivity with contractual changes, which shatters confidence, along with failure to compete institutionally as reflected by an inferior business jurisdiction.  Moreover, labor laws that constrain firing employees consequently discourage employers from hiring.  Finally, squandering resources (ghost airport, duplicate highways) and minimal useful investments further detract from Spain’s overall productivity level.

Inefficient uses of capital also occurred in Spain’s financial sector.  Spanish consumers, to include immigrants and foreigners, displayed inappropriate behavior in its demand for financial services.  The euphoric belief that home prices always rise pushed demand for mortgage products.  This movement was advanced as homebuyers irrationally focused on monthly payments, an amount that could be reduced with extended maturity, instead of the overall price of the home.  The consumer banking pain extended to deposits, as consumers believed preferred deposit shares were riskless, even though they were backed by structured products that ultimately failed.

Financial sector regulation fared no better as banks across the country failed to acknowledge the economic and financial decline by avoiding loss provisions.  Alternatively, marking assets at par instead of market value enabled banks to refrain from restructuring nonperforming loans.  Financial regulations further impede the restructuring process as one dissident lender can object to restructuring.  Hence, many banks still hold bad assets on their books, and the creation of SAREB, the newly established bad bank, can assist in restructuring assets across the fourteen remaining banks.  The success of SAREB will be needed because banks that continue to hold nonperforming assets on their books without recognizing losses are less able to extend credit to the economy, thereby further inhibiting capital productivity.

These productivity miscues (corruption, inflated wages) and financial sector mishaps (consumer and bank behavior) were also main contributors to Spain’s housing boom.  Other factors include the introduction of the Eurozone in 2002 and low interest rates.  Historically, the European Union was an evolution of pan-European fiscal policies (European Steel & Coal Community) agreed upon for the purpose of peace and stability.  The Eurozone common currency extended this idea into monetary unity.  This currency unification provided a one-time major boost to European economies by lowering transaction costs and flooded countries with new capital.  Spain benefitted from this new supply of cheap capital, which ultimately found its way into the housing market.  Low interest rates amplified the boom as they encourage debt spending (though at Spain’s long-term expense).  Unfortunately, the housing market boomed far beyond equilibrium and now feeds back as a further strain on productivity.  First, homebuyers who assumed full-recourse debt either cannot move for new jobs (further labor rigidity) or owe a substantial amount, both of which inhibit credit demand.  Second, immigrants and foreigners who fail to repay create losses for banks, thereby restraining credit supply.

Spain needs to resolve its problems from within, and to its credit, has started to do so by partially reforming labor laws, outsourcing public services (police), and reforming bank laws (SAREB, FROB).  These will alleviate some of the productivity and financial sector barriers that impede Spain’s economic progress.  Monetary measures are unlikely to help since the country has no option to devalue its currency, and the ECB is unable to solve fiscal issues.  Spain has a long path ahead of it, but if it continues to improve productivity and progress within the financial sector, then it will see increased economic prosperity.

(January 2013)