Really that bad?

The Pain in Spain
As its economy goes down the drain
BY CHRISTOPHER CALDWELL
April 5 - April 12, 2010, Vol. 15, No. 28
WEEKLY STANDARD

Madrid

A survey taken a few weeks ago found that 60 percent of young people in Spain want to work for the government. You wouldn’t think this was possible. A decade and a half ago, the country’s conservative prime minister, José María Aznar, began to deregulate the system he inherited from the socialist Felipe González and tightened the country’s budget to allow it to join the new European currency. The Spanish economy took off like a rocket, achieving rates of growth that were almost Chinese. Aside from Ireland, no place in the Western world could match it. Unemployment, which had been as high as 25 percent, quickly fell into the mid-single digits. The country’s debt fell just as fast. Aznar does not deserve all the credit. It was González who negotiated the tens of billions of dollars in “structural funds” from the European Union, which were invested wisely in highways, bridges, electrical grids, and high-speed trains. Spain gave the
impression of a country that was not just dynamic but competently managed, no matter what party was in power. Such countries tend to produce young people whose ambitions go a bit further than whiling the days away behind a counter in the ayuntamiento.

But there is something rotten at the heart of the Spanish economy, and has been for quite a while. In the spectacular national elections of 2004, bombs placed by al Qaeda-linked terrorists killed hundreds of Spaniards in and around Atocha station in Madrid, and brought the socialist José Luís Rodríguez Zapatero to power. Zapatero had called for Spain to withdraw from its participation in the U.S.-led Iraq war, and the bombers claimed they had set their bombs in Iraqis’ name. So Zapatero became an accidental prime minister. He pulled out of Iraq immediately, to the delight of the Spanish electorate, which had opposed the war by majorities topping 90 percent. He passed a bunch of social reforms no one had been clamoring for: gay marriage and more liberal laws on abortion and divorce. And rather as Gordon Brown did in Britain, he recklessly allowed the state to grow faster than the economy. But aside from that, he left Aznar’s free market economy
pretty much alone. The economy was almost a distraction for Zapatero. It was not the kind of politics he cared about, and when things began to go desperately wrong for Spain in the fall of 2008, he refused to use the word “crisis,” preferring to describe what was happening as a “deceleration.”

But signs of trouble were proliferating. During Zapatero’s campaign for reelection in early 2008, his economics minister, Pedro Solbes, debated Manuel Pizarro, the economics guru for the main opposition party, now led by Mariano Rajoy. Pizarro warned of certain statistics that showed Spain drifting into crisis. What new factor, he asked Solbes, had led Spain’s current account balance to rise from 4 percent in 2001 to 10 percent in 2007? Why had the price of clothes, and the price of fruit, risen three times as fast in Spain as it had in the rest of Europe? Pizarro raised these questions in the curt, cold manner of the businessman that he was. Solbes was more easygoing and professorial. The big point he wanted to introduce was: Crisis? What crisis? The inflation was due to fluctuations in the price of oil, he explained, and Pizarro’s worries were exaggerated. Solbes disparaged the conservative plan for allowing people to invest their own retirement
funds as “the Pinochet model.” In the phone-in poll after the debate, the consensus was that Solbes had blown Pizarro away, and this was the verdict of Spanish voters, who gave the Socialists and Zapatero another term. It sure does not look that way if you watch the debate now.

Spain is by some measures the country most dangerous to the Western economic system. Unemployment has doubled (to 19 percent) in the past 18 months. Spain is one of the so-called PIIGS (Portugal, Italy, Ireland, Greece, Spain), the European countries running an elevated risk of falling out of the common currency or into sovereign default. Spain is not as bad off as Greece, which was given a credit lifeline at a European Community summit in Brussels last week. But, since Spain’s economy is about four times as large, making up 9 percent of the Eurozone, most of the stopgap solutions that fixed the Greek economy cannot be applied to it. Its problems are like those of the two other countries where a housing bubble fed into a financial crisis that threatened to take down the entire economy. One of them, Ireland, appeared to be in desperate straits a year ago, but has since mustered the will to shrink its government 8 percent. It has slashed benefits, and
cut public employee salaries by 14 percent. As a result, despite going through a period of austerity, it is on track to bring its economy back into balance. Spain’s problems, alas, run deeper. They go back decades. A combination of partisan animosity and unreasonably high expectations of government may make it impossible for the country to right its fiscal ship. In this, Spain has less in common with Ireland than with the second of the two real-estate-boom countries, the United States.

Housing, banks, and government

When GDP in Spain was growing by 6 percent a year, the construction industry was growing by 30 percent a year. At the height of the boom in 2007, construction made up 13 percent of GDP and about 10 percent of employment. As a result, there are now around a million homes in Spain with no one to live in them. There are entire subdivisions in the deserts outside Madrid—including one notorious boondoggle in the town of Seseña with 13,000 housing units—that are standing empty because financing ran out before the infrastructure was quite complete.

Since Spain’s native population was shrinking as all this housing was being built, it might seem obvious now that what was going on was a bubble. But it was less obvious at the time. Several factors were driving the housing boom. First, the market for second homes among Northern Europeans took off. Second, 4.5 million immigrants arrived, mostly from North Africa and Latin America, in the decade after 1999, many of them to work in construction. (In a funny way, they were brought over to build houses for themselves.) They quickly transformed Spain from a zero-immigration country into one in which more than a tenth of residents were foreign-born. Finally, divorce boomed, particularly after the passage of Zapatero’s reforms in the middle of the decade, and this caused the demand for housing to increase by mitosis. Prosperity accelerated the trend. Whereas a young man in his twenties during the dictatorship of Francisco Franco would live in his parents’
house until he married, a “modern” young man in a rich democracy wants—and feels he deserves—a place of his own.

It is in the financing for all this construction that the Spanish crisis differs from the American. Under the circumstances of Spain’s entry into the common European currency, its lending market could not help but overheat. Spain’s interest rates were around 15 percent in the years leading up to its euro membership—and then overnight interest rates fell to levels that were suited to the sluggish economies of Germany and France. These eventually fell into the low single digits, and Spain had negative real interest rates for the whole half-decade after 2002. The banks were paying their customers to borrow money.

That being the case, Spain behaved relatively responsibly. It had neither subprime loans, nor a mortgage market heated to the boiling point by Fannie Mae, nor offshore “special investment vehicles” that permitted banks to take a lot of their mortgage exposure off their books. In fact, it had one of the toughest and most responsible systems in the world for making sure that banks’ loan portfolios were adequately capitalized. Under a system of “dynamic provisioning” introduced in 2000, Spanish banks had to keep reserves of roughly 10 percent of the value of every housing loan they made. That seemed onerous when the default rate of mortgages was 1 percent, as it was 18 months ago, but now that about 7 percent of mortgages are defaulting, it provides a nice cushion.

Unfortunately, it may not be cushion enough. Spain had another problem: the entanglement of its political system with its banking system. This is not just a story of modern interlocking directorates. A system of “cajas” accounts for more than half of Spain’s financial system. There are now about 45 cajas, and they are often compared to savings-and-loans or credit unions, but they are better described as semi-public, semi-private foundations. Cajas date to the 19th century, but there is a tradition of church-based lending organizations that goes back even before that. Cajas pay no dividends but use about 30 percent of their earnings for projects that serve the common good. It is a very noble-sounding enterprise, and that is partly why Spaniards put their money in cajas. They might work as advertised if a church were in charge of them, but Spain’s constitution of 1978 gave the regional governments a voice in how the cajas were run, which, in
effect, made them the policy instrument of whatever political party was in power.

Mostly the cajas were managed responsibly, but, given their link to political parties, they had to keep in mind that loan applicants were often voters, too. What is more, the idea of what constituted the common good broadened. Cajas had traditionally shared their wealth with social programs, health providers, and art institutions. But, for instance, when a plan to build a Warner Brothers theme park outside Madrid—very much desired by the region’s politicians—did not find funding, the Madrid caja took 25 percent of the shares in it. That investment worked. Others didn’t. The government of Castilla/La Mancha—the same one that approved the empty housing in Seseña—prevailed upon the local caja to build an airport in Ciudad Real that nobody needed. The caja went bankrupt. It is the only one to have done so thus far, but another dozen are on the verge. The caja system controls such a huge amount of Spain’s financial activity that they are
unlikely to fail systemically, but they are going to need to be consolidated, and the government reckons that this will cost $120 billion. Moody’s threatened to lower Spain’s sovereign credit ratings if caja mergers don’t push ahead.

One reason local savings banks affect the nation’s credit is that the cajas lend to government, too. The distribution of political power and budgeting authority in Spain is so complex that Spanish political scientists have a hard time understanding it. In simple terms, much budget authority is in the hands of local ayuntamientos (town halls) and autonomias (regions, which have a lot of the prerogatives of states in the early American republic). So about 20 percent of the national debt is not even under the government’s control. The autonomous communities (Catalonia, the Basque Country, Madrid, etc.) will probably be able to make the billions in cuts they need to bring their deficits back down to 3 percent before 2013, as the European Union has urged. But the ayuntamientos, since they are financed mostly by building permits and property taxes, are under water. Very much as in Ireland, when the building boom stops, governments stop with it. One
ayuntamiento, Ochandurí, in Rioja, has debt of $13,000 for every man, woman, and child in the town.

This conflict between central and regional government is what shapes Spanish politics now, and Spanish politics makes budget balance hard to sustain. Zapatero has built his electoral coalition on the loyalties of the autonomous communities, particularly Catalonia, Andalusia, and the Basque country, where distrust of the overarching Spanish state is strong—as is nationalism. He infuriated the conservative Popular party when he described the Spanish state as “a concept that is open for discussion.” The conservatives, in turn, are apt to blame Spain’s present deficits on the alleged waste, fraud, and abuse of autonomous communities and the other minority interests that Zapatero woos. Gays, feminists, Basques, and atheists are no less Spanish than their fellow citizens, conservatives say. But they are not more Spanish either.

It is hard to translate the politics of the autonomous communities into American terms. In some places, such as Andalusia, it resembles U.S. minority politics. State handouts account for a significant proportion of the region’s income—about 25 percent, according to some estimates. Zapatero, who faces critical regional elections there next year, can keep his forces together provided he can offer enough state money. On a trip to Andalusia in mid-March, he did just that.

In Catalonia, however, where his Socialists have scraped together a coalition with nationalist parties of the left, the politics is more like the U.S. politics of states’ rights. A substantial proportion of the Catalans, who make up one-fifth of the population but account for about a third of the country’s economic activity, want more autonomy. They feel the left-wing nationalists who made a coalition with Zapatero have done a poor job of securing it. Catalans have an allergy to the Spanish conservatives that dates from the Civil War of the 1930s and will not vote for them in the next election. They appear likely to restore to power Convergència i Unió, the relatively free-market party of the nationalist right, which is the region’s natural majority.

The politics of labor reform

The toughest nut to crack for Zapatero will be reforming the Spanish labor market, which went wrong in the Franco era (1939-75) and has proved impossible to fix. It will be tough to crack because he doesn’t want to crack it. Spain’s labor market has much to do with the present dangers to Spain’s economy, and no attempt to get Spain out of its fiscal hole will be convincing without a reform of it.

Franco’s corporatist model offered low-wage jobs for life. Spanish workers were keen on the “for life” part of this bargain, less so on the “low wage” part. During the transition to democracy, unions were legalized and added to the mix. While the level of unionization in Spain has never been high, unions are seen as the custodians of the will of the free working class. Any victory by the country’s General Workers’ Union quickly gets translated into policy across the entire labor market.

The benefits and protections would be thought generous even by French or German standards. Unemployment compensation lasts up to two years. It initially pays 70 percent of final salary, which falls over time, but only to about 60 percent, and in the present climate of high joblessness, there is great pressure to extend these benefits. If a worker has a permanent contract, you cannot fire him without cause, unless you are willing to pay 45 days’ worth of salary for every year worked. If you claim to have cause, you need to go to court to prove it—a drawn-out, expensive, and probably futile process during which you still have to pay the worker his salary. The unions consider these arrangements derechos adquiridos (acquired rights), almost a kind of property. Any suggestion that they are negotiable is considered an insult. “It used to be machines were fixed, capital and labor was variable,” one former government economist (a Socialist) told me.
“But now it has changed. A machine you can throw out, a worker you’re stuck with.”

Since this level of worker benefits was hobbling the economy even in the 1980s, a new kind of temporary contract was introduced. The attempt to institute it resulted in a general strike. Spain’s unions called general strikes in 1988, 1992, 1994, and 2004 when labor reforms were proposed, and in each case they threatened to make the country ungovernable.

The idea of temporary contracts was that workers could be hired and fired at will, but after three years of good performance they had to be offered full-time, permanent contracts. What resulted, as anyone but a politician could have predicted, was a strange dual labor market that leaves Spain with both the most pampered and the most exploited workers in Europe. The arrangement has a crippling effect on productivity. Older workers are inefficient because they are too secure. Younger workers, who tend to be much better credentialed than the older ones, can work hard for peanuts and then be put out on the street after two years and 364 days. Career-wise, they tend to spin their wheels for three or six years at just the time of life when people are willing to take risks, move, start companies. Unsurprisingly, no company wants permanent workers. What they want is people who will take low-wage jobs. In practice, the dual labor market has been a recruiting call
for immigrants, and it has encouraged the sort of low-tech work that immigrants do—roofing, dishwashing, landscaping—instead of investment in productivity. During the boom, 85 percent of contracts were temporary, and no more than a tenth were ever converted to permanent contracts. Now the rate of conversion is even lower.

Getting out of this mess will take some political courage. Any serious labor reform will probably, in the short term, drive the unemployment rate upward from the 19 percent where it stands now. Zapatero is an instinctual leftist with a Manichean view of the Spanish Civil War. As such, he fears nothing more than a general strike. General strikes are things that only happen to fascist dictators and other enemies of the working class. It has surely not been lost on Zapatero that Greece has had three of them since it started trying to put its financial house in order this winter. In February, after Zapatero suggested in remarks at the World Economic Forum in Davos that he would favor raising Spain’s retirement age from 65 to 67, the unions went into the streets, and a general strike was the implicit threat.

Over the falls

This makes the probability that the government will tackle Spain’s labor arrangements—at the heart of the problem—very low. It means that piecemeal measures are the order of the day. The government has introduced a Value-Added Tax that conservatives have promised to oppose, it has scrapped its plan to modernize the army, it has announced that it will phase out the mortgage-interest deduction starting next year. It has passed something called the Law on the Sustainable Economy, which will incentivize high-tech start-ups over real estate start-ups, as if a million empty housing units were not incentive enough.

Like many Western governments—like the United States, in fact—Spain has a clear path to recovery provided the economy grows at utterly implausible rates. The secretary of state for the economy now gives presentations to investors in London and Paris professing that Spain is “determined to act” to reduce its deficit. But this is very much like American noises on the deficit: lots of declarations of will and idealism and very little concrete description of how to get there. Olli Rehn, the monetary commissioner of the European Union, has described the Spanish promise to cut the deficit to 3 percent of GDP in 2013 as wishful thinking. Standard & Poor’s lowered its rating of the Bank of Spain’s debt from Group 2 to Group 3 (which includes the United States).

The Spanish debt crisis can be looked at in a lot of different ways. You can see the housing bubble, the labor market, the division of governmental labor between Madrid and the autonomous communities, or the lack of political will as the main cause. There are so many budget-cutting measures you may possibly have to take that a good case can be made for shutting down almost any aspect of the welfare state. The whole kit and kaboodle may be nearing the point of unsustainability. The system of state guarantees and welfare rights that Spain has erected may be the biggest bubble of them all. In that case, the wisest course for a politician may be to stay in the boat, hope you are wrong that you are going over the falls, and wait and see what you really have to do to survive.

Christopher Caldwell is a senior editor at The Weekly Standard and the author of Reflections on the Revolution in Europe.