30 June 2023
I love Spain: the food, wine, sun, landscape, art, architecture, and the unmistakable roar of happy people cascading into the streeets from busy bodegas! Indeed, I just returned from trendy Valencia where the post-Covid atmosphere is bouyant.
The 1992 Maastricht treaty — outlining a path towards the introduction of the Euro in 1999 — required that Spain converge with its wealthier European partners. Of course, considerable progress has been made during the past 30 years. However, the job is far from accomplished. Indeed, powerful structural rigidities — stemming from the Franco years or even the Imperial era — have slowed progress, and left the Spanish economy vulnerable to both global and domestic economic shocks.
To be sure, Spain has considerable untapped economic potential, and reform could lift living standards towards the European average or beyond. In recent decades, Spain’s most successful periods relied on strong political backing for reform, usually involving deeper integration into the European economy. Does the political consensus exist for the changes the next phase of convergence will require? Past achievements benefited from the existence of Spain’s two-party political system. However, if the upcoming elections continue the recent fragmentation of the political landscape, as I expect, pursuing an ambitious reform agenda may become more complicated.
Inflation Convergence: Not Derailed by Covid or Ukraine Shocks
The Chart above illustrates how successfully Spanish inflation converged with the Eurozone average. But, will the external shocks of Covid and Russia’s invasion of Ukraine derail this achievement? To be sure, the Covid recession in Spain was amongst the deepest in Europe. Therefore, despite a strong two-year rebound, the Spanish economy has recouped lost output later than other European neighbours (next Chart). As a result, the Spanish economy still has more spare capacity than other nations, as reflected also in its higher unemployment rate, which will contribute to lower inflation in coming months.
Fortunately, unlike many of its European partners, Spain never became heavily reliant on Russian energy sources (next Chart). As a result, Spain has not been directly vulnerable to cuts in Russian supplies, nor has it had to scramble to find new energy sources. In addition, Spain has Europe’s most developed LNG infrastructure.
Nevertheless, Spain is more reliant on external sources of energy than most other European countries — just not from Russia. As a result, the economic shock — rising inflation and declining GDP — from rising energy prices is potentially large in Spain.
After rising more sharply than elsewhere, Spanish inflation has peaked in recent months (earlier Chart). Indeed, Spain’s CPI growth is now lower than the EU average. In particular, Spain is now benefiting from YOY declines in oil prices (producer prices declined 7% in May), which will be passed through to CPI in coming months. On the other hand, both Spain and the Eurozone still are experiencing double-digit food price increases as a result of the Ukraine war.
Meanwhile, however, Eurozone “core” inflation may prove “sticky” (decline less rapidly than headline prices), reflecting accelerating European wage hikes. Underlying price gains in Spain have been even more stubborn than in the region overall: “core” prices in May rose 5.9% and 5.3% in Spain and the Eurozone respectively.
Putting the pieces together, neither Covid nor Ukraine have derailed Spain’s inflation convergence success. To be sure, the ECB may not deliver 2-2.5% inflation until the end of 2024, but prices increases will moderate further. Indeed, Spain may record lower inflation than the Eurozone in the next couple years, as spare capacity is greater, unemployment higher, and wage gains more modest.
Convergence II: Now the Harder Part
Spain’s success in converging inflation is marvelous, but the ultimate goal is to lift living standards to the average European level or beyond. The Chart above provides several valuable lessons. First of all, Spain has made considerable progress in reducing the per capita GDP (GDPPC) gap with its neighbours since joining the European Union in 1986. Indeed, the gap relative to the EU was completely eliminated by 2005. In addition, improvements have been greatest during periods of reform. Indeed, the 1960’s reforms began lifting living standards sharply even before Franco’s death.
However, the process has experienced significant setbacks. The political volatility during early transition to democracy widened the gap between 1975-85. And, reflecting Spain’s social and institutional rigidities, the economy underperforms following macro shocks, e.g., the Global Financial and Euro Crises 2007-13, and the recent Covid/Ukraine shocks. Spanish GDP per capita remains roughly 15% below the European average. Resuming GDPPC convergence will be most likely if the election produces a stable, reform-oriented , pro-EU government. Vamos!!
Productivity: The Path to Prosperity
The path to higher living standards is achieved by lifting productivity. Spain’s lower per capita income reflects output per hour levels 15% and 25% lower than in the Eurozone and USA respectively. Likewise, the Chart above illustrates Spain’s efficiency improvements lagged the G7 even during the successful decades following EU membership. As in other advanced economies, Spain’s productivity growth has slowed sharply since the GFC. Addressing this issue is especially important, as the OECD suggests Spain is especially vulnerable to automation and AI.
To be sure, a comprehensive assessment of the sources of Spain’s subpar productivity is beyond the scope of this blog. But, a couple of initial observations. First of all, R&D investment is significantly lower than the EU average and the USA (Chart above). Likewise, while Spain’s educational system has many fine attributes, the number of students not finishing formal education is disproportionately high, especially among young boys (next Chart). In addition, the share of students involved in vocational training lags well behind other EU partners. Productivity is also hampered by the preponderance of small firms, which cannot achieve economies of scale. Enterprises with less than 10 employees account for 90% of businesses — the highest in Europe.
Labour Markets: Women and Immigrants Can Play a Big Role
Rigid labour market arrangements contribute to chronically high unemployment in Spain (currently 13% versus EU 6.5%), limit its long-term GDP growth potential, impede the convergence of living standards with the Eurozone, and contribute to inequality. Much progress is being made, but there’s lots more to do.
High costs and regulation regarding the hiring and firing of workers limit labour demand. As an example, Spain’s “wage gap” — the difference between after-tax compensation and the total cost of employment — is well above the OECD average (Chart above). The primary cause is the very large contributions employers are required to make to towards workers’ social security benefits. As a result, temporary employment in Spain is Europe’s highest: contributing to job insecurity, low pay, and income inquality.
On the supply side, long-term GDP growth will be constrained by Spain’s negligible population gains — rising only 1% during the past decade. Complicating matters further, Spain’s labour force participation rate has been declining, especially amongst men where the greatest mismatch between skills needed and sought is greatest (Chart above). High housing cost and unavailability of rental options have been a disincentive to relocate to pursue new job opportunities.
Fortunately, relief is at hand. The participation of women in the labour force has risen sharply (although it appears to have peaked following the GFC/Euro Crises), which is now in line with the OECD average (Chart above). This can rise further, as Germany and the Scandinavian countries have much higher female participation rates.
Likewise, immigration has a valuable role to play. Indeed, as Spain’s “native born” population peaked in 2020, “foreign born” immigrants have accounted for all the population growth in recent years. Numerically, Spain welcomes more immigrants than any EU countries other than Germany. New-arrivals totaled 530,000 in 2021, compared to 336K and 318K in France and Italy respectively. Before the pandemic, 750,000 arrived in 2019.
As in other countries, immigration has become a hot-button political issue. However, given Spain’s size, the inflow is by no means the largest in Europe, although it’s much greater than in other Mediteranean countries (Chart above). Likewise, the following Chart indicates immigrants’ share of Spain’s total population is in the middle of the European pack, although France, Italy, Portugal, and Greece are less welcoming. Most of Spain’s newcomers are from non-EU countries (77% of the total, the highest in Europe), suggesting these workers will compete for low skilled jobs.
Fiscal Challenges: Growth Headwind Ahead
As in other countries, Covid support has taken a toll on Spain’s government finances. To be sure, the old European fiscal rules are out the window. The medium-term goal, however, will be to stabilise (or reduce) public sector debt (now at 105% of GDP). I estimate this will require about 2% of belt-tightening over the next few years.
How can Spain reduce its deficit while still pursuing the reforms needed to lift living standards towards European levels? While Spain’s tax revenues (as a percent of GDP) are higher than the USA and UK, they are lower than most European nations. Taxes may rise, but the composition can surely change. Employer social security contributions should decline. Meanwhile, higher income and wealth taxes amongst the affluent would make the system more progressive, and reduce income inequality, which is amongst Europe’s most skewed (Chart above). Higher carbon taxes, which are low compared to other EU nations, will help achieve climate goals.
Spain’s fiscal problems are not unlike the rest of Europe. What is different is that Spain’s population is aging more quickly than elsewhere, with the associated fiscal, labour market, and social challenges (Chart above).
Climate Change: Challenges Ahead, but a Good Start
The new government will also confront the challenge of reducing carbon emissions. Spain is off to a good start, as the share of electricity generated by renewable sources exceeds the European average, and is well above that of many competitors (Chart above). A successful climate strategy will create new, high-paying jobs, and will contribute to the convergence of living standards relative to the European Union.