Effects of the Economic Recession on Spain

The main focus of this project is to examine the causes of the current economic recession and the effect it has had in Spain, It will also look at the background of the current recession, its impact and describe how the recession has hit different sectors. The final part of the project will look into the future of the economy and the road to recovery.

Spain has the fifth largest economy in the European Union (E.U), [1] and for many years its economy has been booming, but now the recession has hit hard. As other countries in the E.U climbed out of the recession in the third quarter of 2009, the Spanish economy consecutively decreased from the second quarter of 2008. [2] Although the German, Italian and British Economy have performed worse, it is Spain that is feeling the pain the most.

Spain’s accession to the EU in 1986 forced it to match the economy to trade and investment, as well as improving its infrastructure and revising economic legislation to conform to the guidelines of the EU. Due to these measures the country grew rapidly over the next 20 years and unemployment reached a low of 8% in mid 2007. [3] 

As the European central bank (ECB) cut its benchmark rate to less than 3% the cost of home loans fell dramatically in 1998. More Spanish women began entering the workforce and the Euro brought financial stability and foreign investment increased creating financial stability.

The adoption of the Euro in 2002 led to increased financial stability and helped reduced the interest rates which in turn prompted the housing boom and consequently stimulated even more growth. However eventually the housing boom ended in 2007, construction declined and sales of houses fell dramatically as the international financial crisis led to the recession. [4] 

According to economist Dominic Bryant Spain is facing its worst recession since 1959. This economic crisis is very unusual one in terms of what we have become accustomed to in developed economies in modern times.

2. When did the recession start?

According to The National Bureau of Economic Research (NBER) “A recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in production, employment, real income, and other indicators. A recession begins when the economy reaches a peak of activity and ends when the economy reaches its trough.” NBER states the U.S entered recession in December 2007. [5] 

It can be argued than on any reasonable measure Spain’s recession started earlier than the second quarter of 2008, however for historical record purposes the 1st July 2008 will go down as the date the Spanish economy entered the current recession. [6] But from an economic analysis purpose it should be considered that the business cycle very clearly turned, and went past its peak not in the summer of 2008, but in the third quarter of 2007 as this is when employment reached its peak. [7] 

Graph 1 shows two breaks in the data, the first in the middle of 2006 which represents the housing slowdown, which was provoked by the raising of interest rates at the European Central Bank (EBC) along with the rising cost of mortgages. The second break is comes in during the second half of 2007 caused by the closing of the wholesale money markets to Spanish financial products. This is when the long boom in the economy reached its peak and the recession got underway.

Graph 1 [8] 

3. What caused it?

There is a central debate about the origins and the cause of the world economic crisis, but the origins of the Spanish financial crisis are many and complex.

The problem stemmed from deregulation of real estate mortgages in the US. The US mortgage backed securities which had risks that were hard to access were sold around the world.

The emergence of sub-prime loan losses in 2007 were the catalyst for starting the financial crisis and it was made worse by rising oil and food prices. A big panic broke out within the inter bank loan market, as loan losses were building up and the global financial services firm Lehman Brothers collapsed. Many well established investment and commercial banks in the USA and Europe faced bankruptcy and public financial assistance was needed as a result of declining share and housing prices. [9] 

The 12 month euribor interest rates rose considerably and were also an underlying factor but the main reason for Spain now having over a million vacant properties waiting to be sold is because the Spanish banks have been unable to raise enough money to provide the mortgages needed to enable people to buy them. Or in other words the banks were unable to raise the money at prices which made the mortgage business profitable for them. [10] 

Spain’s “two- tier” job market can be partly to blame. Permanent workers that are very costly to fire make up the top tier which has two thirds of the workforce. But if companies cannot easily get rid of their workers, they will be less likely to hire them at all, and this will consequently lead to higher unemployment.

In the mid 1990’s Spain allowed the spread of temporary contracts for newer recruits which gave the economy more flexibility and created jobs. However it also moved the country towards the more unskilled type of jobs, where productivity is slightly lower. Because the top tier workers are too expensive to fire, most of the job losses in Spain are those of temporary workers (usually the young and migrant). [11] 

In a nutshell the roots of the Spanish financial crisis are unquestionably very complicated, however there is an underlying factor in the present dynamic which more or less dictates everything else: The dependence on external financing. Because of the continuing account deficit and the difficulties banks have had in raising these external finances since the financial turmoil began in August 2007 as a result of the subprime crisis in the US.

What has been worse affected?

The Spanish economy is very much based on and around the property market and tourism which have been very badly affected by the Spanish financial crisis. According to Professor Juan Jose Toribio from IESE Madrid business School “Unemployment is the greatest problem for the Spanish economy”. [12] 

Spain’s jobless total increased for the fourth consecutive month in November 2009 and will continue rising as the recession continues. [13] 

Data showed the jobless rate in the service industry rose 1.7 % month-on-month and by 1.3 % in construction. Joblessness also increased by 0.6 % in the industrial sector and by 2.6 % in agriculture.

Working class families have already had to pay the price for Spain’s crisis and many of these families are left without means of support because their entitlement to unemployment pay has expired. As a consequence 180,000 houses were reprocessed in 2008. There are also record numbers of youth unemployment.

The construction boom of previous years is evidently the key to the countries success, more houses were built in Spain in 2008 than the UK, France and German put together. This was sustained by higher property prices in northern Europe and foreign investment. The collapse of the construction industry has had a very big effect not just on construction workers but also on those who rely on it such as plumbers, electricians and estate agents. [14] 

Zapartero’s government injected around €8 billion (which is almost 1% of GDP) into the economy this year in order to create more than 400,000 low skilled jobs in order to temporarily patch up the hole left by the housing sector.

Banks that had been supporting the construction companies had to agree to swap bad debt for properties which has caused banks to reduce prices even further by up to 30% in one go. [15] 

In September 2009 there were 1.67 million properties available on the Spanish property market, there were also 372,000 properties still under construction and not yet for sale. Despite this there are also 1.1 million which have received planning permission. Under Spanish law a property which has received planning permission must be completed within two years otherwise there will be problems for the construction companies involved. [16] 

The effect of this would be a significant increase in Spanish unemployment, and yet more pressure on the Spanish authorities and Spanish national debt. The more construction companies which feel the financial pressure of the recession, the more pressure Spanish banks will feel and the more bad debts will emerge, as the banks feel the pressure the more bad debts will emerge.

The Prime Minister José Luis Rodríguez Zapatero has admitted that the housing boom was a bad idea because 90,000 of the newly unemployed are unskilled construction workers who may have lost their jobs forever.

5. The Spanish Banking system

The head of the International monetary fund (IMF) Dominique Strauss-Khan joined forces in an attempt to help ease the problems in the eurozone, he supports Zapatero and the Spanish governments’ labour reforms. However although Spanish employees have dismissed the efforts as half-hearted, Zapaterro has said the changes would help lead to long term economic growth.

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A problem that still remains unresolved in the eurozone is the lack of access for Spanish and other banks to the wholesale money market. As a result it has left them heavily dependent for liquidity on the European central bank (EBC). The German chancellor Angela Merkle also supports Spain’s economic reforms and austerity measures whilst Zapatero insures all the measures taken by his government had been designed to reinforce confidence back into the country.

With the 20% unemployment rate and the bad property loans of the savings bank it is clear that the Spanish lenders have had funding difficulties, yet despite many warnings from central banks Zapatero delayed his actions. It took a bank liquidity and sovereign debt crisis to stimulate him into action and so far the pressure had forced him to tale his plans to transform the labour market. Coming clear about the bank especially the cajas (savings bank)

There is concern that because Spain has a very weak banking system and a government with weak finance, it means the government has limited resources to rescue its banks and in turn this will increase the chances Spain will be forced to borrow emergency funds from the newly established European stabilisation fund.

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Why has Spain been hit worse in comparison to other countries?

The current recession has had a major effect around the world.

Countries with falling housing markets, notably the UK, Ireland and Spain, are expected to suffer more than others. [17] 

But Spain’s problem is special. It would have happened one day or another, global crisis or no global crisis.

Although France is also part of the Eurozone and the same monetary policies apply, it has not had the housing and debt problems that Spain has. This is because the Bank of France had regulated the situation in a better way, and the French political system was not so dependent for financing on building permits.

If the supply of land for building was regulated then the prices could have been pumped up whilst keeping it systematically below demand. However in Spain’s situation people inevitably got greedy and things got out of hand. [18] 

Because Spain had entered the recession in an already weakened state due to the previous housing and construction boom which ended in 2007 it will take longer to recover than other European countries.

The rest of the E.U and the Spanish Government

As economics inevitably turns into politics, the leader of the Partido Socialista Obrero España (PSOE) Jose Luis Rodriguez Zapatero, faces opposition from the Partido Popular party (PP).

Zapatero came under scrutiny when he failed to come to terms of the scale of Spain’s problems, but despite this he is confident he can steer the country out of the recession and into growth. Zapatero has recently taken measures to help the recession by unveiling a “sustainability economy” law and other measures. [19] 

1* sustainable economy law

The new law is based on the saving of energy, the promotion of renewable energy, quality education, reform of the financial system, investment in research and development in both the public and private sectors, and in the area of town planning. The legislation also intends to get rid of red tape in company administration, to help with the creation of more industry, improve competiveness and create a greater equality between the sexes. The new law respects and protects the rights of workers. [20] However it can be criticised for not including structural reforms, including changes to the labour market, and any successes would take time.

2* stress tests

The governor of the Bank of Spain, Miguel Fernández Ordóñez said that the “Stress tests” will be carried out to verify commercial banks, savings banks and co-operative lenders have enough capital available to support even difficult growth situations. The results will be made public and they will show: estimated loan losses, consequent capital requirements and contribution of balance sheet reinforcements so that the markets have a perfect understanding of the circumstances of the Spanish banking system. [21] 

3* Labour reform

Spain’s parliament has ratified labour reforms designed to bring down high unemployment.

The measures include promoting youth employment and cutting the cost of firing workers, however this may have a negative effect as employers would be more reluctant to hire more staff.

4* €15 austerity package

Zapatero’s Socialist government won approval for a 15 billion austerity package in order to accelerate the reduction of the deficit. The party won by just one vote but the Partidio popular voted against the bill, saying they didn’t want Spain to be plunged into a Greek style crisis. The program is intended to reduce the deficit of 11.2% GDP in 2009 to below 3% in 2013. A series of measures have been implemented to reduce the large deficit: to cut staff costs by 2,400 million, remove the retroactivity of the Law Unit, the check-baby and reduce public investment by another 6,000 million.

If the bill had been be defeated, the government’s plans to get its budget deficit under control would have been thrown into disarray, potentially dismaying credit markets by raising concerns the eurozone’s fourth largest economy was fiscally unsustainable. [22] 

It is not only Spain that is en economic difficulty other European countries such as Portugal, Italy, Ireland, and Greece, collectively known as PIIGS are also having major problems.

Portugal’s economy is ranked 17th in the E.U, it has a level of indebtedness of 84.6% of GDP and unemployment stands at 10.4%

Italy is the largest of the PIIGS, having the fourth-largest economy in the EU. The Italian economy shrunk by 4.8% in 2009, Italy has 58.1 million residents and 7.5% unemployment.

Ireland for years, its economy 15th in size in the EU — would surprise to the upside, but that ride ended in 2008. In 2009, the economy shrank by 7.5%. The Irish government has a rate of indebtedness at 82.9% of GDP, but it has to be noted that the debt burden has tripled in the past three years from 25.4%. The small population of 4.4 million is suffering a very high unemployment rate of 13.3%

Greece is the most talked about the economy it is 13th in the EU by size, but debt to GDP is among the highest at 125. [23] 

Solutions to the Spanish crisis

In order to improve the current economic situation the government should carry out measures to put the country back on the path of recovery. Spain needs a solution which has two simultaneous components:

1) Immediate measures

2) A series of structural reforms

As well as the 15 million austerity package the government has enforced there are other effective measures that could be enforced to help the country.

1) The establishment of a new type of Toledo Pact which would include unions, employers and the two main Spanish political parties, to make a realistic plan to carry out an internal devaluation of 20% over three years. However in order for this to work a consensus between the parties is essential.

2) Another solution could be the development by the industry ministry of a completely new national plan to identify areas of potential growth in economic activity (with a strong unskilled labour component), to transfer land from the land agency for possible industrial or other alternative uses, and to create incentives to attract foreign investors in productive activities highlighting the new cost advantages of doing business in Spain.

3) A “Ley de Hipotecas” (mortgage law) to carry out a revaluation of the outstanding mortgage debt in line with the new level of property prices. If this is not done, domestic demand will never recover, and immigrants with mortgages and young people will have no alternative but to simply hand their properties back to the banks and leave.

4) Buy out and close down the bankrupt builders as part of a general restructuring program such as the one which was developed for the shipyards and the mines during the 1960s.

5) Establish a program to help immigrants in difficult circumstances, and offer training to them to prepare for the future.

6) Restructure all existing mortgage contracts which will involve everyone paying more in order to put mortgage financing back on track. This will require legislative intervention, and will equally involve breaking the direct tie with one year euribor.

7) Unemployment could greatly postpone Spain’s recovery from the recession and could do some serious economic damage. A solution for Spain is to raise aggregate demand. Aggregate demand is the total demand for final goods and services in the economy. If the government can somehow raise the aggregate demand, then we will see a consequent raise in aggregate supply. This means a greater need for output and companies will undoubtedly need more workers. That is why you can also see in the graph that demand for labour will increase.

9. How long will the recession last?

It is difficult to say when Spain will regain economic stability, even optimists expect real recovery to come only in 2011. The German secretary of state Ulrich Wilhelm, argues that:

“The key to correcting imbalances in the eurozone and restoring fiscal stability lies in raising the competitiveness of Europe as a whole. The more countries with current account deficits are able to increase their competitiveness, the easier they will find it to decrease their public and foreign trade deficits. A less stability-oriented policy in Germany would damage the eurozone as a whole.”

Ben May, an economist at Capital Economics in London, said: “Spain will need to tighten fiscal policy considerably to make large inroads into its huge budget deficit” as a “strong and sustained recovery remains a long way off. “Events in Greece, mountains of private sector debt and troubles in the banking sector all suggest that any upturn could prove short lived,” he added.

Spain eased out of recession with 0.1 percent growth in first quarter of 2010 according to the government’s statistics office. But the country is on the verge of a double dip recession, given although the country has barley come out of recession.

Spain’s national debt is so burdensome that they are now caught in a debt spiral where anything they do will harm the economy.  If they cut government expenditures in an effort to get debt under control it will devastate economic growth and crush badly needed tax revenues.  But if the Spanish government keeps borrowing money their credit rating will continue to decline and they will almost certainly default.  The truth is that the Spanish government is caught in a “no win” situation.

The IMF is projecting that the Spanish economy is going nowhere fast.  The IMF says there will be no positive GDP growth in Spain until 2011, at which point it will still be below one percent.  As bleak as that forecast is, many analysts believe that it is too optimistic considering the fact that Spain’s economy declined by about 3.6 percent in 2009 and things are rapidly getting worse.

Conclusion

Due to the complexity and ever changing nature of the economy it is difficult to come to a final conclusion but with the information I have gained through research I have concluded at June 2010.

It has become evident throughout my research that Spain’s role has been on the defensive and the government has mostly taken reactive as opposed to proactive measures on events they did not expect to happen.

Whilst most countries in Europe are have started showing signs of recovery, Spain shows signs of little or no recovery.

The politics of the situation plays the greatest role in deciding the fate of Spain’s recovery. The popularity of the Prime Minister Zapatero has decreased throughout the recession due to a slow reaction to respond to country’s evolving crisis. Pension reform plans and wage cuts are also highly unpopular with the Spanish people. Although a national election is not due until 2012, any request for a bail-out by Spain would be extremely controversial, and could potentially bring down the government.

Zapatero’s ability to maintain his reforms are yet to be tested but he proclaims full confidence in the strength and solvency of Spain.

The high unemployment that the crisis has generated has hit the deepest corners of society. It is the unemployment that is slowing Spain’s recovery, and recovery can only take place when jobs are created.

Housing and construction Spain needs to find a way to build a competitive workforce with valuable skills. It was evident from the housing crash that Spain was over reliant on the construction industry, as it had very little to fall back on in terms of creating jobs.

The short and medium term outlook is bleak, as most economists predict a very slow growth. Spain faces big economic challenges ahead but Zapatero’s government should focus its strategy on social protection and to reform the growth model to focus more on innovative sectors like renewable energies and biotechnology.

Public sector deficit

Double dip Spain faces another problem