Spain’s Economic Crisis: Causes, Consequences, and Reforms

Posted on Feb 2, 2025 in Economy

Causes of the Economic Meltdown

Spain experienced higher inflation rates than the Eurozone average due to:

  • Loose monetary conditions (1996-2007)
  • Accommodation of monetary policy
  • Committed countercyclical fiscal policy

These policies led to greater fiscal effort, public sector surpluses, and containment of public expenditure.

Consequences of Joining the Eurozone

  • Liquidity overhang
  • Bubble in the housing market
  • Risk premium plummeted
  • Growth in real interest rates
  • Strong domestic demand
  • Increased imports, widening the trade deficit
  • Deterioration of external price and cost-competitiveness

What Should Spain Have Done?

Spain should have narrowed price and Unit Labor Cost (ULC) differentials and maintained similar growth in productivity and labor costs. This was not a new challenge, as a similar situation occurred between 1986 and 1992, leading to the devaluation of the Peseta.

Golden rule: Adjustment begins at home.

Possible Solutions and Their Consequences

  1. Abandon the Euro: High short-term and long-term costs
  2. Deflate the economy: Reduce ULC
  3. Reduce ULC by cutting social contributions, not wages

Additional measures included increasing VAT and reducing corporate taxes. However, these actions led to a collapse of the labor market and increased unemployment.

Spain’s Major Macroeconomic Imbalances and Weaknesses

Spain entered a recession in mid-2008 and another in 2012. The main problems were:

  • Low domestic savings rates
  • Poor productivity records

Major weaknesses included:

  • External deficit
  • Over-dimensioned and undercapitalized economic sector
  • Need for structural reforms

Proposed Solutions

  • Rebalance the domestic economy
  • Regain competitiveness in exports
  • Improve long-term growth capacity by increasing potential output
  • Reduce the trade deficit by decreasing domestic demand, improving competitiveness and growth
  • Overcome the current credit crunch

Key factors to address are productivity, wage costs, and non-wage costs.

Over-Dimensioned Sectors and Structural Reforms

The Housing Market

Housing prices rose exponentially, leading to a lack of affordability and increased household debt. Factors contributing to this included:

  • Supply side: Absence of alternative productive investment opportunities for entrepreneurs
  • Demand side: Emergence of immigrants, fueled by low interest rates, increased housing prices
  • Absence of attractive speculative investment opportunities for households
  • Extensive use of fiscal rebates for the acquisition of a house as a primary residence

The housing bubble was characterized by an exorbitant increase in prices. The problem in Spain was a supply-driven speculative process where land prices rose and influenced the final value of the house, and vice versa. Land prices were initially low due to plentiful supply. However, an oligopoly of building societies, coupled with a low share of officially protected housing, forced prices up.

The Spanish problem started after the liberalization of the property promoters’ sector. Spanish banks, along with other EU banks, made poor decisions by giving credits to promoting societies, accumulating damaged assets, and becoming saddled with bad debt.

In conclusion, cheap money and fiscal rebates were the driving forces behind the housing sector, driving up prices in the housing market.

The Financial Sector

The financial sector was over-dimensioned, with an excess number of branches in savings banks. Issues at stake before Bankia’s collapse included the quality of assets and lesser access to liquidity. In 2012, the first stress tests for banks were conducted.

Labor Market Reforms

In 2010, Royal Decree-Law 10/2010 was enacted, affecting:

  • Internal flexibility
  • Adjustment of daily working hours to the company’s economic circumstances
  • Special efforts to provide employment for young workers
  • Private placement offices were allowed to operate

The effort was to stimulate hiring by reducing severance pay obligations. The contract to encourage permanent employment was made universal, and all companies became eligible for FOGASA funds, similar to an Austrian-style system.