Despite having a public debt-to-GDP ratio that is lower not only than Italy’s but also than that of France, Germany, and the UK, and despite having a new government committed to fiscal consolidation, Spain is still in trouble. It faces difficulties obtaining credit in international financial markets. Aside from the unresolved restructuring of its banking sector, this situation has arisen mainly as a result of a lack of competitiveness and low expected economic growth.
Indeed, in response to Standard and Poor’s recent threat to further downgrade Spain’s sovereign rating if the country doesn't move quickly on implementing its labour-reform plans, Prime Minister Mariano Rajoy declared earlier this week that his government “knows perfectly well what it needs to do to improve Spain's reputation, stimulate growth and create jobs".
At the root of these problems lies an extremely dysfunctional labour market that has performed very poorly in every slump since the 1980s. Moreover, during the Great Recession, Spain has suffered the highest employment losses per point of GDP in the OECD, while its unemployment rate has rocketed from 8% to 21.5%, and is still on the rise.
Why so costly?
Spanish labour-market institutions appear to be those of a typical continental European country, but there are important differences.
First, Spain has the most extreme case of what economists call a ‘dual labour market’ – in which temporary workers have few rights and are easy to fire, while incumbent workers are on permanent contracts and the cost of dismissal is prohibitively high. In Spain, temporary jobs represent on average one third of employees. The use of temporary contracts with low firing costs was eased in 1984, while the very high firing costs of permanent contracts were kept unchanged. Since then, there has been a long sequence of ineffectual attempts at reform.
Second, collective bargaining – stemming from the industrial relations system under the Franco regime – mostly takes place at the industry or province level and collective agreements have the status of a law, affecting all workers and firms in the relevant area. This leaves little scope for firms, especially small- and medium-sized ones, to adjust wages and labour conditions to their productivity levels or accommodate adverse shocks.
Wages and other working conditions of employees under permanent contracts are covered by collective bargaining agreements that protect them against inflation and adverse negative shocks. By contrast, workers with temporary contracts – a group in which young people, women, and low-skilled workers are overrepresented – suffer the burden of adjustment. Out of the 1.6 million employees to have lost their jobs since mid-2007, 1.4 million had temporary contracts. Also, large and high-productivity firms are less constrained by these regulations, since firm-level bargaining is easier for them and their wage levels are often above the minimums set at the industry level. At the same time, they can use the latter to reduce competition from smaller and low-productivity firms, which find those minimums much more binding.
Why so hard to eliminate?
In standard insider-outsider models (eg Blanchard and Summers 1988), the outsiders are the unemployed. In two-tier labour markets, temporary workers are outsiders too. They have little employment protection and therefore suffer very high turnover (in Spain, on average fewer than 6% of these contracts are converted to permanent). As a result, temporary workers usually have a weak attachment to the firm and so their interests are often neglected by worker representatives. The interaction between collective-bargaining regulations and employment-protection legislation thus affords labour unions and employer associations powerful instruments to reinforce the insider-outsider divide. Indeed, insiders were able to raise their wages in the 1990s recession without jeopardising their jobs, since temporary workers were a buffer against shocks (Bentolila and Dolado 1994). The same has happened during the Great Recession: massive employment loses, having fallen mostly on temporary workers, have not triggered significant wage moderation. In other words, insiders have been little exposed to the risk of job loss.
Labour reforms are more likely to happen the higher that exposure is (Saint-Paul 1996) and the larger the share of outsiders in the labour force is. Figure 1, from a recent paper of ours (Bentolila et al 2011), plots two indices of the share of outsiders in the Spanish labour force. It shows that the most important reforms, in 1994 and 1997, took place at a time when outsiders, measured as the sum of temporary and unemployed workers, outnumbered insiders. Subsequently, as unemployment fell and permanent contracts increased – due to the lengthy 1997–2007 expansion – the share of outsiders fell clearly below 50%, which is consistent with the absence of major reforms over that period.
Figure 1. Indicators of political viability of labour reform (share of employees plus unemployed)
Among employees with permanent contracts, most have the old ordinary contract –with severance pay of 45 days' wages per year of service – while others have the employment-promotion contract introduced in 1997 – with 33 days. Since the latter have much higher turnover rates than the former, it is unclear whether they really view themselves as insiders. If not, Figure 1 shows that in the recession outsiders get close to being the majority, while strictly speaking remaining below it.
So why did the previous Socialist government undertake labour reforms over 2010–11? After the Greek bailout and the creation of the European Financial Stability Facility, the risk premium on Spanish ten-year bonds escalated sharply, reaching 217 basis points in mid-June 2010. Forced by financial markets, the government reluctantly approved a reform that followed the traditional piecemeal strategy (Bertola 2010 argues that high public debt can trigger labour reform).
The core of the two key institutions sustaining the insider-outsider divide, namely dual employment protection legislation and the regulation of collective bargaining, was nevertheless left in place. Also, part of the reform, like subsidies for reduced hours (as opposed to dismissals), was meant to benefit insiders. Moreover, the outgoing government took measures undoing limitations on the chaining of temporary contracts and raising the probability that workers will challenge dismissals in court. Unsurprisingly, the reforms were ineffectual.
The new, right-of-centre government has announced that labour reform is high on its agenda. Will it succeed? Academics generally agree that it is high time to abandon the marginal-reform strategy. On the one hand, small reductions in severance pay for some permanent contracts still leave a too-high firing-cost gap with temporary contracts. On the other, severely penalising the use of temporary contracts while keeping the current employment protection legislation for permanent contracts would simply prevent job creation in the subsequent recovery and make the labour-market uniformly much more rigid.
A more radical approach is therefore needed to reduce the firing-cost gap and achieve a better balance between flexibility and social protection. Its main goal should be to eliminate the detrimental effects of the excessive churning of temporary workers on job stability, training, and future career prospects. A sound policy proposal is to introduce a single open-ended contract for new hires, while abolishing temporary contracts – except for the replacement of workers on maternity or sickness leave. The single open-ended contract has no pre-set duration and its severance pay smoothly increases with seniority. This is justified because the longer a worker stays in a given firm, the larger his or her loss of specific human capital and psychological costs from dismissal.
By contrast with the dual employment protection legislation, the open-ended contract removes the discontinuity in marginal expected severance pay faced by employers when deciding whether to upgrade expiring temporary contracts to permanent. A gradual increase in severance pay dramatically reduces incentives for excess turnover and encourages job creation and longer tenures. Moreover, it need not harm employers, since the cost of uncertainty about the quality of job matches is reduced. Similar proposals have been made for France and Italy (Bentolila et al 2010).
The single open-ended contract would not be the cure-all for Spanish unemployment, however. Reform of collective bargaining regulations should aim at bringing wage changes more in line with productivity changes. This requires giving more scope for firm-level bargaining and limiting wage indexation. The 2010–11 reforms eased the opting-out from industry agreements and established firm-level agreements as the default. But, by giving labour unions and employers' associations effective veto power over these changes, which has indeed been used in the new agreements signed since June 2011, it is unlikely that it will significantly reduce the negative consequences of sector level collective bargaining.
Introducing the single open-ended contract and making opting out of industry-wide agreements truly operational would sharply reduce the insider-outsider divide, which would bring about higher job creation, much-needed productivity gains and lower earnings inequality. These measures should be complemented by others aimed at reducing long-term unemployment, such as improving active labour-market policies, through a proper evaluation of their effects with financial consequences for the agents undertaking them, mostly absent so far.
The Spanish economy is in a dire situation. External financial conditions are very unfavourable, making reductions in private and public indebtedness urgent and tying fiscal policy. Since a domestic monetary policy is not available, supply policies should dominate the policy agenda.
Two further ideas should guide labour-market reform. The first is that reducing the insider-outsider divide and lowering barriers to product-market competition would raise job creation and productivity growth, thereby increasing fiscal revenues and easing the fiscal constraint. The second is the need to be aware of reform fatigue. There have been far too many unsuccessful labour-market reforms. The new reform will be implemented in the midst of an intense fiscal retrenchment and with public opinion being highly critical of the management of the crisis so far. The reform should therefore have clear goals, be properly communicated to the public, and be perceived as equitable. The task is not easy but its time has come.
Bentolila, Samuel and Juan J Dolado (1994), "Labour Flexibility and Wages: Lessons from Spain", Economic Policy 18:53-99.
Bentolila, Samuel, Juan J Dolado, and Juan F Jimeno (2011), "Reforming an Insider-Outsider Labor Market: The Spanish Experience", CEPR Discussion Paper No. 8691.
Bentolila, Samuel, Tito Boeri, and Pierre Cahuc (2010), "Ending the scourge of dual labour markets in Europe", VoxEU.org, 12 July.
Bertola (2010), "Europe Fiscal Policy and Labor Markets at Times of Public Debt", Nordic Economic Policy Review, 1/2010:111-147.
Blanchard, O and L Summers (1986), “Hysteresis and the European Unemployment Problem”, NBER Macroeconomics Annual, vol. 1, Cambridge, MA: MIT Press, , 15- 77.
Saint-Paul, Gilles (1996), "Exploring the Political Economy of Labour Market Institutions", Economic Policy,11:265-300.