Wage depression – December 21th will mark the second anniversary of the election of Mariano Rajoy as Spain’s Prime Minister after the parliamentary elections that saw the conservative PP sweeping into power. Half way through its four year term, it is a good time to assess the government economic policies.
In late 2011 the Spanish economy was deep in economic recession and facing serious macroeconomic imbalances. Two years later, things are not much better: economic growth has been negative, 2013 will still end with a negative growth of around -1.7%, while forecasts for the following years are lukewarm. Public debt has continued to grow and will reach 100% of GDP, while private debt remains still at 195%. External imbalances have improved, particularly the current account deficit, which peaked at about 12% of GDP and is now balanced, thanks to a robust growth of exports, coupled with falling imports and a very good tourism season.
Why wage depression does not help competitiveness
From the beginning the government’s main objective was to regain competitiveness lost during the boom years in order to export the way out of the crisis. To do this, absent the possibility of nominal exchange rate devaluation, the government sought full internal deflation – no matter how painful. Labor market reforms enacted in 2012 went much further than previous ones and essentially eschewed labour relations in favour of employers, weakened collective bargaining and allowed a free hand to fire and lower salaries. As one could have expected for an economy in recession, the main effect of easing dismissals was massive dismissals: over one million jobs have been lost in the last two years. The unemployment rate has increased from 22.8% in 2011 to 25.9%, temporary contracts remain at 24% of all contracts but now the large majority of new hires are under temporary contracts – over 90% in November. In one aspect the labour reform has been effective: real wages have fallen between 5 %and 10% in the last 2 years.
The main flaw with this strategy is that it missed the point about the causes behind competitiveness losses. It was argued that the problem was high growth of wages fueled by trade union’s demands in a rigid labor market. In fact, real unit labor costs have been falling in Spain since 1986 as a report from the State Centro Económico y Social  showed earlier in the year, with only short periods in which they increased, such as 2007-2009. Overall, workers remunerations as a share of GDP have dropped by 3 percent since 2000, an amount mostly transferred to profit margins. Thus the real problem lies elsewhere: Spanish prices grew faster than those in the rest of the Euroarea by about 1.5% on average. This was not caused by high salaries but by low labour productivity and high profit margins. So although real salaries did not grow, because of higher inflation nominal labor costs increased faster in Spain than in the rest of the Euroarea.
Yet, the effect on competitiveness was not so clear-cut. Spain’s share of world exports in industrial products did not fall despite the apparent loss in competitiveness during the boom years, whereas other countries like France or US lost close to 20% and 30% of market share during the decade up to 2009. So it does not look like the loss of competitiveness greatly affected Spain’s exports performance. This is probably due to the dual structure of the Spanish economy, with a small number of very large and competitive multinationals that are world leaders in their sectors (infrastructure, renewable energy, construction, biotechnology) and the bulk of SMEs focusing on the domestic market and very little attention to exports.
Elasticity of consumption to salary levels is much higher than elasticity of exports to labor costs. Thus deep and sustained falls in real salaries in Spain have depressed domestic consumption, which has been falling consistently every quarter for the last 2 years, far outweighing the competitive gains obtained from the external sector. Exports represent around 22% of GDP, about half the weight of household consumption, so for every percentage point that consumption falls exports need to grow several times larger in order to sustain output. This is not realistic.
Moreover, most exported products incorporate imported inputs, so that growth of exports also pushes imports up, reducing the contribution of the external sector to GDP. Furthermore, salary repression as a way to grow exports is an imperfect channel. Given Spain’s chronic lack of competition labour cost reductions are often not passed-through to final export prices. In reality, most firms are using lower wages to reduce their high debt levels – not to lower prices. So ultimately the much needed private deleveraging is taking place on the back of workers purchasing power.
In this context, leaving aside equity considerations which are not insignificant, it is hard to see how growth can pick up with falling domestic demand. But is even harder to imagine how consumption can recover with unemployment rates above 25%, almost all new hires on precarious contracts, higher taxes and a general depression of salaries.
What are the alternatives to wage depression?
Alternative policies to internal devaluation do exist. They involve some adjustment to the labour market reforms in order to restore collective bargaining, getting credit flowing back to SMEs and households and designing and implementing a robust industrial policy in order to revert the decline of industry as a share of GDP that has occurred since 2000. The latter should involve increasing expenditure on R&D and innovation, which have been slashed by the government leaving Spain with the lowest R&D investment in the EU, liberalization of closed sectors that are sheltered from competition and thus keep pushing prices up and negotiation of a grand bargain between the government, unions and employers to moderate wages, alongside prices and profit margins, so that the country can improve competitiveness while not repressing domestic demand.
Above all, the key to improve the situation lies in investing massively in education and active labour market policies to retrain and enhance the skills of the millions of workers, especially young ones, left with no jobs and no education by the burst of the construction bubble. In the same way that in the 1990s Spain made huge strides in upgrading its physical infrastructure resulting in one of the world’s best, today all efforts must focus on improving the country’s human capital, which should constitute the backbone of a new productive economic model based on innovation, technology and high-value sectors.
 ¨Informe: Distribución de la Renta en España: desigualdad, cambios estructurales y ciclos¨. Centro Económico y Social. 03/2013.