To market, to market

A fat pig awaits, if only the Socialists will do to the economy what the PP did not

IN MANY respects Mr Zapatero and his team appear to have inherited an economy working so well that they can only enjoy it, or destroy it. In truth, they have a great opportunity to improve it. In doing so they could show that they are not doctrinaire socialists wedded to the sort of Franco-German welfarism that Mr Aznar claimed to dislike, but more market-friendly than ever he was. It will be a test.

The PP's stewardship of the public finances was exemplary, but Spain's splendid record of economic growth in 1996-2003 owed as much to the EU as to the government's management. Mr Aznar took over an economy set for take-off. Tax revenues rolled in just as interest rates began to drop in anticipation of Spain's membership of the new euro. Confidence rose and debt-service costs fell, as did public spending and then the budget deficit. When the euro was launched, low interest rates - real short-term rates have been negative for two years - set the scene for a big boost to both consumption and building.

The PP government undertook a large privatisation programme, but it did not exploit its good economic fortune to make the sort of changes that would have created a truly liberal market economy. The big state-owned enterprises in electricity, natural gas, oil and telecoms were privatised, but the state kept golden shares (since ruled illegal by the EU), picked the bosses and, directly or indirectly, appointed most of the directors.

Deregulation was similarly less than thorough. The competition court is weak and, in the big privatised industries, as Professor Jordi Gual of the IESE Business School in Barcelona points out, the aim was not so much to cut prices, which remain relatively high by EU standards, or increase consumer choice; rather it was to promote strong firms with the financial muscle to enter markets abroad and defend themselves from foreign takeover.

The first problems for the new government are the demand for housing, which is such a large component of general economic growth, and the supply of labour, which also drives growth, though by boosting jobs, not productivity. Spain made a start on 700,000 houses last year, four times as many as Britain. Even so, prices for new Spanish houses rose 18.5% and for existing ones 16.7%. The boom continues, fuelled partly by foreigners drawn to Spain by the thought of a house in a sunny part of the euro area, partly by share-shy Spaniards looking for an investment. The upshot is that though 3m-4m houses stand empty and a similar number are used as secondary residences, many young Spaniards cannot afford even the smallest flat, and thousands of workers turn down job offers that involve moving house because they cannot find a house to move to. At the same time household indebtedness has risen sharply (nearly half of the average family's disposable income goes on servicing housing debt), while some 40% of Spanish capital stock is in nothing more productive than property.

The government has set up a housing ministry, unknown in Spain since Franco's day, and talks of creating an agency to help create a market by assuming some of the risks involved in renting. The aim is to test the agency idea in a few big cities. It does not have to be a triumph to help: even if it brought only 10% of the housing stock into the rental market, that would be a doubling. At present, nearly nine out of ten houses in Spain are owner-occupied, much the highest proportion in Europe. But no one expects quick results, partly because the high price of housing also reflects the high price of development land, which in turn reflects a scarcity artificially created by local governments that benefit from the shortage. So the system of local-government finance also needs reform.

The labour problem is equally difficult. Though 3m-4m jobs were created under the Aznar government, Spain still has an unemployment rate of 11%, the highest in the EU 15, bar Belgium's. Moreover, about 30% of those in work are on short-term contracts, and many in the black economy have no contracts at all. This reflects the unions' ability to bargain up wages and the compensation bosses must pay when a job disappears, whatever the reason.

The roots of unemployment

The trouble really began with Franco, who wanted full employment at the expense of wages, and so made it all but impossible for employers to get rid of anyone (except on political grounds). Not surprisingly, when they could, the bosses substituted capital for labour. Excess labour was exported to Europe. With democracy, the unions won the right to increase wages while keeping their no-dismissal privileges. Unemployment, and then short-term contracts, ensued.

The new government has changed the national-insurance system to encourage the creation of more permanent and fewer short-term jobs. But the collective-bargaining system, in which negotiations are conducted by sector at national or regional level, has to change. Sceptics believe that Jess Caldera, the new labour minister, is not the man for a fight with the unions; he has already announced an increase in the minimum wage (of 6.6%), in an economy where onlookers like the IMF and the Organisation for Economic Co-operation and Development (OECD) worry about both wage increases and productivity. If Mr Zapatero is nonetheless ready to have a showdown, it would be a sign of his mettle: Mr Caldera is perhaps his closest ally.

Other pressures will crowd in upon the new team. Mr Solbes is well aware that he faces “very tough” negotiations with his colleagues before the September budget. The government is committed to lots more social spending - which has been falling as a share of GDP since 1994 and, at 20%, is well below the EU-15 average of 27.5% - as well as more foreign aid, more police and such projects as extending the high-speed railway to Barcelona. At the same time Mr Solbes directly controls less than half the economy - the remainder is in the hands of the regions - and the government is dependent in parliament on regional parties.

Nonetheless, he is pledged to balance the budget over the economic cycle, as befits the stern guardian, until recently, of the EU's growth and stability pact (as the monetary commissioner in Brussels). The budget was just in surplus last year, but this year is likely to be in deficit to the tune of 0.9% of GDP. With the economy expected to grow at about 3% in 2004, shouldn't Spain instead be running a big budget surplus, so that it can run a deficit when the cycle demands it? Aha, says Mr Solbes, it all depends on when the cycle is said to begin and end.

No one expects Mr Solbes to be profligate. The harder question is whether he and his colleagues will prove to be liberalisers. Some people already detect worrying signs of a hankering for “national champions”: Endesa, the biggest electricity supplier, has been talking to La Caixa, the biggest savings bank (which happens to control a water company and the former gas monopoly), about the formation of a conglomerate offering the cross-marketing of water, gas and electricity. Spanish Socialists who take their cue from France might welcome such a merger.

However, the budget minister, Miguel ngel Fernndez Ordnez, is likely to push for market reforms, as is Miguel Sebastin, the prime minister's economic adviser. Mr Fernndez Ordnez has already shown his lack of socialist dogma by saying he would not rule out the privatisation of the state's hideously indebted television company; and Mr Sebastin, who was chief economist at Banco Bilbao Vizcaya Argentaria, Spain's second-largest bank, is known to favour a flat-rate income tax. Indeed, he was fired from his job at BBVA at the request of the Aznar government for his work on this subject; so too was his counterpart, Fernando Fernandez Mendez de Andes, at Santander Central Hispano, the biggest bank, for the same misdemeanour.

The tax system is certainly due for reform. Evasion is widespread - Spain's black economy is commonly put at over a fifth of GDP, nearly as much as Italy's - and too many poor people pay too much tax, while too many rich pay too little. The seriously rich need pay very little indeed, thanks to vehicles such as family-owned mutual funds or companies which enable them to pay just 1% of realised gains and nothing at all on undistributed dividends.

Mind your three Ps

A responsible government would soon tackle three other issues - prices, productivity and pensions. Price inflation is reducing the competitiveness of Spain's exports, especially in Europe. But holding prices down will be painful. Any closing of the differential with other countries depends, at least partly, on cutting wage costs through labour-market reforms.

Productivity is also related to the labour market, though any improvement here will involve efforts on a variety of fronts including education, bringing women into the workforce, and research and development. Everyone is agreed that Spain spends too little on R&D (about 1% of GDP, which is roughly half the EU's average and roughly a third of America's), and that it makes too little use of technology. Spain's banks are automated and efficient; likewise Inditex, which owns the fashion chain Zara, makes clever use of technology, albeit of a fairly unsophisticated kind. But Spain has been slow to embrace the internet - only 23% of households were wired in 2002 - and its universities are weak in science and technology.

The OECD last year called for “an ambitious and speedy reform” of the pension system to bring retired people's pensions more closely into line with their contributions, and to slow the growth of pension spending after 2015-20. One difficulty is that, while Spaniards' life expectancy is growing - that is, the population is getting older - Spanish women have lost their eagerness to have babies. The fertility rate (the average number of children per woman) dropped from 3.0 in 1967 to 1.3 in 2001, well below the replacement rate of 2.1. It is now one of the lowest in the world. The result is that, even with immigration, Spain is in for a demographic shock, which, though it will strike later than similar shocks in most other rich countries, predicts the OECD, will be more severe.

The new government says it will extend monthly payments of €100 a child to non-working mothers to encourage them to breed, but pension reform is also needed. The OECD suggests a first step would be to base pensions on workers' contributions over their entire career, not, as at present, over the final 15 years.

No government could put all this right overnight. But by fostering competition, Mr Zapatero could stimulate the necessary changes. If he pressed on with privatisation, strengthened utility regulation and the competition court, and improved corporate governance, Spain would have a competitive economy, with businesses strong enough to venture out into the non-Spanish-speaking world.

That was at least part of what was supposed to happen when Mr Aznar joined other European leaders in Lisbon four years ago to pledge themselves to making the EU “the most competitive and dynamic knowledge-based economy in the world” by 2010. Like most EU countries, Spain still has a long way to go.

Writer says that the new Spanish Government needs to do much to create a truly liberal market economy. Article forms part of a survey of Spain in this issue of The Economist.