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Spanish Economy Needs Major Reform by Sven R. Larson

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Spanish Economy Needs Major Reform

As Bridget Ryder recently reported, the Spanish economy still has not returned to its 2019 pre-pandemic levels. There are both short-term reasons—Ryder points to the loss of tourism during the pandemic—and long-term factors. In the latter category we find big government spending, which weighs down on every economy where it is imposed. We also find the high taxes that come with big spending. 

Due to its inordinately large government, Spain went into the pandemic weaker than most other European countries. The Spanish economy had just about gotten out of the dungeon of austerity, which it was thrown into during the Great Recession of 2008-2011. As of 2019, according to Eurostat data,

  • Spanish businesses spent less than 82 cents on investments, or capital formation, per euro they spent in 2007; and
  • Private consumption was still 0.4 percentage points behind its 2007 level.

These inflation-adjusted numbers may seem purely technical, but they speak of an economy where businesses have lost much of their hope in the future, and where households are barely scraping by.

Declining domestic spending

Another way to see the real decline in capital formation and consumer spending is to look at their share of gross domestic product, GDP. In 2007, capital formation accounted for 26% of GDP; in 2013 it had declined to 17.4% of GDP. In that short period of time, Spain lost almost 39 cents of every euro of business investments. 

Since then, the investment share of GDP has increased, though modestly. About one in five euros spent in the Spanish economy now goes toward the formation of new productive capital. This is a reasonably good level, but it is still well below where it was prior to the Great Recession. 

Bluntly: by historic comparison, the productive capital stock of the Spanish economy is slowly getting smaller.

Private consumption has also declined, in relative terms. In 2007, Spanish household spending accounted for 60.8% of the total economy; in 2019, that share was down to just over 56%. 

The practical meaning of this, and of the decline in capital formation, is that the Spanish workforce is working less and less to take care of its own economy and the needs of its own population. More and more of their time is used to provide for people and businesses in other countries. 

Exports, for short. 

Spain has become more dependent on exports. From the bottom of the Great Recession to 2019, just before the pandemic, exports increased from 25% of the economy to 35%. 

Increased exports are often taken as a positive sign for an economy. This is true under specific circumstances, primarily when a country is using a desirable natural resource to undergo a rapid economic transformation. However, for a developed industrialized economy like the Spanish, a general rise in exports while domestic demand is stagnant, is actually a sign of economic impoverishment. 

This is a problem that economists almost universally overlook. Being a practicing economist myself, I find this strange, even curious.

When exports hurt the economy

Since Spain is part of the euro zone, it is unwise to use the so-called terms of the trade to analyze whether exports are helping the economy—or weighing it down. A better approach is to analyze the role of exports in the relationship between, on the one hand, exports growth and, on the other hand, growth in private consumption and capital formation. 

As mentioned, exports can indeed benefit the economy as a whole. This happens when rising international demand for a country’s goods and services generates enough growth in income and wealth to lift domestic spending alongside exports. To take one example: when the Japanese economy rose from the ashes of World War II and its manufacturing industries started conquering the world market, there was such high demand for input products, engineering and banking services, and specialized labor skills, that the rest of the economy rose with growing exports. 

Behind the Japanese success—which has subsequently been repeated by other countries—was the simple economic fact that the export market generated more profits and higher wages for Japanese companies and their workers than the domestic market. Exporting industries became leaders in technology; the rest of the economy had something tangible to rise to.

That is not the case in Spain, whose exports are composed of products, goods, and services of a value that is equal to, or lower than, the value of the average product sold in the Spanish economy. Where Japan earned more money and more economic growth on exports than on its domestic economy, Spain is almost in the opposite situation. Two-thirds of Spanish exports consist of goods of various kinds; the rest are exports of services. This is almost the exact opposite relationship between goods and services as in the Spanish economy as a whole. In fact, all modern economies are dominated by the production and sale of services, while the same economies tend to export predominantly goods.

When economists talk about “goods,” they mean everything under the sun, from potatoes and apples to nuclear reactors and spaceships. However, the balance in terms of wages tends to be on the lower side, simply because there aren’t that many jobs available in the nuclear-plant production and exports business. Therefore, as a general rule, production of goods generates less value than the production of services; wages, in goods production, come in below wages in the services sector. 

For this reason, the increase in Spanish exports over the past few years does not increase the overall level of productivity and value creation for the Spanish economy. If anything, it contributes to holding back household earnings and making it less profitable to invest in the nation’s economic future.

The aforementioned trends in private consumption and capital formation strongly suggest that this is exactly what the Spanish economy is currently experiencing. With growing exports with relatively little value added, the Spanish economy will likely remain in its current virtually-stagnant economic quagmire.

Government does not help

Government policy is not exactly helping the economy grow. During the Great Recession, the Spanish government implemented a series of tough austerity packages; for a detailed analysis, see Larson, S: Industrial Poverty (Gower, 2014), pp. 107-119. In order not to place all the austerity on the welfare state, the Spanish government implemented a series of tax hikes, part of which were analyzed in a 2012 white paper by the Cato Institute, a U.S.-based think tank: 

[A] week following the December 21, 2011, inauguration of Prime Minister Mariano Rajoy, the government announced a significant tax hike that will have pernicious effects on the Spanish economy. 

The Spanish government was worried that it would not be able to bring down its budget deficit as intended, if it canceled or even punted on its planned tax hikes. 

Spending cuts in the midst of an austerity episode are never productive; it is preferable to implement them when the economy is strong and resilient. Tax hikes in the midst of a recession do not help either. Therefore, it is not surprising that, according to Eurostat, in 2012 Spanish unemployment was 53% among 15-24 year olds, and 24% fell in the 20-64 age group.

From 2008 to 2012, 3.2 million workers aged 20-64 lost their jobs. In 2012, there were 235 unemployed Spaniards for every 100 unemployed in 2008. 

When workers lose their jobs, they also lose a good chunk of their income. When they lose income, they spend less.

The spiral of the economic downturn continues downward. In actual numbers: from 2008 to 2012, private consumption declined by 9%. This ripped 60 billion inflation-adjusted euros of household spending out of the Spanish economy.

The drop in business investments was even worse. Looking again at 2008-2012, businesses cut their investments by a full one third. In four years, Spain lost €91.1 billion (again, adjusted for inflation) worth of capital formation. This is a major loss of confidence in the future; when businesses postpone investments, or even scrap them altogether, the productive capacity of the economy suffers for a long time.

In fact, when we add the decline in investments to the rise in exports, we get an ominous shift in economic activity. More exports need less capital formation, suggesting that the goods exported are generally “simpler” from a technical viewpoint. While not entirely accurate, we can think of it as “less machines” and more “vegetables.” The lower the technical complexity of a product, the less value it generates; the less value, the lower the wages earned in producing it. 

Wherever an hour worked generates less value than before, economic growth will slow down. As more hours worked produce less value, the economy gets stuck in stagnation.

This is, again, a stylized and somewhat exaggerated picture of the Spanish economy, but it captures the essence of the structural economic change that Spain has to some degree undergone over the past 15 years.

An economic quagmire

As mentioned, there is not much help to be expected from economic policy makers. They are bound by the constitution of the European Union, in which the Stability and Growth Pact mandates small budget deficits and limited debt. 

Figure 1 illustrates where the Pact went to work in the Spanish economy during the Great Recession. The gray columns report real annual growth rates (values to the left), while the blue line (values to the right) represents total government tax revenue as percent of GDP. 

After having expanded at healthy rates around 3% per year for ten years leading up to the Great Recession, the Spanish economy took a nosedive in 2008 and did not get back on track again until 2014:

Figure 1

Source of raw data: Eurostat.

The plunge in economic activity in 2009-2013 brought about a precipitous decline in tax revenue. From 2007—the top revenue year before the recession started—to 2011 right before the Rajoy government’s tax hikes, government lost 12.5% of its tax revenue. This decline was almost four times the decline in GDP (a logical consequence of how the Spanish tax system is configured) and is a big reason why the budget suffered from a major budget deficit. 

Figure 2 illustrates the trends in government spending (green) and tax revenue. The gray area indicates budget surpluses, while the red areas represent deficits. 

Figure 2

Source of raw data: Eurostat.

Ideological problem, ideological solution

There is no doubt that the Spanish government spends far too much money. However, cutting spending on a permanent basis is easier said than done. While there are ideas out there worth considering, it is also important to keep in mind that Spain is a traditional, socialist welfare state. Its government spends by far the most of its money on reducing economic differences (colloquially known as “inequalities”) between individual citizens. 

The ideologically motivated, redistributive share of Spanish government spending has increased sharply in recent years. In 1995, spending programs known as housing, health, recreation, education, and social protection consumed 59% of all government spending. By 2019, that share had risen to 69%. 

Social protection alone takes 41.3% of all government spending, up from 32.5% in 1995.

Putting aside the ideologically questionable motive behind such spending, it is worth remembering that these spending programs tend to be designed in such a way that their spending goes up in tough economic times. They also increase when an economy stagnates over time: as people’s incomes stall, they also remain eligible longer for the types of programs that a welfare state offers. 

As more people get trapped in modestly paying jobs, tax revenue falls short of government spending on a permanent basis. In other words, there is a Faustian pact embedded in the welfare state: the more economic redistribution that the government promises, the more difficult it will be for the government to pay for all its spending. 

While short-term adjustments in spending can boost government efficiency and eliminate wasteful programs, a permanent solution to economic stagnation and unending budget deficits must focus on the ideological core of the welfare state. The key to future prosperity, a balanced budget and economic self-determination for all Spaniards lies in rewriting the very role of government: instead of promising benefits to gainfully employed people, government must confine itself to a role as the provider of last resort

Plain and simple: replace the socialist welfare state with a conservative one. 

Sven R. Larson is a political economist and author. He received a Ph.D. in Economics from Roskilde University, Denmark. Originally from Sweden, he lives in America where for the past 16 years he has worked in politics and public policy. He has written several books, including Democracy or Socialism: The Fateful Question for America in 2024.