- The role played by structural reforms in the recovery in Spain is far from clear-cut. Without economic policies to support demand, reforms would probably not have been enough to trigger a recovery in production and employment. Indeed, some of the literature suggests that in times of recession and at the frontiers of zero interest rates, measures to increase market flexibility tend to deepen the recession.
- However, whilst reforms may not have been directly responsible for the recovery, their implementation probably helped create the room for manoeuvre that was necessary for the adoption of more supportive macroeconomic policies. Besides, as demand prospects improve, reforms should produce a faster response from production.
- Yet, their influence will be more determinant over the long term. The demographic shift and the consequences of a lasting under-utilisation of production capacities suggest a marked decline in the potential growth rate. Improved functionning of the markets for labour, goods and services will become even more essential.
Spain’s recent economic performances invite optimism. Average quarterly GDP growth in 2014 was 0.5%. More importantly, growth accelerated over the course of the year: from 0.3% in Q1 it rose to 0.5% in Q2 and Q3 and ended the year at 0.7% in Q4. We expect a further increase in growth over the course of 2015, with figures of between 0.8% and 0.9% each quarter.
The fruit of reform?
The return to growth in Spain is often interpreted as the result of the structural reforms introduced during the recession years. Through their effect on prices, measures to improve flexibility in the markets for labour, goods and services (see appendix) have, in this analysis, created the conditions for a recovery in production and employment.The debate on the effect of structural reforms on activity occupies a significant place in the economic literature. Although there is something of a consensus about the positive effects over the medium to long term, opinion is more divided as to their short-term effects. In general, one observes a negative impact on consumer spending. This is the case, for example, in reforms seeking to reallocate factors of production towards more productive sectors, which initially result in large job losses in less productive areas. Some argue that this negative effect is counterbalanced by increased investment (in the short term) driven by expectations of higher productivity and, more generally, revenues over the medium term. Anderson et al (2014)1 thus estimate that “OECD-type” reforms have small but beneficial effects on euro zone countries from year one. The ECB notes that in most micro-based models, the short-term effects are neutral or negligible.
The question of the short-term effect of structural reforms takes another turn when the ex ante state of the economy (i.e. when reforms are introduced) is taken into account. Under “normal” circumstances the fall in inflation resulting from supply-side stimulation can be offset by a cut in policy rates by the central bank, thus supporting investment and consumption. In contrast, reforms introduced during a recession, when policy interest rates are already at the zero lower bound, can exacerbate the contraction of the economy.
The divergence of outcomes is due to the fact that the relationship between inflation and demand change is modified when interest rates are close to zero. Under normal circumstances, the aggregate demand curve slopes downwards – demand increases when inflation falls (notably because the central bank cuts its rates) – but this relationship reverses close to zero rates: the fall in prices (or disinflation) can not be offset by a cut in key interest rates thus triggering an increase in real interest rates and a contraction in aggregate demand.
An economic policy that is effective under normal conditions can be counter-productive in a crisis. Eggertsson (2010)2 highlights the “paradox of toil”, where an increase in labour supply (produced for example by a reform in unemployment insurance) can, under certain circumstances, result in an increase in unemployment. This is particularly the case when the economy is contracting, there are deflationary pressures and interest rates are at the zero bound. Increased competition for jobs weighs on the formation of wages and thus on prices; in doing so it further depresses demand and, in end, total employment. This is a typical example of the fallacy of composition: applied to all economic agents, a given individual behaviour (the desire to work more in this instance) can produce the opposite result.
In Spain, labour market reforms have produced significant moderation in nominal wages, generating gains in cost competitiveness that helped exports. Moreover, the fall in real wages has also contributed to keeping employees in certain companies. However, from an aggregate point of view, the fall in domestic demand as a result of falling wages has had a greater impact on total employment via, in particular, the bankrupt of firms unable to internationalise. Although at the microeconomic level there were positive effects (on the competitiveness of exporting firms for example) on the macroeconomic level, negative effects won out (see Figure 1). The recovery in job creation at the beginning of 2014 would not have been possible without an improvement in prospects for demand. In other words, increased flexibility may have increased the propensity to hire (i.e. reduced the growth rate necessary for job creation) but this required favourable conditions.
The improvement in domestic demand is firstly linked to the easing of austerity. The change in the primary structural balance (a proxy for fiscal effort) fell from 3.2 points of GDP in 2012 to 1.6 points in 2013 and then to just 0.2 points in 2014. Given the size of fiscal multipliers - also exacerbated duringa recession - the end of austerity removed a significant growth constraint. Subsequently, demand benefited from the ECB’s highly accommodating policy, accentuated in 2014 by the deposit facility rate’s move into negative territory and the launch of targeted longer-term refinancing operations (TLTRO). This resulted in an easing of financing conditions, which was further helped by the clean-up of bank balance sheets that took place during the crisis. Rates on bank loans to companies of up to EUR1 million fell from 5% in January to 3.8% by December 2014. The expected divergence of the respective monetary policies of the Fed and the ECB also triggered a weakening of the euro, boosting external demand. Lastly, the fall in oil prices provided additional support to household spending power and business profitability.
In the final analysis, it is difficult to isolate the role played by structural reforms in the economic recovery in Spain. Without economic policies to support demand, reforms would probably not have been enough to trigger a recovery in production and employment. Indeed, some of the literature suggests that in times of recession and at the frontiers of zero interest rates, measures to increase market flexibility tend to accentuate the recession.
Does this mean that the reforms have not been useful? No. First, although they might not have been directly responsible for the recovery, they will now contribute to stronger growth in production as demand prospects improve. Secondly, their implementation probably helped create the room needed for the adoption of more supportive macro-economic policies. On the fiscal front, the Stability and Growth Pact takes account the implementation of structural measures in the fiscal effort demanded to member states. Thus, when a country is engaged in a programme of reforms, it enjoys greater flexibility in the interpretation of fiscal rules. In Spain, moderation of fiscal austerity was made possible by the government’s reform efforts. On the monetary front, although the rules are far less explicit, it seems reasonable to believe that the implementation of structural reforms in the “peripheral” countries of the euro zone (Spain, Greece, Portugal and Ireland) has made the adoption of non-conventional measures by the ECB more politically acceptable. From a more pragmatic point of view, the strong deflationary effects created by supply-side policies implemented in the South of the euro zone created a threat to price stability within the currency union, opening the way to an expansion of the action of the ECB, to the point that it is now pursuing a policy of quantitative easing that would have been unthinkable just a few years ago.
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