Where Spain Is Worse Than Greece

Spain still has a lot of government austerity to endure before the cutting is done

By Matthew Dalton

By most measures, Greece’s economy is in worse shape than Spain’s. Greece has been largely shut off from financial markets for more than two years; yields on its bonds are still sky high. Gross domestic product has fallen nearly 20% over the previous three years. Spain can still borrow from private investors, and its GDP has fallen around 5% during the crisis.

But if you take forecasts from the European Commission seriously, Greece enjoys one formidable advantage over Spain: Its economy is running well below capacity, while the Spanish economy, despite an unemployment rate around 25%, is operating relatively close to full steam.

Why is that an advantage? According to the commission, it means that the Greek unemployment rate should fall sharply if the economy starts to recover again, without causing inflation. Spain faces a much more difficult situation. If the structure of its labor market doesn’t change, the commission’s analysis suggests that a nascent economic recovery in Spain could be hampered by labor shortages that would spark wage inflation.

Seems like a strange thing to believe for a country with 25% of its workforce sitting idle. How can this be?

The reason is the commission’s view of the Spanish labor market. During the previous decade, the Spanish unemployment rate dropped sharply as millions of Spaniards found work in the booming Spanish real estate sector.

But the bubble has burst, probably for good.  This means, according to the commission’s analysis, that millions of Spaniards need to be retrained to do non-real-estate-bubble-related jobs. In the meantime, their labor won’t be available to do the new jobs that will drive Spanish growth in the future.

Greece faces similar problems, but they are less serious, according to the commission’s analysis. Yes, the “government-borrows-money-and funds-consumption” model of growth won’t be available to Greece anymore. But it didn’t endure the same private-sector credit bubble that hit Spain during the previous decade.

The differences between Greece and Spain can be seen in several economic metrics published by the commission. There is the output gap, or the difference between actual GDP and potential GDP (as a percentage of potential GDP). The figure is a whopping 13% for Greece but just 4.6% for Spain.

Then take a look at the commission’s estimates of the so-called non-accelerating wage rate of unemployment (NAWRU) in Greece and Spain. This is the unemployment rate below which the commission believes the inflation rate starts to rise. It’s also known as the “natural rate” of unemployment. The natural unemployment rate for Greece is around 14.8%; it is 21.5% for Spain. This despite unemployment rates around 25% in both countries.

These numbers speak to the depth of the structural transformation that the commission believes Spain must endure before it can return to sustainable, non-inflationary growth.

Of course, neither the “natural” unemployment rate nor the output gap are directly observable figures. They are estimates made by economists to help central bankers and finance ministry officials figure out whether economies are close to becoming inflationary. So maybe the commission’s estimates are incorrect.

In fact, there is considerable disagreement over the commission’s view of the U.S. economy: It sees the natural U.S. unemployment rate at 7.8%. Not even the most hawkish members of the Federal Reserve’s Board of Governors believe the natural rate is much over 6%.

The problem is that European policymakers are now relying on these estimates more than ever before to draft national budgets. They are giving more weight to the “structural balance” – that’s the actual government balance accounting for the size of the output gap, the “natural unemployment rate” and the general strength of the economy.

Spain’s structural budget deficit is somewhat smaller than its actual deficit (6.3% of GDP vs. 8%), because of the country’s weak economy. But most of the deficit is still “structural,” according to the commission, a disturbing thought in a country where 25% of the workforce is unemployed.

And because the euro zone’s new “Fiscal Pact” requires countries to bring their structural deficits under 0.5% of GDP, Spain still has a lot of government austerity to endure before the cutting is done.