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"Reforming the labor market in Spain" is the title of new working paper by the OECD. Here is a part of the abstract:

After steady employment growth since the 1990s, Spain has experienced the sharpest increase in unemployment among OECD countries during the crisis, amplified by structural problems of the labour market. Very high de facto severance payment of permanent contracts has resulted in a rigid dual market with adverse effects on unemployment and productivity. The collective wage bargaining system has hindered firms from adapting to macroeconomic shocks exacerbating their negative effects on the labour market .... The large drop-out rate from lower secondary education is an important factor explaining very high unemployment among young workers. Better access of young people to training is an effective tool to keep them out of a depressed labour market. Finally, the matching of people to jobs, notably through the public employment services, needs to be made more efficient, all the more so under currently tight fiscal constraints.

Since I have been in and out of Spain since 1999, let me comment very broadly on this perspective. First of all, I agree that there is a dual labor market. Young people carry the burden of unemployment while older workers are better protected. However, I doubt that making it possible to fire older workers also will help Spain. Rigidity in the labor market is not behind the unemployment rate that is hovering around 20% for some time now (youth unemployment is around 40%).

Spain has seen large capital inflows in the years leading up to the crisis. The capital was used to finance a real estate bonanza. In 2006, more houses were built in Spain than in the UK, France and Germany combined, as The Times reported then. From my view, it was obvious by 2003 that a real estate bubble was occurring. Real estate prices in Barcelona’s quarter El Born doubled in one year around that time, rising in double-digit rates in other quarters.

The boom in real estate, I will argue in the following, caused a misallocation in the labor market. I remember that in the year after graduation from university, a Spaniard earned on average around €13,000 a year (before taxes). I also recall that wages in the construction sector were higher than that (construction average income). Coming from school, you could skip university and start working right away, earning a higher wage than most university graduates.

A recent paper by Peter Henry and Diego Sasson finds significant effects on wages after capital inflows in developing countries:

For three years after the typical developing country opens its stock market to inflows of foreign capital, the average annual growth rate of the real wage in the manufacturing sector increases by a factor of seven. No such increase occurs in a control group of developing countries. The temporary increase in the growth rate of the real wage drives up the level of average annual compensation for each worker in the sample by 609 US dollars — an increase equal to 25 percent of their annual pre-liberalization salary. The increase in the growth rate of labor productivity in the aftermath of liberalization exceeds the increase in the growth rate of the real wage so that the increase in workers’ incomes actually coincides with a rise in manufacturing sector profitability. Overall, the results suggest that trade in capital may have a larger impact on wages than trade in goods.

That, I would argue, had happened in Spain. Therefore, the structural problems in the labor market are caused by the inflows of foreign capital and the real estate bubble. Young people reacted to monetary incentives, and since they could not know that there was a bubble, they fell for the idea of entering the job market with no university education. It was relatively high wages that induced them to do so, made possible by foreign capital.

In order to understand the crisis, you have to look at market interactions. Assuming that huge capital inflows have no effect on labor and goods markets – apart from the financial market – is naive. The rising wages also caused inflation to rise, which then led to a fall in the real rate of interest. This interaction was ongoing, as the bubble built up over the early 2000s.

Spain has many problems in the labor market. It is dual in the sense that older workers are protected and younger ones are not. It is dual since public sector pay is relatively high while productivity is relatively low, compared to the private sector. These inefficiencies are a cause of concern, and they should be fixed.

However, the distortions from the last years were caused by capital inflows. Therefore, capital outflows will probably cause wages to fall on their own. Some Spanish regions have experienced deflation, and Spain was the first euro member to see a month with overall deflation in 2009. Policy advice should take account of these effects.

Source: The OECD on Unemployment in Spain