The necessary change of the production model in Spain

Rafael Pampillón. Professor. IE Business School

5 October 2010

Economic recovery worldwide will help lift Spain out of the crisis, but in order to avoid problems in the future we need to accompany improvement with a change of model.

The world gross domestic product (GDP) will grow at more than 3% in 2010 and the same will happen in 2011. However, this growth will not be the same in every country or in every region in the world. Each area is overcoming the economic crisis in different ways and at different speeds. Thus, while the World Bank believes that the Eurozone economy will grow at 1.5% in 2010 and at 2% in 2011, the rest of the world will grow at much higher rates. The economies of Latin America, which have already left the crisis behind thanks to their exports and their domestic demand, will grow 4.5% this year and 4.1% in 2011. The United States has also come out of its recession and has been growing since the second half of 2009. Africa is anticipating a growth of 4.3% in 2010 and 5% in 2011. Asia, especially India, Indonesia, Pakistan, South Korea and China, will continue to be the world´s driving force, together with the USA and Latin America, with increases in their GDP of 8% in 2010 and 2011.

The economies of Southern Europe, which include Spain, will have an L-shaped recovery. The countries of the South (Portugal, Italy, Greece and Spain) are performing worse than those of Northern Europe and it appears that they will remain at a standstill for several years. Indeed, there are two countries in Southern Europe (Italy and Portugal) that have had very low or negative annual growth rates for the last 10 years. In these countries, bank loans remain out of reach for many businesses and families. As a result, many countries are still experiencing negative economic growth, but that will soon disappear and be replaced by positive growth rates, albeit very low and without the creation of jobs.

In Spain, the expansive monetary policy of the European Central Bank is being ineffective (as has happened in Japan over the last 20 years) and the fiscal policy for 2010 and 2011 will be less expensive than in 2009, but it will gradually reduce fiscal deficits. However, the public debt/GDP ratio will continue to increase. This is because debt will grow more than the GDP, even though it will grow at a lower rate than at present. The absence of in-depth economic reforms, the need for outside finance, the high level of unemployment, the irresponsible behaviour of unions and the lack of competitiveness in exports will worsen the situation considerably and, as a result, there may be social unrest (general strikes and other protests), as has unfortunately happened in Greece in 2010.

Credit flows will remain stagnant owing to falling expectations and many savings banks will be privatised, merged or intervened by the Bank of Spain. The Spanish economy will embark on the long process of redesigning its economic model. High levels of family debt will delay consumer decisions. Consumers will remain cautious about spending after the crisis has wiped out so much of their net wealth, with a feeling of poverty as a knock-on effect (reduction of family wealth) that may remain for one or more years. High unemployment levels will also make people consume less and save as a precaution. We will enter a stop-go period where room for manoeuvre in economic policy will be reduced.

Consequently, the economic crisis that has had such a dramatic effect on Spain requires a collective effort aimed at changing the economic model. This change consists of moving from the current production model focused on sectors that are not affected by international competition, such as certain services and construction, to a structure designed to produce more competitive goods and services. In short, the aim would be to increase the competitiveness of our economy by placing more emphasis on the sectors and businesses that export and on those currently competing with imported goods. Hence, Spanish business is at a critical point with regard to its future.

A little background

This change is nothing new. Over the last 50 years businesses in Spain and the Spanish economy have adapted more or less successfully to the demand of international competition marked by the phenomenon of globalisation. The process of opening up to the exterior started in 1959. The Spanish government (after almost 100 years of protectionism) then decided to implement the Stabilisation Plan, designed to deregulate the country’s trade and financial relations with the exterior. This led to the opening up of the Spanish economy to the world economy and, in particular, to the European economy. The milestones of this process were: 1962 (new tax and new legislation on movements of capital); 1970 (preferential trade agreement with Europe); 1978 (entry of foreign banks); 1986 (entry into the European Community); 1993 (coming into effect of the EU market); and 1999 (incorporation of Spain into the founding group of the euro). With the single currency, Spain closed its process of opening up to the outside world and assumed the challenge of its full integration into the European and world economy.

The result of having opted for an open economic model (1959-2009) instead of autarky (1939-1958) has been very positive. In the 50 years that have passed, the standard of living of Spanish people has improved spectacularly and is now close to European levels. Furthermore, every instance of deregulation has always come with periods of intense economic expansion (1962-1967, 1970-1974, 1986-1995 and 1999-2007), as if to confirm that opening up to the exterior was the right move.

Can the production model be changed?

Despite the deregulation efforts of the last 50 years, the Spanish economy has been subjected to an economic crisis since 2007, and leaving its effects behind will not be easy. The origin of the crisis lies in the Spanish production model, based on low-productivity services and industries and on the construction sector, which has led to high unemployment owing to a fall in activity. It would be absurd to blame international competition and globalisation for the shortcomings of the Spanish economy. That blame must be placed on the inflexibility of the labour market, lack of competition in certain key economic sectors, a collective subsidy culture and, therefore, one of public spending further problems include the shortage of technological innovation, the problems that affect the financial system, a deficient education model, and the failure to embrace modern, more efficient business management systems.

Given the critical situation of the Spanish economy, the ability to change Spain’s economic model will depend on its capacity for solving the problems that affect the financial system and for making its economy and job market more flexible, as well as the capacity to build its technological capital. Consequently, it is a question of improving production and the competitive structure to increase exports and Spanish investment abroad. Nobody knows what the key sectors of the future will be, but we must not forget that Spain is very competitive in the services sector. Most of Spain´s investment abroad is not in the manufacturing sector (although there is some), but rather in banking, distribution, engineering, management and the construction of infrastructures (airports, motorways, etc.), waste and water management, hotels, energy production and distribution, renewable energies, insurance and telephony, etc. As a result, companies such as Repsol YPF, Gas Natural, Endesa, Abertis, Santander, BBVA, Meliá, NH, Mapfre, Iberdrola, Telefónica, ACS, OHL and FCC, among others, have found excellent business opportunities in Europe and in the Americas. Since the end of the 1980s, many Spanish companies have been operating in Europe and, since the mid-1990s, they have been one of the main investors in Latin America, preceded only by the US.

A credible economic policy

Although business organizations are responsible for their own competitiveness, their decisions are affected by the level and quality of national production models and the macroeconomic environment, which, in turn, depends on actions taken by the public sector. Accordingly, a credible, stable, orthodox and well-defined macroeconomic policy is still necessary for Spain to overcome the crisis. Legal security and confidence in the government will play a role in changing the model, as they will attract foreign capital, help build capital, create competitive businesses and encourage exports. An uncertain economic policy, on the other hand, leads to expectations of political changes, which delays private investment decisions and also leads to a reallocation of resources and profits that does not augur well for productivity levels. Consequently, the government of Spain must continue to apply market deregulation policies to send out the kind of signals that encourage the private sector to make new investments, take decisions on production, and create employment.

Public spending

It would also seem advisable for those responsible for the fiscal policy to decide to reduce public spending for the following reasons: (a) the size of the public administration in Spain is noticeably large and it is becoming increasingly inefficient; (b) there are reasons to think that giving some of the duties currently assumed by the welfare state back to society would improve the supply of collective services and increase the population´s interest in them without losing any of the rare wealth redistribution aspects of public services. In education, health and pensions, privatisation is a possibility. Many citizens no longer need to be forced to spend on education, health or saving for retirement because they already spend more than the mandatory amount. (c) The reduction of spending will provide private capital (crowding-in effect) with more resources for productive investment as well as creating new employment.

Increase in VAT

In light of the above comments, there can be no doubt that the Spanish economy is in a situation of great weakness and it would appear that now it is more necessary than ever to actively encourage private consumption. In circumstances such as the present, with its uncertainty and economic deterioration, the government should have avoided increasing taxes and reduced public spending even further. Despite the norms of every manual on economics, the government stated that the increase in value added tax (VAT) would not affect consumption. The increase in VAT will affect consumption, however, since it will reduce citizens´ purchasing power. Salary and income cuts such as those of the unemployed and public sector employees, coupled with the increase in VAT, will have a negative effect on consumption.

If consumption falls, the production of the businesses that provide the goods and services also falls and the lower-level production of goods and services means more unemployment. However, encouraging consumption would be a determining factor for increasing production, employment and the total wage bill. What´s more, as a result of the fall in economic activity, this increase in taxes will probably not lead to more taxes being collected by the public administration, at least in the short term.

When considering the question of whether the VAT collected in 2010 will rise or fall, it is a good idea to remember that in 2007 the economic growth in Germany slowed down during the first six months of the year owing to the increase in VAT, which rose from 16% to 19% in 2007. That was due to a sharp fall in consumption. Consequently, it would come as no surprise for the growth of the Spanish economy to also suffer during the second half of the year as a result of the hike in VAT. The same happened in Portugal and Spain in January 1995: the Socialist government of Felipe González increased all three VAT rates. However, during that year, the amount of taxes collected was much lower than the amount budgeted for and the main culprit was VAT.

Although a greater reduction of public spending also has its disadvantages and can be difficult to implement in our complex, decentralised state, it is far more preferable than an increase in taxes. Citizens occasionally consider that public spending leads to wastefulness, corruption and scandal. So, to reduce the fiscal deficit, a reduction of public spending, especially unnecessary public spending, would be more readily accepted by citizens than tax increases.

Conclusion

At the beginning of this article we saw that the context of the world economy is improving. Like the bacteria and viruses that are transmitted from one human being to another, crises and economic recoveries are also transmitted from one country to another. In both cases, for the good or bad to spread, there must be a mechanism that transports the success or the failure. In Europe, the current economic crisis affecting the countries of the South (Portugal, Italy, Greece and Spain) is being transmitted to the countries of the North. The mechanisms for its transmission include debt markets, the stock exchange and the financial system. Similarly, Central and Northern Europe, the USA and the rest of the world can also transmit to Spain the positive elements that would help it overcome the crisis.

However, in Spain the current economic crisis, the most negative effect of which is the widespread destruction of employment, requires a change of economic model. If the Spanish economy wants to be more competitive, it must look towards sectors with higher levels of quality and technology that would improve the competitiveness of its products abroad. Furthermore, for the private sector to be able to take over from the public sector and become the driving force behind the economy, credit conditions need to be improved and it has to inspire more trust among entrepreneurs. It would also be very desirable to start reducing the excessive interventionism of the public sector in the economy as soon as possible.

The economic policy must also focus on a gradual deregulation of our markets, including the employment market, changes to the productive structure and a fiscal consolidation that reduces the growth of the public debt, thereby improving Spain’s economy outside finance. Consequently, public spending must be selective; in other words, public spending must focus on changing the economic model, on improving productivity, for example, infrastructures (roads, toll motorways, hydraulic and railroad infrastructures), information and knowledge technologies, education and R&D.

Improved technology, the restructuring of production, the promotion of national saving and increased competition must be the stepping-stones along the road towards this new economic model. The main players in the model must be the old and new businesses that invest in R&D and innovation; in other words, those that supply innovation, but also those that demand innovation. The public sector must aim its spending at increasing the productivity and, consequently, the competitiveness of our products, such as the reform of the educational model to promote excellence and effort, motivate activities that generate R&D and innovation and speed up the construction of infrastructures. In short, we must continue our commitment to an economic model that is open to the exterior and avoid protectionism in the Spanish economy. The solution to our problems does not lie in protecting our economy from foreign competition, but rather in increasing the quantity and quality of our exports. As a result and despite all its negative effects, the increase in VAT will reduce the trade deficit we so desperately need. Indeed, while exports do not pay VAT in Spain (they pay it in the country of destination), with the increase, imports will pay more VAT.

That means that imports will be more expensive.

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