It is by now clear that Spain is in the throes of its deepest economic slump since the early eighties. By comparison, the previous downturn in the early nineties looks slight. After a miraculous decade where GDP and employment grew at average annual rates close to 4% and 5%, respectively, the latest officially released figures (corresponding to 2008: III) paint a rather bleak picture. GDP, employment, household consumption and investment have all plummeted down by 0.24, 0.76, 0.97 and 3.33 percentage points, respectively. The so-called employment-creation locomotive in Europe has suddenly come to a halt and its unemployment rate (11.3%) is growing much faster than anywhere else. The prospects for 2009 are even bleaker with forecasts pointing out to a reduction of 1.0% to 1.5% in GDP while unemployment is bound to surge to 15% of the labour force. The economic situation has become so gloomy that the Economist recently devoted a 14-page special report on the Spanish downturn under the suggestive title “The party’s over”. The behaviour of the housing market is a key element to understand what has gone wrong – during the preceding expansion, the construction sector explained around 25% of GDP growth.
Another brick in the wall?
A first observation is that Spain is a country where most city dwellers are relative newcomers to owning property. Until 1960, there was no law regulating home ownership since it was simply not necessary. People living in the cities rented apartments from the owners of the buildings they were living in. Owning a flat became possible and even desirable with the bout of growth experienced between the late fifties and sixties. This first generation of owners saw their fixed-interest mortgages paid off by the high inflation of the seventies. As a result, many Spaniards grew up thinking that property ownership was the best, safest investment available, and generous tax deductions for mortgage-interest payments later reinforced this “culture for bricks” even more. A recent study by Olympia Bover (2008) shows that Spain has one of the largest fractions of personal wealth invested in housing of all developed countries. This is true even for the wealthiest people, for whom financial wealth represents a much lower share than in other countries with high percentages of owner-occupied housing. Curiously, 10% of the households in the lowest decile of the income distribution own a second residence.
The drastic fall in real interest rates following Spain’s access to the euro zone only strengthened the belief that housing was the perfect investment. These investors, however, did not realise that their mortgages could not be paid off by inflation like their parents’, since their mortgages were overwhelmingly set at variable interest rates. They also did not realise that house prices could go down as well as up. There was simply no instance of this in anybody’s memory. One of us has been publishing a long stream of articles in financial newspapers and blogs since 2002 warning of the dangers of falling house prices, with the examples of Japan and Germany in mind, as well as noting that, in nominal terms, house prices went down in Spain in the early eighties and between 1992 and 1993. This had been received with widespread scepticism.
The result of all this was a housing bubble of gigantic proportions, by all reasonable measures. The ratio of housing prices over household disposable income went up from the usual 3.7 years to 7.1 years. In addition, the price-rent ratio reached 50. All kinds of excuses were proposed by supposedly informed analysts to rationalise this phenomenon: black money looking for a safe haven as a result of euro accession (Spain has been the member state with the largest proportion of 500 € notes since 2002, having accumulated 114 millions of those notes or 26% of the stock in the Euro zone), historically low real interest rates, a fast growing population (fed by an intense immigration boom attracted by construction sites and other sectors demanding unskilled labour), a poor quality housing stock from the sixties, a very low emancipation rate with large number of youngsters (20-35) who had not left the nest yet, and so on.
The banks did their bit by competing ferociously for mortgages. The spread in the Spanish mortgage market was the lowest of all the countries in the euro zone while it was higher in all other types of credits. The savings banks (cajas de ahorro), whose regulation did not allow them to expand beyond their regions of origin until the nineties, used very cheap mortgages (often just 50 basis points above the Euro Interbank Offered Rate) to penetrate other markets. The theory was that getting a mortgage client meant getting a customer for life (hence the push to extend mortgages to even 40 and 50 year periods), and the nearly zero gains made on mortgages could be compensated via commissions on other financial products, notably investment and pension funds.
The only bright side in this story is that special investment vehicles were regulated in a way that discouraged them. The conservative regulatory stance of the central bank and its pro-cyclical provisioning rule have also made the financial system a bit more secure than could have been the case, as illustrated by the fact that, so far, no Spanish banks have gone astray though they are finding no longer possible to finance 100 billion euros per year of foreign debt. This may lead fairly soon to mergers of some small cajas with the larger ones.
Overall, the prognosis is still rather bad. An economy with weak productivity that is overly reliant on cheap credit and a “dead” housing sector must adjust to a completely different situation, even if its highly regulated labour market and still-too-powerful unions make the adjustment hard. With estimates placing between 1 and 1.5 million of unsold new dwellings by the end of 2008 and banks demanding building companies 20% of the loan upfront and annual mortgage instalments that do not exceed 30% of household income, a fall in housing prices of at least 30% seems unavoidable.
The solution, however, should not rely on the government’s attempt to place 150,000 new public-subsidised houses (VPOs) into the market yearly by buying land or unsold dwellings from the building companies. This would be a good idea if these flats were to be sold at official VPO subsidised prices. However, this is not likely to be the case since, so far, these prices are being agreed with the promoters or even set unilaterally by the latter. It would be rather amazing that, at the end of the day, taxpayers’ money is used to finance more expensive dwellings than those available in the free market. Neither seems to be working the newly available, yet rather limited, official loan facilities for building companies that convert their unfinished housing promotions into homes for rent, nor the new credits available for VPOs. As highlighted in the media, there are regions where 30% of low-income people who were awarded a VPO could not take it because there was no way they could get a mortgage.
We have argued that the problem originated from wrong expectations by both sides of the housing market. This, we hope, will be cured by the bitter medicine provided by current events. Yet the adjustment will be unduly long if the incentives to rent, rather than buying, remain unaltered. The share of rental homes, 11% of the housing stock, is abnormally low in Spain. The government should replace the current generous fiscal subsidy for home ownership (around 1% of GDP) by subsidies to those landlords who rent their properties to low-income households, change the overly protective legislation for renters, and abolish VPOs for home ownership.
Desperately seeking a new economy
The remaining needed adjustment is that the human capital now deployed in defunct building companies should be effectively re-deployed in other sectors of the economy. Spain has some world-class companies in renewable energy, textiles, communications and, yes, even banking. The government should make it easier for struggling companies to shed unnecessary employees and provide retraining for the unemployed. The current severance payments system (high for permanent contracts and low for temporary ones) – besides giving rise to one of the most segmented labour markets in the EU and being a driving factor behind disappointing growth of labour productivity and TFP – is only providing lip service in the current restructuring phase. It should be urgently replaced by an alternative experience-related system with dismissal costs increasing much more smoothly as a function of tenure, which can be easily redesigned to provide the same degree of employment protection as available today (see Bentolila, Dolado and Jimeno, 2008).
Further, the government should reform once and for all the Spanish research system, which also has some excellent, if isolated, spots. Likewise, it is paramount to introduce competition in a rather mediocre higher-education system fully dominated by inbreeding, whose students’ dropout rate is one of the highest in the world and which is costing 0.7% of GDP each year to Spanish taxpayers. It is also paramount to facilitate the immigration of high-skilled workers who suffer enormous barriers to entry. The government should also facilitate railway t haulage, whose onerous licensing requirements prevent entry and restructuring, rather than road freight haulage. Finally, it would not hurt if the government made it easier to do business: Spain is 23 out of 27 OECD countries in the general ranking of the World Bank’s Doing Business indicator, while it is placed last in the ranking of ease to open a business. These are worthy policies on which Spain ought to immediately spend a few billion euros.
Bover, O. (2008) "Wealth Inequality and Household Structure: US vs. Spain", CEPR Discussion Paper No. 6680.
Bentolila, S., Dolado, J. and J.F. Jimeno (2008), “Two-tier Employment Protection Reforms: The Spanish Experience”, forthcoming in CESifo-DICE Journal for Institutional Comparisons.