IREF - Institute for Research in Economic and Fiscal issues
Fiscal competition and economic freedom
“What would you (try to) do to save your country from economic collapse?” This is indeed a difficult and tricky question, and one that is normally answered along the lines of interventionist economic thinking. The fatal conceit that Hayek wrote about is embedded in this same question: it assumes that the leader of the State will be able to take the appropriate actions to lead the economy (a very complex social order) to whatever goals.
The opposite position was epitomized by Ludwig von Mises’ answer when he was asked what he would do if he was the president of his country. He just said: “I would resign”. Between these two extreme perspectives, there may be a valid position. After all, if the good public-policy analyst does not propose a sensible course of actions for policy-makers, there will be plenty of bad public-policy analysis out there being sold.
In the very tough times we are living through right now in Europe, this is even more important. Fortunately, in Spain a small opportunity –for the kind of free-market reforms we would like to see… and we badly need- has just opened. As everyone expected, the Socialist Party lost the recent Spanish elections by a wide margin. Their mismanagement of the economic crisis destroyed their credibility with the Spanish people. This is the fact that best explains why the Popular Party –the right-wing party headed by Mariano Rajoy – gained an absolute majority.
The situation facing the Spanish economy is extremely complicated. Recent data suggest that the double-dip recession may already be a reality. The labour market situation keeps deteriorating, adding ever more people to the already huge pool of unemployed – about 5 million, which amounts to an unemployment rate of almost 23%, by far the highest in the EU (Eurostat).
Moreover, bond yields and the risk premium, despite dropping lately, remain at historically high levels. And it is very likely that the general public deficit goal of 6% will not be fulfilled – it might actually be closer to 7% – particularly as a result of actions by regional governments.
The Spanish financial institutions are also experiencing difficulties, with still high exposure to bad housing loans, especially among the Cajas (largely politicised savings banks). The huge housing bubble of the last decade has not completely deflated yet. The banking sector and real estate developers, with the help of government, have avoided a sharp, quick housing supply and price adjustment. Thus, the problem has been temporarily postponed and therefore aggravated.
Given the economic outlook we just outlined, Rajoy should implement urgent and bold – and, unfortunately, unpopular – measures in order to achieve these three inter-related objectives:
1) Bring the fiscal house in order by sharply cutting public spending and fostering economic growth to boost public revenues, through market deregulation and the removal of the many barriers to entrepreneurship. While some Keynesians defend increasing spending as a way to stimulate the economy, there are far better alternatives to do this. In addition, given that a big part of the government deficit is of a structural nature, deeper reforms of the currently inefficient welfare system should be considered.
As Alberto Mingardi described it recently writing about the situation in Italy, the truth is that the welfare state, as it exists now, is not consistent with demographic and financial reality. The three pillars of this system should be revised:
a. Pensions: although the transition towards a private market capitalization system is difficult, this seems to be the best choice towards more sustainability and higher pensions.
b. Health-care: spending should be rationalized through the introduction of some consumer payment mechanisms and the better alignment of incentives among the different agents involved –doctors, hospitals’ managers, local governments, patients- to increase efficiency.
c. Education: our system clearly lags behind many other developed countries. Competition, school autonomy, and more parental choice should be the key guidelines. It has to be understood that the most important thing in the education policy debate is not how much resources a country spends, but how efficiently used they are. Thus, we might get better quality with fewer public resources if we move toward the right direction.
2) Halt the disastrous job-loss trend and lay the foundations for a vigorous employment recovery. In this case, a radical reform of the very rigid and deficient labour market regulation is badly needed. One of the manifestations of this is the dual reality of the Spanish labour market, with a marked difference between temporary contracts (outsiders) and indefinite contracts (insiders) with high layoff costs. Not surprisingly, the first category of workers –many of them youngsters- has suffered the bulk of the employment adjustment, while indefinite workers have remained almost intact in aggregate terms.
Moreover, the overcentralisation of collective bargaining –who decides the labour conditions between employees and employers- greatly curtails companies’ ability to adapt to changing circumstances. Thus, from my point of view labour relations should become much more flexible and decentralized. Furthermore, labour costs should be lowered in order to encourage employers to hire, perhaps through a reduction of social security contributions.
3) Fix the banking sector shortfall through clear and transparent mechanisms, with the aim to soften the sharp credit contraction that puts a further drag on economic activity. This implies that, first, financial institutions have to adjust the value of their assets – particularly loans to real estate developers – to more reasonable levels given the housing price deflation.
Although it is unclear what the Popular Party has in mind in this area, the idea of the so-called ‘bad bank’ has been proposed by people close to Rajoy. This would be a dangerous and unfair instrument, given that it would create moral hazard –taxpayers would cover banks’ losses- and further increase public debt.
On the 20th December, one month after the Elections, Rajoy won a vote of confidence in parliament, becoming the new Spanish Prime Minister. However, although he has been speaking lately on his plans for the future, the details of the particular reforms are virtually unknown. He seems to be devoted to fiscal austerity without increasing taxes, but the spending cuts he has proposed so far are clearly insufficient. In addition, the labor market reform proposal is still too vague.
For the reforms we outlined above to be effective, they must be framed in a coherent and credible plan. Rajoy has to persuade international investors and observers that the Spanish economy and public finances are sound. This has to be done with real facts and a strong commitment to structural reforms.
However, let’s set the record straight: even if the right set of reforms is implemented, output and employment growth will be weak, given the overall economy’s need to reduce debt and adjust large imbalances created during the housing bubble period.
More positively, the current situation presents an historic opportunity for Spain to carry out the many and deep reforms that would make the country a more productive, competitive and financially sustainable economy.
Ángel Martín Oro is an IREF fellow, PhD student in economic and research fellow of the Instituto Juan de Mariana