The Pain in Spain: Recession Hits Hard

The economic downturn is exposing deeper structural problems that likely must be fixed before the country can get back on a growth track

By Mark Scott

Madrid's financial district has lost its shine. Near the iconic Puerta de Europa Towers in the northern part of the city, For Sale signs adorn newly completed office blocks while cranes sit motionless next to half-finished construction projects. In a local restaurant that tailors to the once-bustling lunch crowd, 31-year-old waiter Manuel Gutiérrez can't remember business ever being so slow: "No one expected the [economic] crisis to last this long," he says.

The recession may have taken some Spaniards by surprise, but its consequences will be felt for many years. After posting average annual gross domestic product growth of 3% over the past decade, Spain's economy is now expected to contract by around 3% this year. Unemployment already stands at 16%—the worst in the European Union—and many economists reckon the level could hit 20% by 2010, the highest since the early 1990s.

"The crisis is getting worse and worse," says Fernando Ballabriga, director of the economics department at ESADE business school in Barcelona. "If things don't pick up in three or four months, companies will run out of money. People are now in a panic"

The severity of the crisis is forcing policymakers to take a hard look at the country's growth model. When credit was cheap and abundant, Spain's real estate and construction industries, which constituted a combined 20% of the country's annual GDP in 2007, boomed as firms such as Sacyr Vallehermoso (SVO.F) and Metrovacesa (MVC.F) invested billions of dollars in commercial and residential property. Although financial regulators steered Spanish banks away from U.S. subprime assets—sparing them that toxic exposure—many, including partly government-owned savings and loans such as La Caixa and Caja Madrid, became highly leveraged on domestic real estate.

Costly Inefficiencies

Now the downturn has wiped billions off property prices, thrown thousands of workers out of jobs, and left banks reeling with bad debt. Equally important, the recession has exposed costly inefficiencies in the Spanish economy such as low worker productivity and high administrative costs that were papered over during boom times. All of a sudden, Spain has turned from a highflier to the sick man of Europe.

The drastic change of fortune has prompted calls from the country's business leaders, politicians, and citizens for wholesale reform in how the domestic economy is run. Topping many economists' lists of desired structural reforms are changes to Spain's rigid labor laws and internal market. That includes everything from reducing labor costs to cutting bureaucratic hurdles for businesses and startups in an effort to jump-start the lagging economy.

"We need to change our growth model," says Rafael Domenech, head economist for Spain and Europe at Spanish bank BBVA (BBV). "Luckily, it's easier to change things in the bad times, when reforms are more acceptable to the entire society."

Still, policymakers may face an uphill battle to persuade Spaniards to give up some of their social benefits. Take the country's labor market: As in many European nations, Spain offers generous employment protections that make it difficult to fire workers—and thus make companies less willing to hire them in the first place. For instance, laid-off workers get up to 45 days of severance pay for every year they've been employed—so sacking a 15-year employee could cost nearly two years' salary.