Romesh Vaitilingam interviews Juan Dolado for Vox

September 2010

Transcription of an VoxEU audio interview [http://www.voxeu.org/index.php?q=node/5550]

Romesh Vaitilingam: Welcome to Vox Talks, a series of audio interviews with leading economists from around the world. My name is Romesh Vaitilingam and today's interview is with Juan Dolado from the Universidad Carlos III in Madrid. Juan and I met at the European Economic Association's annual meetings in Glasgow in August 2010 where we spoke about the labor market in Spain. I began there by asking him to lay what broadly had happened to European labor markets in the wake of the Great Recession.

Juan Dolado: Well, the broad picture would be one where the losses in terms of output have been much larger than the losses in terms of employment. That is, productivity has gone down--with the exception of Spain, where the output growth was serious but not an outlier with respect to the other European partners. However, employment has been in a freefall. Apart from Spain, this reaction of employment has been different to previous recessions like in the '90s where employment fell by much more than output.

Romesh: We can come back to talk about the particular case of Spain as you say, which is different from many of the other European countries. Why do you think, though, broadly speaking, that employment hasn't fallen by as much as output in this recession compared to previous recessions?

Juan: I guess because we just have been much more flexible. In the case, for instance, with the UK or in the case of the Netherlands or in the case of Denmark and sort of Anglo Saxon, Nordic economies, all the ways of introducing flexibility, like in working time, which is what has happened in Germany with the Kruselbeit arrangement. Typically in the 90s and in the 80s, most adjustment was through quantities. And now most of the adjustment is through prices, with the exception of Spain.

Romesh: And then do you think that, in a way, policymakers have learned lessons from the responses to previous recessions policymakers both at government level but also decision makers as workers and decision makers as employers?

Juan: I think the fact that the reaction has been so different must imply that policy changes have changed incentives by firms and workers about what to do in a slump and how to adjust to a crisis. And I think both in terms of labor market policies like, for instance, unemployment benefit reforms like the one that took place in the UK or some reforms which have taken also place in Germany or in France have been effective in that.

Romesh: So, in a way, the kind of reforms that economists have been calling for for many years and the head of the European Central Bank has been calling for for many years, some of these have actually been implemented. The European labor markets aren't, perhaps, quite as rigid as is sometimes claimed perhaps by American commentators.

Juan: Well, this is the big surprise, the big puzzle in this crisis which is that, in the past in Europe, employment fell by much more than output. This is what is happening now in the US as opposed to Europe. So Europe is adjusting through prices, and the US is adjusting through quantities and there are several theories for why such is the case.

Romesh: Let's focus on Spain which, as you've say, is an outlier. Why has unemployment risen so much more in Spain than in most of the other European countries?

Juan: Because of the great segmentation in the labor market. The old permanent/ temporary contracts divide, this is what I've christened as a ‘bulimic’ labor market. So it's a labor market which creates a lot of jobs during expansions and destroys a lot of jobs during the recessions. So the volatility, for instance, of the Spanish market is about twice the US labour market, which is amazing given that two thirds of the population have been enjoying extremely rigid contracts with very difficult to dismiss and also difficulties of hiring. And still you have this one third of the population, which is just like workers in Hong Kong in the spot market, where they get hired on Mondays, fired on Tuesdays, rehired on Thursdays, and so on and so forth.

The basic difference between Spain and other countries in my view has to do with this great divide. So basically what happens is that the firing clause for permanent contracts and the timing of the legal disputes for permanent contracts is very, very expensive as opposed to temporary contracts. So the conversion typically is natural, that temporary contracts are perfect contracts for youngsters as sort of stepping stone. But this stepping stone never occurs because employers refuse to promote these workers in the fear of having to pay this high dismissal cost.

So this means that there is this huge turnover, all these workers, workers with high education, with less skilled workers, etc., who never get into the population of stable workers or workers with a stable contract. And this is why these temporary contracts are easy to create in booms because they are cheap. They don't attract the most skilled workers, and therefore, for instance, they're good for the construction sector. And they are very easy to destroy during recessions.

And this creates a great divide in the society because the degree of temporary contracts is not uniformly distributed across the population. They are overrepresented on youngsters, on women, on migrants. So it creates also an inter generational conflict between parents who have protected jobs and kids who cannot leave home. For instance, the proportion of youngsters between 25 and 35 who still live at home is two thirds. So it is really amazing.

So this also creates slow mobility. So, for instance, now with an unemployment rate of 20 percent, there are regions which have a 10 percent unemployment and other regions which have 30 percent unemployment. But you don't see inter regional flows from people who lost their job in the high unemployment region to people looking for a job in the low unemployment region. So it has to do with all these rigidities, mismatch, etc. And the politicians need to have the courage to take the bull by the horns and once and for all finish with this great divide.

So, for instance, there is this group of economists which got a lot of media attention advocating the use of a single contract. So the idea of a single contract is a contract whose dismissal cost is increasing with your tenure. So at the beginning you get a few days per year of service, a few days of salary, but then that increases. Instead of like now where you have a huge increase in the marginal cost of promoting a worker from temporary to permanent contract, the marginal cost with this single contract will be very, very smooth. It will be two days more per year or something like that. And on average the worker will get the same as he would get with the old system except that now the conversion rate will increase dramatically. We have simulated that.

That, of course, raises issues about the degree of protection that unions are not ready to accept. The socialist government has been supported by the unions for a long time, but now they've reached a situation where there's a call for a general strike, because finally the social dialogue did not reach anywhere. The unions and the employers were not talking to each other, so the government introduced light reform. But in the economists' view, we believe it to be very light, with support strong for the unions, so there is a general strike on the 29th of September, and we'll see what happens.

Romesh: Can we turn to the structure of the Spanish economy and how much that was responsible for the particularly damaging impact of the Great Recession on the Spanish economy, particularly the importance of the construction boom and bust in leading to these very high rates of unemployment?

Juan: Spain has had a residential construction bubble. The reason for that, in my view, has to do with the relative abundance of skilled and unskilled labor. Let me go back to the '90s, when there were stages for preparation for access to the Eurozone. Spain experienced a high decrease in real interest rates because it had a hefty inflation rate and we adopted a nominal German interest rate. So that meant a big fall, six percentage points, in the real interest rate that gave a boost to investment and the type of projects that could be undertaken were either those who would be complementary to unskilled people, unskilled workers, or to very, very skilled workers.

There was an abundance of unskilled workers. Why? Because the facility with which temporary jobs were created was increasing the drop out rate from school quite dramatically. Kids didn't even finish compulsory secondary education, just to go to the construction site and get paid 500 euros a month. So that meant that the drop out rate is about 33 percent in secondary school. So there was relative abundance of unskilled labor.

Furthermore, with the rigid permanent contracts, it is very difficult to invest in innovative sectors when you have a lot of creation and destruction before the firm stabilizes and, therefore, the only sector that investors in Spain could specialize was in what we call bricks. And that was the reason, so it reached about 10 percent, 11 percent, of GDP, which in most economies is about four or five percent, and in terms of employment, it almost reached 14 percent of employment.

So now, in the crisis, we have lost two million jobs, which is about a fall of 10 percent of employment, and about 60 percent is due to the collapse of the construction sector. Just to give you a very lucid example, we were producing the same number of new houses as France and Germany together.

Romesh: Juan, you've talked a little bit about the potential policy response to dealing with the rigidities in the labor market. How about some of the other issues that the Spanish policy makers are having to address, things like trying to encourage rebalancing the economy, to encourage innovation in new areas to kind of take over from the construction sector, but also thinking about the whole context of the program for fiscal consolidation that the bond markets and others are seeming to demand.

Juan: The Spanish government is talking, and the media talks about the new productive model. What do we do with this 1.2 million workers who have lost their jobs in the construction sites? What are they going to do? Well, I think the only recipe is to improve the educational system and of course correct those regulations which impede high labor mobility--for instance, those that give very beneficial treatment of home ownership against renting.

But the education system is in dire straights due, in part, to this segmentation of the labor market. It has one of the highest drop out rates in the world. In terms of primary and secondary education, I think there is more money to be put in, so more public investment. As opposed to many other countries in Europe, private, unchartered schools are much better considered than the public education system.

The opposite happens when you go to the university. The university system is a system dominated by inbreeding, very few competition, so I think there is quite a lot of money to be saved in terms of restructuring. For instance, merging universities, introducing another compensation system. For instance, university professors are civil servants, so it means they have infinite firing cause and things like those. So there is a lot of money that could be saved from the higher education system which could be sent back to the secondary education system. That's one issue.

Some other issues related to fiscal policy have to do with the fact that the degree of tax evading is still high, so more effort should be put on strengthening the tax inspection, etc. And there are many other little reforms. For instance, transportation is not very effective, despite having one of the largest networks of high speed trains in Europe. These trains are far from the coast. Goods transportation is really expensive.

The education system is the next step to be taken.

As for fiscal consolidation, I mean, the measures that have been taken are simple. Civil servants have received nominal wage cuts of about five to 10 percent of earnings. And then a lot of infrastructure has been stopped. My view is that the markets are overreacting, but they are overreacting in part because the problem--when you look at our debt, you have in mind the evolution or the development of a ratio, which is the debt to GDP ratio. So if GDP grows enough, you will have enough to pay back the principal and interest rate of your debt. And the problem is what is going to happen to the growth rate? We are the laggards of Europe in that respect. So it's not so much the numerator but the denominator, which is really making noise in the markets.

On top of that, we have general elections coming in 2012 and so that means that the government is looking at too many fronts at the same time.

Romesh: Well, I was going to ask you as a final question, Spain's got this incredibly high unemployment rate by European standards and by standards over time, but it has been there before relatively recently without seeming to tear apart the fabric of Spanish society. Do you think at this particular point the pressures are there enough to make some of the fundamental reforms that you're calling for?

Juan: Well, one of the reasons for the sustainability of the Spanish fabric, as you say, is in the past, is that this divide of protection in jobs is within parents and kids. So kids stay at home, parents pay for their expenses. Kids, in exchange, look after them. So the family ties are very, very important in Mediterranean countries, and most important in Spain. So the pillar of the welfare state is the family, is the household. In that respect, nothing is new in this crisis with respect to the previous one. Except that, of course, with the technical change, many of the parents are starting to suffer the risk of losing their jobs.

In a sense, this is good news because sooner or later the fact that this risk is increased implies that the support for changes increases. So it's when you feel the fear of losing your job that you may be ready to accept some changes, which increase the probability of finding another job once you lose your job.

So this is why many reforms take place in recessions rather than in expansions/ It's the fear, the exposure to the fear. In that respect I'm more positive. And in respect to the fact that the recent labor market reform has been quite shy. The median life of labor market reforms in Spain have been three years, so everything can be overthrown, overcome.

Romesh: Juan Dolado, thank you very much.

Juan: Thanks a lot.