Structural reform is the key

While Europe's governments struggle to contain their debt meltdown, a big part of what's gone wrong is easy to forget.

Through force of repetition, starting not just with this emergency but before the single-currency experiment even began, calls for "structural reform" in the European Union have become an empty incantation. It's worth pausing to understand just how badly parts of the EU still need it.

We'll get to what structural reform actually means in a second. First, consider Spain. Last week its unemployment rate rose to 22.9 per cent. Think about that. In the US, unemployment of 8 per cent is rightly seen as a national disaster. Joblessness in Spain is nearly triple that. Spain has 14 per cent of the euro area's population and a third of its unemployed. Among young people, one in two is without work. And Spain, like many other EU countries, expects to fall back into recession this year, so those numbers are going higher.

Let's acknowledge that the now familiar cycle of credit — driven boom and bust is mostly what lies behind this social and economic catastrophe. Spain's euro membership drove interest rates too low and optimism too high; borrowing and asset prices soared; housing and construction boomed; then the bubble burst, and the economy collapsed.

Look beyond cycle

The public-sector profligacy that played such a leading role in Greece's version of this calamity was absent, by the way. Spain was balancing its budget before the crisis, and even now its public debt is lower than Germany's. Yet the risk premium on Spanish public borrowing is now so crippling, and the country's growth prospects so poor, that analysts are talking about a possible default. And, to repeat, one in four Spaniards is without a job.

The focus on borrowing and lending isn't wrong, but you have to look beyond the financial cycle to understand Spanish unemployment. Why has the recession hit so hard? And why is it so expensive for Spain to borrow?

Here's where "structural reform" comes into play. Maybe second only to Greece, Spain is Europe's most notorious instance of a broken labour market. In Spain, as in many other failing EU countries, "structural reform" means "labour-market reform" — and "labour-market reform" is a euphemism for confronting the unions.

Spain has two main forms of labour contract: temporary and permanent. This division and its implications are admirably explained by Samuel Bentolila and his colleagues at Spain's Centro de Estudios Monetarios y Financieros research institute in a paper published by the Centre for Economic Policy Research in London. Temporary workers, who make up about a third of the workforce, have few rights and are easy to fire; permanent workers have lots of rights and are nearly impossible to fire. In addition, collective bargaining happens not at the level of the factory or the company but at the level of industries and entire provinces, and collective-bargaining agreements have the force of law.

Temporary workers

As a result, companies facing worsened circumstances can't adjust the wages, benefits or working conditions of permanent workers. Temporary workers, with no rights, are left to carry the whole burden.

The system has other, more subtle perversities. It is anti-growth and anti-competition.

In the years before the crisis hit, Spain's wage-setting system helped push its costs of production up much faster than in Germany and Europe's other best-performing countries. Despite this lack of competitiveness, it increased its exports at a respectable clip — but not nearly as much as Germany, and far less than if its labour costs had been better controlled.

This accumulated competitiveness deficit will hold back Spain's economic growth and influence the markets' assessment of Spain's ability to service its debts. That's the connection between a dysfunctional labour market, the risk premium on Spain's cost of borrowing and the danger of a Spanish default.

To say the problem is merely the power of organised labour is too simple-minded. The problem is not powerful unions in their own right, but powerful unions combined with maladapted wage-setting arrangements that, once established, unions are determined to defend.

In other words, there's a social justice component to structural reform — but not the soak-the-rich, save-the-worker one emphasised by the European left. It would be good to understand that before taking sides.

— Bloomberg