Why the IMF’s last report on Spain doesn’t make the cut


In order to improve the labor market dynamics, a really employment-friendly strategy would require an agreement between unions and employers, whereby employers would commit to significant job increases in return for across-the-board wage cuts accepted by unions. Fiscal incentives –by reducing social costs- would be the government’s contribution to the agreement.

The IMF has been running model-simulations of the Spanish economy and found that employment responds positively to wage cuts. The social agreement would be necessary to set the country again on a path of growth. Trouble always waits when you get down to the nitty-gritty of a real economy. Here are a few reasons why the IMF’s proposal can’t make the cut:

Let’s start with the basic tradeoff to be agreed by the social partners: job-creation Vs wage-cuts. The beauty of the model lies in the symmetric commitments of the social partners. Everyone seems to accept commensurate sacrifices for the common good. Wage-earners would accept taking home leaner paychecks, effective tomorrow (so to speak). Employers would commit to create jobs. Unavoidably, a few eyebrows have risen at this point.

First, let us have a quick look at the real world. Can anyone expect a downtrodden economy, with six million unemployed and a huge negative output gap, to turn around just because labor submits to wage cuts? Lower wages would reduce demand for goods and services and slam a brake on the process of private deleveraging. All this would deepen the depression further. Hardly an enticing scenario for employers to commit to wide-ranging hiring policies.

Even if there were signs of the economy beginning to pick up, job-creation is generally sluggish in the first stages of recovery. Employers bid their time, turn up the heat on their employees, and for a while achieve higher production targets on the back of the existing workforce. It is also not unusual for an economy struggling to come out of depression to make a few false starts and dip again. Only the widespread feeling that this time round the recovery looks sustainable will consolidate entrepreneurial expectations, trigger major investment decisions and get the economy moving again.

To make it short, the social agreement out of the IMF’s bag is fatally asymmetric. Unions must act now. Paychecks are to be cut right at the start. But the employers’ reaction is dependent on the behavior of a cluster of exogenous variables that give shape to their expectations. This may well take quite some time and renders meaningless any commitment along the lines suggested by the IMF.

Second, the model deals with the problem of falling incomes and the subsequent, undesirable shift of overall demand by assuming a commensurate reduction in prices. Now, how would a blanket price cut ever come about? The model nowhere explains how, it takes it for granted, just the flip side of the wage cut, “wage reduction, and associated fall in prices…” which, moreover, would take place “relatively fast”. Now, is it realistic to expect that? By what means would an across-the-board downward readjustment of prices come about? Can the IMF bring up another case in which a market economy more or less like Spain took substantial wage cuts –the IMF suggests 10%, “for illustrative purposes “- and, in one swoop, made them good by a proportional cutback in prices?

Now, cheaper labor will trigger job creation and, with lower CPI inflation, the new wage earners will help maintain current demand levels, and thus prevent descent into more recession. This would round off the model as such. But it is strongly asymmetric, as pointed out above. Employment would come, if and when it does, well after current wages had been cut back. Price behavior is just a major “known unknown“. The different events do not occur within the same time frame. Policymakers would be ill-advised to build economic policies based on such a set of relationships.

A couple of final comments to recap:

Some people among us felt that the IMF shouldn’t embark on providing public, unrequested advise to Spain –and mostly on such an extremely sensitive issue.

Well, let’s not overreact. The IMF always slips a few recommendations to its members into an Art IV report. Nowadays, this seldom causes any furious reaction. If the national authorities disagree, they will simply ignore the recommendations. This is in fact what the Spanish authorities did a few years ago when successive IMF missions felt they should broach for discussion a couple of delicate subjects, such as the reform of the savings banks and the growing real estate bubble. Our authorities nonchalantly shrugged off the recommendations. Too bad. We would be better off if both issues had been tackled at the time. Outright displeasure with the current proposal of the IMF should not blind us to the fact that sometimes, on critical issues, they got it right.

What I find disappointing is the simulation upon which the IMF is building its advice to Spain. Employment grows as we feed lower wages into the model. Employers and unions are supposed to come to an agreement on this wide ranging issue. Associated to falling wages, prices also fall. All together, more jobs and lower prices make good the cutback in wages. In about two years’ time, employment could improve by six or seven points.

This interaction of key macro variables is quite interesting, except that the country is not dealing with modeling techniques but with a serious problem in political economy. The IMF should know this. The institution has quite often in the past –but as recently as during the Asian crisis of the late nineties- recommended, or imposed, well-structured adjustment programs which however showed little concern for the social or political constraints that would limit the choice to second- or third-best solutions. The advice to Spain involves kind of a timeless frame, where the workforce takes a sound whipping right at the start while job-creation, as shown by experience, will proceed slowly, riding on the signs of recovery. A social agreement on these terms is quite simply out of the question.

The blanket fall in prices is another key element in the understanding of the IMF’s proposal. The report doesn’t give a single indication how it could come about. We only learn that it is “associated” to the wage cut, but are none the wiser for that. No policy-makers would find a basis for a political “sell” of the proposal.

At the end of the day, we read that the staff “sees merit in exploring this option”, possibly not now but in the future. Well, after all the trouble in building the model as a key contribution to the report, we find a hesitant touch in the authors themselves, in sharp contrast to the enthusiasm expressed by the EU Commissioner for Economic and Monetary Affairs, the officer in charge of the Spanish Excess Deficit Procedure. He wholeheartedly supported –from his blog- the simulation exercise and the ensuing recommendations, and even took the high moral ground in advising the Spanish players of their responsibility in staying idle. Didn’t he detect the practical inconsistencies of the model, leading to an abyss between the theoretical exercise and the rough and tumble of the real world? Let’s now leave it like that.

About the Author

Luis Marti
Luis Martí is Commercial Technician and State Economist. He was executive director at the International Monetary Fund and World Bank appointed by Spain, and deputy president of the European Investment Bank.

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