Shelter Island Capital Management

A shot in the arm for Spain

In the previous blog, we suggested some modest political reform in Spain which might deliver a fairer representation of the electorate in parliament and more accountability from elected officials and public servants. Accountability may be the biggest weakness in governance in Spain, both in the public and private sectors. The most sought-after positions in the country are those that provide generous pay, control over large budgets, and discretion over the compensation of as many people as possible. However, all this magnificent authority must come without any of the usual strictures seen in other parts, such as reporting or accountability. The masters of the Peninsula have it all!

One of Spain’s largest insurance companies allegedly spends €2 million annually sponsoring a professional tennis tournament in Madrid. This magnanimous contribution affords top management access to VIP boxes, presumably for client entertainment. The issue here is that this mutual insurance company’s main line of business is auto insurance and therefore the company likely has a much smaller percentage or total revenues coming from corporate clients than its peers. In any case, this expense is close to 5% of earnings, which is perhaps excessive for such a low-profitability insurer. At just below 6%, its return on equity is well below that of its peers.

Unlike in other major football leagues in Europe, the two largest football clubs in Spain are still “owned” by their members. This leads to total opacity around strategy, the day-to-day management, or the financial health of the clubs. Is it then surprising that the boards of so many public companies try to emulate these arrangements with varying degrees of success?

Corporate flight and lax governance

There was some debate a few weeks ago when Ferrovial, the most successful infrastructures, engineering, and construction company in the country, announced a change of domicile to the Netherlands. Unbeknownst to a clueless economy minister, the question is not why Ferrovial would abandon ship, but rather why many more Spanish companies do not follow suit. Arguably, Amsterdam is fast replacing London as the stock market capital of the EU. In addition, that country’s AAA Sovereign credit rating cannot hurt anybody, nor do its credentials for financial and legal stability.

The answer may be partly that other companies’ boards would not work well in a more open society. Many Spanish companies would not want any more scrutiny than they currently face, nor would they want to part with the protection afforded to management by a very inefficient market for corporate control, which, until the end of 2023, includes the Spanish Government’s veto power over takeovers of Spanish companies. Where else would a transaction such as the recently completed merger of BFE-MediaforEurope and Mediaset Espana, which valued the target at less than 2x earnings, not raise any criticism from institutional shareholders (or trigger the Government’s veto power)?

Living a life of illusion under Sánchez

Pedro Sánchez has presided over one of one of the worst, if not the worst, peace time economies in Spanish history. Yet, such is this Government’s hold over the media that you would never know that from reading the domestic or foreign press.

As has been the case for decades, Spain has one of the highest unemployment rates in the world today. At 13%, the unemployment rate it is more than double the EU’s 6% rate. Worse yet are the fates of women and children with this progressive government. 15% of women are unemployed vs. 6% in the EU and the youth unemployment rate is still a staggering 30% vs. 14% in the EU. Raising the minimum wage nearly 50% in the current legislature has likely contributed to this awful employment market.

High unemployment hurts economic activity. GDP has yet to recover its pre-pandemic level in real terms. Spain is the EU member with the lowest GDP growth rate since 2018, 0.4% vs. 1.3%. It is also the only country in the EU where per capita GDP is lower today than five years ago, decreasing 1.2% vs. a 4.3% growth on average in the EU. This statistic is even worse in Purchasing Power Parity (PPP) terms, which records a loss of 7%. As a result, GDP per capita has decreased from 90% to 85% of the EU’s average. Spain now ranks 13th out 27 EU countries on that metric. We have moved from expecting a “sorpasso” of Italy to being overtaken by Malta and Cyprus.

While progressives would want you to think that the tax burden is low in Spain because they point to Government spending-to-GDP, they fail to see that the tax burden on earned income is one of the highest in the world. It is currently 5 percentage points higher than the OECD average and it will keep rising if the Social Security reform passed in this legislature is implemented. This confiscatory taxation naturally results in higher unemployment and lower investment. Gross fixed capital formation as a percentage of GDP has declined from averaging 25% to just below 20%. The follies of the communist cabinet members do have a real cost.

No growth + high taxes + large fiscal deficits = higher inflation + higher unemployment!

No growth and high taxes have not prevented cumulative price inflation of 16% since February 2021. The food component of that index has risen 25% in that period and 29% since Pedro Sanchez became prime minister. This is likely the case, among other reasons, because Government spending is on a tear. At €612 billion, expenditures are 22% higher than in 2022. Despite this, the percentage of families living in poverty is at its highest since Spain joined the EU in 1986.

Clearly there is something very wrong when the non-accelerating inflation rate of unemployment (NAIRU) is above 10%. Worse yet, Spain’s productivity, measured by GDP per hour worked, is below the EU’s average and well below that of the largest economies in the EU. Labour productivity in France, one of Spain’s largest trading partners, is 70% higher, according to a recently published IMF staff paper.

No pain, no gain

What could be done to fix this mess? Pension and labour market reforms should be a top priority.

These are politically charged reforms that will be met by massive industrial action and street protests, like those we have seen in France. Is it better then to wait until the next crisis brings Spain closer to the precipice of sovereign default at which point these reforms will be imposed by Brussels and the IMF? While this is the politically expedient choice, the cost of waiting may far outweigh the cost of social strife. Not only should the retirement age be raised, but we believe that Government pensions will need to be means-tested at some point unless Spain is ready to face structural unemployment in the 20% region. Who in their right mind would ever hire anybody to manufacture or provide any tradeable goods or services when taxes on labour will continue to rise for decades under the latest pension reform scheme?

When justice means “just us” for companies

In parallel, the Justice system needs to be overhauled. Until such time as it is fixed, important criminal or civil cases may need to be tried elsewhere to ensure a swift process. There is already a deeply entrenched double standard of justice, as most corporate cases are settled in arbitration courts that are unaffordable to ordinary citizens. While many believe that the problem is underfunding, Eurostat data suggest that spending in law courts, police, and other public order and safety areas as a percentage of GDP is above average in the EU. This is most urgent a fix as the economy may not grow at its potential without legal security. This is the main reason why Ferrovial, and many other companies, are moving abroad. This lack of legal security, and previously mentioned governance issues. are reflected in the higher cost of capital that Spanish businesses face relative to other EU firms.

Fix the internal market(s)

Mercifully, there are some quick fixes, including plenty of arbitrary and unnecessary restrictions on commerce. Most internal markets need to be liberalized and homogenised. Tourism is Spain’s largest industry yet only two out of seventeen autonomous regions allow stores to open freely on Sundays year-round. If this were not bad enough, rigid labour laws make it very difficult for most restaurants to open seven days a week. Worse yet, strict limits on the number of hours that employees may work have forced some of the leading restaurants in the world to only open for lunch or limit dinner service to three evenings per week as they cannot find adequately trained staff to serve more meals and the number of hours their staff may work is capped by law.

Regulatory capture in services in general, and in financial services in particular, detracts from consumer choice while keeping prices high relative to other EU markets. Regulators need to be overhauled or, in the case of the banking industry, more decision making should be taken by the EU supervisor as the local regulator seems incapable of preventing mis selling. Competition should be encouraged and yet it is stifled in many regulated industries.

Let’s make a deal

Meanwhile, Spain remains saddled with an antiquated system of sector-wide collective bargaining between unrepresentative labour unions and cartel-like employers’ associations. These collective negotiations do not seem to work very well for the workers the unions profess to represent. This is evidenced in the monotonously declining number of memberships. Only 13.7% of the labour force are union members, a rate well below the OECD’s 16%. It is high time for employers to recognize this reality and stop pretending that they should continue negotiating these agreements with unions who represent very few people. Labour unions in Spain survive thanks to generous taxpayer funding. Why should the 86% of employees who are not union members subsidize these organizations?

The net effect of all these problems is that despite lower real wages, labour productivity is not improving. Add to this one of the most rapidly ageing populations in the world (in 2022 there were more deaths than births), a large net debtor international position, and growing social unrest and one would think that Spain is not a great place to live. Yet, Madrid has become a mecca for many affluent Latin Americans and the tourism industry is recovering fully.

The way forward

A much brighter future might be in store, especially when compared to the stagnation since 2006, should a new Government take some proactive measures, including an improved resident non-domicile tax regime that can compete with those of Italy or Portugal, cutting red tape for new and existing businesses, lowering taxes, especially taxes on labour, liberalising labour markets, removing barriers to commerce, including regulation of opening hours, and tackling the structural public pension system deficit. Perhaps then the relative and absolute decline of the past sixteen years may be reversed.

Three weeks ago, we set out to explore some of the ills that ail sunny Spain. It is often said it is far easier to criticize than to come up with solutions. Nevertheless, we will try here to set forth a road map to a more representative political system as well as reforms aiming towards healthier and faster economic growth. Today we will focus on politics.

We worry that Spain may be descending into a demagoguery. We believe that the country is suffering socially, economically, and financially as a result. Despite popular opinion to the contrary, the data showing decline is crystal clear: a typical middle class or working-class Spanish family is worse off today than it was in 2007.

Our goal is to try to identify policies that may in time reverse this trend and set the country on a path to social and economic development. The first thing that we need to agree on is that the two golden periods of growth since 1975 are neither replicable today nor necessarily good growth models for the future. Spain can no longer count on massive Foreign Direct Investment as in 1986 to 2006 nor on the demographic surge of 1999 to 2007. In any case, our aim is to set the foundations for sustainable economic growth per capita based on productivity growth and not on accounting tricks. For this, Spain needs political reform that would make it easier to set strategic targets.

Decline into demagoguery as democracy decays

But first, we will try to understand the mechanics of demagoguery. Wikipedia tell us that demagoguery is a “political activity or practices that seek support by appealing to the desires and prejudices of ordinary people rather than by using rational argument”.

Chat GPT surmises,

“In “The Republic,” Plato discusses the nature of political systems and their potential for corruption. He believed that democracy, if left unchecked, could degenerate into demagoguery.

According to Plato, demagoguery occurs when a democracy becomes dominated by individuals who seek power and popularity through pandering to the desires and emotions of the masses. He argued that demagogues exploit the ignorance, prejudices, and base instincts of the people to gain and maintain their influence.

Plato criticized demagogues for their ability to manipulate public opinion and deceive the citizens by appealing to their passions rather than reason. He believed that demagogues would use persuasive rhetoric and flattery to win support, even if their proposals were irrational or detrimental to the well-being of the state.”

We will argue here that the current political arrangement of partial sovereignty and a fixed exchange rate regime with its largest trading partners is a source of stability for Spain, but it also causes some problems. Spain abrogated some areas of sovereignty when it joined the EU. Later it gave up monetary sovereignty when it joined the euro. In 2011, the country accepted a commitment on fiscal sovereignty beyond the strictures of the EU Stability and Growth Pact when compelled to reform its Constitution with a balanced budget amendment.

Cumplo pero no obedezco

Regrettably, governments since then have gotten away with partial or no compliance with Spain’s obligations under the Treaties of the EU and the EU directives. Spain, alone among the periphery countries, has not been able to generate a primary fiscal surplus, not even once since the sovereign and banking crises.

The fiscal deficit continues to breach the Treaty’s cap even as income taxes have become extortionate. The marginal income and capital gains tax rates are currently 60% for some of those who pay the Solidarity wealth tax. Arguably, this runaway fiscal spending is the result of the fracture of the two-party system since the crisis. This difficulty in reaching a majority in parliament is exacerbated by the over representation of separatist parties, which combined have 44 members of the 350-seat Chamber of Deputies. Yet none of these parties individually has 4% of the national vote. The threshold for parliamentary representation is 4% of the national vote, or higher, in Austria, Belgium, Czech Republic, Estonia, Germany, Ireland, Iceland, Norway, Poland, Sweden, and Slovakia. It is 3% or higher in Italy and Greece. The reform of the Elections Law is of the utmost importance. Yet, the last time a party had a sufficient majority to make this reform, President Mariano Rajoy decided not to confront the Socialist Party on this issue.

Over-weighted votes means under-weighted representation

As a result, the value of a vote in Spain varies significantly from one place to the next. Whereas it takes 102,000 votes to get elected to Congress in Madrid, it takes just 26,000 votes in Teruel. It is also interesting to note that whereas devolution in Spain has been effected through the delegation of power to the governments of its 17 Autonomous Communities, congressional districts are still apportioned to the 50 provinces that were designed in 1833.

This is the reason why not only fringe parties, but also low-population provinces are overrepresented in the Spanish lower house. The number of votes to obtain representation vary widely. Teruel Existe has a single congressman thanks to 19,871 votes, while each of Cs ten representatives got 165,031 votes. The Socialists and the Popular Party, the two large national parties, needed just 56,600 votes per congressman, while smaller national parties such as Vox needed 70,326 and Unidas Podemos 89,124. Conversely the ETA sympathising EH Bildu, which only tables candidates in the Basque Country and Navarre, needed only 55,524 votes for each of its five national representatives.

This outcome seems to run contrary to the Spanish Constitution which establishes that ‘The Spanish people are the depositaries of the national sovereignty from whom arise the powers of the State.’ The Constitution of 1978 clearly establishes that there is no shared sovereignty between the people and the provinces. So why does that districting system persist when it clearly is neither fair nor equitable? This situation calls for redrawing congressional districts in a manner which guarantees equal voting power to all citizens.

We would also argue that if the United States House of Representatives has been known to work with just 435 members representing 332 million US citizens, the lower house of the Spanish Parliament should work efficiently with many fewer members than the current 350. There are nearly no legislative initiatives that come from individual members of parliament in Spain. Nearly all new bills are presented by the Government for the consideration and debate of the chambers. In addition, there are very few instances where members vote differently from the instructions received from their party’s whip. Thus, a smaller chamber with congressional districts that are apportioned based on population would be a great improvement. Another welcome reform would be direct lists for candidates that would make representatives accountable to their district.

Play by the rules

We will also argue here that Spain should embrace the EU rules wholeheartedly, even if Brexit has given its leaders the idea that they can get away with murder because Brussels cannot afford a second leaver. We understand the average Spanish voter is not interested in EU affairs beyond the nuclear attack shield provided by the euro and the hope that from time-to-time Spain may receive some EU funds. Yet Spaniards would do well to seek EU protection from the misgovernment and corruption they suffer.

Is the process of decay reversible? Or are most democracies destined to become ‘Argentinas’ as Plato predicted? Some take the most recent upheaval in France in response to Macron’s executive order on pension reform to confirm the latter trend. On closer inspection, there are specific issues around that process that could justify protests, such as bypassing parliament which is the seat of sovereignty. In addition, Macron’s aristocratic style may be fast approaching authoritarianism when he prohibits demonstrations sponsored by some political parties but not those sponsored by others. The Spanish Prime Minister seldom ever addresses the topic of PM questions in the chamber. Mr Sanchez has been ruling by decree, often unconstitutionally, for four insufferably long years. He has packed the Constitutional Court with flunkies and has made it clear that the Attorney General works for him.

The biggest challenge: Education costs, but ignorance costs more

Education, or rather the lack thereof, seems to be the root cause of many of these problems. The public education system in Spain has been on the wane, amongst other reasons because teachers’ pay has lagged that of alternative career paths for those who invest comparable amounts of time and money in their education. At the same time, Spain’s politicians have managed to effectively bring down private education to a similar level of incompetence and irrelevance thanks to mandatory national curricula. It is of little or no use to have better teachers when they are forced to follow a politicised and dumbed down syllabus.

As a result, those who can afford it send their children to British or American schools and universities. It would seem logical to do away with national or regional curricula, allow schools to set their own study programs, and most importantly, start a voucher system that empowers lower income parents to be free to choose a school for their children. As we will suggest later, in this area as well for other areas we target for reform, Spain may consider giving up sovereignty on this matter as well. Many parents, including King Felipe and Queen Letizia, have chosen the International Baccalaureate program for their children; why not let all schools chose whether they want to offer that curriculum or any other for that matter?

Spain has nearly 100 universities today, most of which are public. Many of them are research universities, yet as far as we know none of the private universities conduct scientific research. In any case, it is not easy to establish this fact accurately as, once again, opacity wins the day. For all that spending on new universities (in 1975 there were only 28), Spain has produced no Nobel Prize winners in physics or chemistry, nor a single winner of the Fields Medal in Mathematics. There are no Spanish Nobels in economics either.

While some will point out that two Spaniards received the Nobel prize in medicine, the most recent award is questionably Spanish as the recipient, Dr Severo Ochoa, had long before become a US citizen and renounced his Spanish citizenship. In any case, this award took place sixty-four years ago. When confronted with this dearth of recognition, local enthusiasts remind their audience that Nobel Prizes are awarded to those who spend the most money lobbying the academy. This penchant for confronting reality with magical thinking is as dangerous as ineffective.

Yet in a country full of nationalists and optimists, one often hears warm praise for some professional class or another. Whether it is medical doctors or engineers, the argument is that Spanish members of those professions excel universally. However, the Polytechnic Universities of Madrid and Barcelona rank 58 and 60 in the QS World University rankings. In medicine, the University of Barcelona ranks 52 and is the only Spanish representative in the top 100. For all the alleged technical prowess, Spain ranks 29th in the Global Innovation Index league tables, 38th when adjusted for income and 18th in its home region of Europe. One may surmise that as with most other broad issues on which there is an apparent consensus in Spanish society, neither education nor innovation are top policy priorities. In fact, one could argue that the opposite is true.

Reversing centuries of indifference towards knowledge and innovation may well be the biggest challenge for the country. “Qué inventen ellos!” (Let them (i.e., foreigners) invent) was Miguel de Unamuno’s cri de coeur to express his disdain for contemporary scientific research. Alas, he confused science and technology. He was right to think that Spain might be able to continue to benefit from technologies developed elsewhere, Spain still trades today oranges for iPhones. Conversely, he missed that since the scientific revolution, philosophers with no scientific training have not made any contributions to the fundamental understanding of reality. Nothing is more urgent for Spain today than a shot of reality!