Spain´s labor market reform, approved by Royal Decree Law last month, is not only the most ambitious ever attempted in Spain; it is the most dramatic recorded anywhere in the OECD in the postwar period.  Is that good or bad news?  In the short term, it may be bad; in the longer term it will be good.

The labor market reform tackled all components of Spain´s dysfunctional labor market, for the first time since the Workers´ Statute was approved in 1980.

It reformed aspects of the collective bargaining system (making it easier for firms to break with sectorally-agreed wage increases and to unblock negotiations), of the training system (by making training a right for workers and mandating 20 hours of training per year), and especially of labor market contracts, the area where Spain was the greatest outlier in the OECD.  The unfair dismissal pay of 45 days per year worked was slashed to 20 in most cases, since unfair dismissal will become more difficult to prove.

The decree-law also set time limits for the legal proceedings associated with firings to avoid the drawn-out court cases that caused firms to settle for the upper limit on dismissal pay rather than pay court costs.  It created a new permanent contract for small and medium-sized firms with a one-year trial period, aimed at young people.  And it eliminated prior authorization for collective dismissals.  It also declared an intention to use temporary work agencies to support the feeble job-search efforts of the public employment service, although little detail was given and it is not certain how and when this change will be implemented.

Overall, the reform means a dramatic change in Spain´s labor markets.  According to my calculations, using the OECD´s quantitative indicator for employment-protection legislation (EPL), the rigidity of Spain´s labor markets drops by more than 25% following the reforms.  No decline of this size has been recorded anywhere in the OECD since World War II, according to my time series; and especially not in Spain.

Hence the reform is substantial, even though it still leaves Spain without the single contract that experts have called for for years and which would help the country to begin to address the duality of its labor market.

What will be the results of the reforms?  In the short term, the unfortunate reality is that they will destroy jobs.  Many firms in Spain have been waiting for a reduction in severance pay to shed unproductive workers or readjust costs, and now they will do it for a lower amount.  In essence, what the reform does in the short term is enable firms to survive the crisis, helped as well by the sharp cuts in corporate tax and the expansion of lines of credit that the government has also implemented.

In the longer term, however, the reform will stimulate job creation.  The effect may be small at first –maybe shaving half a point off the unemployment rate every year– , but this effect will be added to the impulse of economic growth once it returns next year.  Reducing joblessness to normal levels will not happen quickly, but hopefully with the reform in place, the new jobs that will be created from 2013 on will not be nearly all temporary.

It should be remembered as well that the labor market in Spain needed reform not just because it caused high unemployment or low employment, but because it had a negative effect on the overall functioning of the economy.  Productivity, for instance, is reduced by a rigid labor market.

Spain may have gotten itself “stuck” in the low-productivity, low-value-added model in large part because of its rigid labor market.  Once companies have more flexibility and workers have greater incentives to be productive and innovative, productivity should begin to grow faster.  This will mean better jobs, better incomes and a new productive model for the country in decades to come.

The labor reform will not solve all of Spain´s problems at once.  It may make things worse before they begin to get better.  But it was needed and it will make a difference.