Reinventing Spain's economyJuly 10, 2012: 5:00 AM ET
The nation has a big productivity problem compared with its trading partners.
By Pankaj Ghemawat and Stijn Vanormelingen
FORTUNE -- As Europe's leaders attend one emergency meeting after another, the political high drama shouldn't make us lose sight of the fact that if the debt crisis is to be solved, Southern European companies need to change how they compete. Nowhere is that more evident than in Spain, whose elites fret over interest rates while protesters in the streets call for closing the borders and a return to barter.
Almost no one there is talking about how to make the real economy more productive. According to our research with IESE Business School colleague Bruno Cassiman, Spanish labor productivity (real output per worker) went up by only 15% between 1990 and 2010, vs. 25% in Northern Europe. Meanwhile Spanish costs per worker went up by 120%, vs. 60% in Northern Europe. That means labor costs per unit produced in Spain rose three times faster than in Northern Europe -- the region that includes its two largest trading partners, France and Germany. Italy and Greece have fallen behind the productivity curve as well.
How can Spain compete with this cost disadvantage? First, forget the idea that closing the borders would help. Over the past two decades Spanish companies in sectors where products and services can be traded internationally raised their productivity five times more than their counterparts in purely domestic sectors. Raising prosperity through trade will require Spanish firms to upgrade. Consider the wine sector. Spain is the world's second-largest wine exporter but has focused on volume rather than value. In 2010, Spanish wines were exported, on average, for only $1.36 per liter, compared with $1.74 per liter 10 years ago. Moving upscale and thus being able to charge what other leading producers do seems the most plausible way to boost productivity.
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Spanish firms that innovate also increased productivity faster than firms that didn't. Matarromera, a small but fast-growing winemaker that claims to spend 30% of its revenue on innovation, is one example. Its successes include a nonalcoholic wine for Muslim countries.
Another opportunity is provided by information technology. Compared with the U.S., Spanish rates of investment in IT have been abysmally low and haven't paid off in productivity improvements. Funds are scarce these days, but with developments such as cloud computing, the initial cash outlays required are no longer quite so daunting.
Finally, Spain needs to create bigger companies. Spanish employment is, by Northern European standards, disproportionately concentrated among very small firms. If Spain had the same number of big and medium-size companies as Germany, that would, we calculate, increase productivity in a number of sectors by 10% to 20%.
The broader point, once again, is that the restructuring of the Southern European economies will not happen until firms become more international, more innovative, more high tech, and bigger. It's the only way Spain, Italy, Greece, and others will walk away from the edge of the current precipice.
--Pankaj Ghemawat, author of World 3.0, and Stijn Vanormelingen do productivity research at IESE.
This story is from the July 23, 2012 issue of Fortune.