The long period of virtually uninterrupted strong growth since the early 1990s has ended. This is likely to bring about lasting and profound economic changes. Housing construction is slowing sharply from an unsustainable level, and private consumption is also adjusting to more restrictive conditions in financial markets at home and abroad. The slowdown, although still at an early stage, has already had a significant impact on unemployment and is set to deepen in 2009, as the slide in housing construction is steepening. Some driving factors behind the robust historical performance – low real interest rates following euro adoption, ample credit availability, rising female labour force participation and massive immigration – are losing steam, portending only a modest rebound. Although predicting future potential growth is tricky, productivity gains have been weak, notwithstanding rapid capital accumulation, and it is as yet too early to assess whether the recent improvement will be sustained. Implementing an ambitious programme of structural reforms would surely enhance productivity performance in the medium and long term.

Residential construction is slowing sharply towards a level which is sustainable in the long run and investors and consumers are also adjusting strongly to a marked deterioration in financial conditions in the wake of the international financial crisis, as well as to deteriorating job prospects. The slowdown is already having a significant impact on unemployment. Beyond this downturn some of the drivers of historical strong performance may weaken, notably vigorous credit growth, unusually low real interest rates in the wake of the adoption of the euro, exceptionally strong immigration and rapidly rising female labour force participation. An overall robust financial system in international comparison will help limit the economic consequences of shrinking housing-market activity and international financial market turbulence; and the ongoing large rise in tertiary attainment provides a significant potential to raise productivity growth, which has been weak on average over the past decade. However, in part as a result of strict employment protection for incumbent workers and low mobility, young qualified workers are often not employed in jobs commensurate to their skills, the inflow of young workers with a low education level into the labour market remains very large, and these workers are seeing their employment prospects deteriorate. The challenges will therefore be to improve the matching of workers to jobs so as to help limit the impact of the downturn on the labour market and improve the placement of highly qualified workers. Further reforms of the education system are also called for in order to cut the number of drop-outs from lower secondary school and to raise efficiency throughout the system. Reforms to intensify competition in product markets would also raise productivity performance.

The deceleration of economic activity and the necessity for structural change in order to return to sustainable growth imply a need for a better matching of workers to jobs. This chapter looks at the main institutional features and policies in the labour market that are behind the mismatch between qualified workers and available jobs, which is severe in international comparison. A well designed strategy to activate the unemployed can help ensure that unemployment benefit recipients find a suitable job as fast as possible and minimise the risk that the availability of unemployment benefits unduly reduces work incentives. An adequate level of coordination between the administration of unemployment benefits and activation policies lowers the risk of benefit traps if activation policies are used to ensure that recipients re-qualify for unemployment benefits.Reform ofemployment protection legislation would help to increase the employment prospects of highly qualified young workers and other groups who face entry problems. Immigrants have high participation rates and relatively low unemployment, but they hold precarious jobs for which they are overqualified. Hence, there is scope to increase their labour market integration. Housing market policy reforms need to focus on removing barriers to geographic mobility, and the wage bargaining system should be reformed in order to ensure an efficient allocation of labour by allowing wage agreements to reflect firm-level conditions.

Impressive progress has been made in raising participation in early childhood education as well as tertiary educational attainment over the past 30 years. However, the inflow of poorly educated youth into the labour market is unusually heavy for a high-income country, largely on account of elevated drop-out rates in lower secondary education which, in turn, reflect one of the highest grade repetition rates in the OECD. The supply of workers with intermediate vocational skills is surprisingly low, despite the high returns, in terms of labour market outcomes that these skills offer, even if they have recently deteriorated. There is room to raise learning outcomes up to the end of compulsory school, as measured by PISA, although, owing to a compressed distribution of such outcomes, the share of poorly performing pupils is not unusually large. While significant reforms have been undertaken to address these problems, more measures are needed to reduce grade repetition and raise education outcomes, by improving accountability of schools and school staff, as well as by raising school autonomy further than has already occurred. Vocational training needs to become more attractive. In tertiary education, few Spanish universities have attained a high level of international standing, and scope remains to improve the contribution tertiary attainment can make to gains in economic welfare, notably by reforming funding arrangements.

While significant advances have been made in strengthening product market competition in a number of areas, there is still considerable scope to enhance the role it can play in boosting productivity growth. Barriers to competition are still significant, including in sectors that produce intermediate goods and services, extending their negative impact on productivity throughout the economy. This chapter looks at the barriers to increased competition in goods and services markets and analyses the improvements introduced in recent years. These reforms concern sectoral aspects such as the regulation of network industries – in particular, the energy, telecommunications, transport and postal sectors, as well as other markets including savings banks, retail trade and the regulated liberal professions. Recent measures announced by the government, for instance in some network industries and in professional services, are a step in this direction.