* Spain faces years of pain to regain competitiveness
* Government has promised unions not to ease firing rules
* Economists doubt growth can revive without labour reform
By Jason Webb
MADRID, Jan 11 (Reuters) - In just two years, Spain has gone from being Europe's biggest job creator to the fastest destroyer of jobs.
With unemployment close to 4 million or 19 percent of the workforce and rising, the country that holds the European Union's rotating presidency faces a long and painful road to regain lost economic competitiveness within the euro zone.
Whether Spain becomes the next Greece, risking the loss of financial market confidence due to soaring debt and deficits, may depend on Spaniards' willingness to endure years of falling living standards.
"My feeling is the Spanish collective psyche is going to snap at some point because they're still expecting recovery just round the corner," says Barcelona-based economist Edward Hugh.
Prime Minister Jose Luis Rodriguez Zapatero has bought social peace so far by resisting pressure from business and the European Commission to loosen rigid job protection which creates high barriers to hiring and firing workers.
Zapatero promised trade unions, which threatened a general strike if workers' benefits were touched, that he would not change labour laws to make it easier to lay off employees.
But the cost of protecting the employed is being paid in the failure to create new jobs for refugees from the collapsed construction sector and other downsizing industries.
The Socialist government hopes global recovery will spark a Spanish economic revival before the 2012 general election without having to slash welfare spending or ease firing rules.
Economists are unconvinced.
UNCONVINCED
Hugh argues most Spaniards have yet to realise the scale of trouble awaiting them as the economy undergoes the deflation needed to regain competitiveness and remain in the euro zone.
Despite the growing number of boarded-up businesses and idle building sites, consumer confidence data shows many people expect the economy to bounce back soon, he said.
The Greek jitters hit the value of the euro, as doubts appeared about the capacity of the single currency area to withstand a possible fiscal collapse by one of its members.
But despite a cut in Spain's debt outlook by ratings agency Standard & Poor's last month, Spanish 10-year treasury bonds trade at only about 60 basis points over benchmark German bunds, compared to a spread of about 228 for Greek bonds.
This is partly because Spain's public debt still stands at just 55 percent of gross domestic product, half Greece's level and well below the euro zone average.
Brian Coulton of Fitch rating agency contrasted Madrid's fiscal track record with that of Greece.
"We've seen periods of major debt reduction in Spain through this decade, and the Greek government despite GDP growth of 4 percent a year, has failed to make any inroads in debt reduction," he said.
But he warned that Spain must move fast now. "The urgency has increased in Spain's case because of the extent of the negative fiscal surprise which is much bigger than envisaged in June. We're expecting (a budget deficit of) 12.5 pct of GDP in 2009," he said.
Sara Balina of Analistas Financieros Internacionales was cautiously optimistic, although cautioning that Spain's future economic growth potential would be capped at 1.5-2 percent.
"It is possible spreads might rise against the euro area benchmark, Germany, but we won't go back to the levels of 2009," she said, referring to the moment when Standard & Poor's cut its credit rating to AA+ from AAA.
Hugh said bond market tension could occur if Spanish banks struggled with rising property defaults.
"BOUNCE ALONG THE BOTTOM"
Charles Dumas of Lombard Street Research reckons Spain needs to regain 15-20 percentage points of competitiveness against euro zone benchmark Germany following years of relatively high growth in consumer prices. Since euro membership rules out devaluation, Spaniards face continued savage deflation.
"We're not going to bounce out of this problem into new sunny uplands, we're going to bounce along the bottom until something gives," Dumas said.
"So far it's been a financial crisis and an economic crisis, but the next round is going to be politics," he said.
Despite the huge jump in unemployment, the political cost to the Socialists has been mild so far.
Only 2-5 points behind the opposition in the polls and still Spain's best-rated politician, Zapatero has been helped by a relatively weak performance by the conservative Popular Party, plagued with corruption scandals.
Opposition leader Mariano Rajoy has struggled to impress voters. But Spain's uneasy social calm could be tested if the country faces drawn-out stagnation. (Reporting by Jason Webb, editing by Paul Taylor)