May 14 (Bloomberg) -- Spain’s economy, shattered by a housing-market collapse and the global financial crisis, contracted the most in four decades in the first quarter as manufacturing sank and unemployment soared toward 20 percent.

Gross domestic product shrank 1.8 percent in the three months after a 1 percent contraction in the fourth quarter, the Madrid-based National Statistics Institute said in an e-mailed statement today. From a year earlier, the economy contracted 2.9 percent. Both numbers were the sharpest declines since at least 1970, according to the institute’s data.

Spain, whose construction boom made it a motor of job creation in Europe, now has 4 million people out of work, accounting for almost 70 percent of the annual increase in euro- area unemployment over the last year. The European Commission expects Spain to contract further next year even after other economies in the region start to recover. First-quarter data tomorrow may show the euro-region economy shrank 2 percent, a fourth consecutive contraction, according to a Bloomberg News survey.

“While at the moment you’re seeing less negative growth rates in Spain than in the euro zone, that will probably reverse in the next quarter and beyond,” said Ben May, an economist at Capital Economics in London, who forecasts a 5 percent contraction for Spain this year. The economy will return to growth “probably another two or three quarters after the euro zone turns positive,” he said.

Lagging Recovery

Spain’s unemployment rate rose to 17.4 percent in the first quarter, double the EU average, government data show. Iberia Lineas Aereas de Espana SA forecasts its headcount may be 10 percent lower in a year, Chairman Fernando Conte said on May 12. Mecalux SA, Spain’s largest maker of warehouse equipment, said this week it plans to reduce the working hours of almost 1,000 workers because of weak demand.

Joblessness will reach 20.5 percent in 2010 after the economy contracts 3.2 percent this year, the commission forecast this month. More than a million Spanish households lack a family member with a job, and a million unemployed people no longer receive government benefits.

Bad loans have more than tripled, according to the central bank, and the collapse of the debt-fueled building boom and the squeeze on credit pushed 475 construction and real estate companies into bankruptcy proceedings in the first quarter.

Political Toll

“It’s too early to speculate about green shoots,” said Martin van Vliet, senior economist at ING Bank in Amsterdam. “It’ll be a long downturn and the recovery is certainly not in sight but at least the worst quarter is definitely behind us.”

The crisis is taking a political toll on Prime Minister Jose Luis Rodriguez Zapatero, who was re-elected last year after pledges of full employment.

A poll of 2,500 people by the state-run Sociological Research Center in April showed the prime minister’s Socialist Party would have won 40.8 percent of the vote if elections were held then, against 40 percent for the opposition People’s Party. In last year’s election, the Socialists won 43.9 percent of the vote, against the People’s Party’s 39.9 percent.

Consumer prices in Spain, which rose faster than the euro- region average for most of the past decade, fell 0.2 percent from a year earlier in April, the second straight negative inflation rate, data yesterday showed. In the euro zone, prices increased 0.6 percent in April from a year earlier.

Swelling Deficit

Spain has implemented stimulus measures valued at 2.3 percent of GDP this year, more than any other country in Europe, according to the government. Prime Minister Jose Luis Rodriguez Zapatero announced additional measures this week in a bid to encourage Spaniards to buy homes and cars, while promising to trim spending by 1 billion euros.

The budget deficit will grow to 9.8 percent of output next year, more than three times the EU limit, according to the commission. Spain had a budget surplus for the three years ending 2007.

As Spain’s deficit swells, the extra interest that investors demand to hold its bonds instead of German equivalents rose to the most since the euro was created in February. The difference, 65 basis points today, is more than double what it was a year ago.

To contact the reporter on this story: Emma Ross-Thomas in Madrid at erossthomas@bloomberg.net

Last Updated: May 14, 2009 05:40 EDT