Russia’s road to economic ruin

After the Russian invasion of Ukraine in February, the Russian economy looked set to collapse. International sanctions have threatened to strangle the economy, leading to a collapse in the value of the Russian ruble and financial markets. Every day the Russians seemed ready for deprivation.

More than eight months into the war, this scenario has not come true. In fact, some data suggests the opposite is true and the Russian economy is doing well. The ruble strengthened against the dollar, and although Russian GDP has shrunk, the contraction could be limited to less than three percent in 2022.

Looking behind the data of moderate GDP contraction and inflation, however, it becomes clear that the damage is actually serious: the Russian economy is doomed to a long period of stagnation. The state was interfering in the private sector even before the war. This trend has only become more pronounced and threatens to further stifle innovation and market efficiency. The only way to preserve the viability of the Russian economy is through major reforms – which are not in sight – or an institutional disruption similar to that which occurred with the fall of the Soviet Union.

Sanctions are not missiles

The misunderstanding of what sanctions against Russia would accomplish can be explained in part by unrealistic expectations of what economic measures can do. Simply put, they are not the equivalent of a missile strike. Yes, sanctions can weaken the economy and lower GDP in the long run. But in the short term, the most that can reasonably be hoped for is a massive drop in Russian imports. It is natural for the ruble to strengthen rather than weaken as the demand for dollars and euros decreases. And since the money that would have been spent on imports is redirected to domestic production, GDP should indeed increase rather than decrease. The effect of sanctions on consumption and quality of life takes longer to make its way into the economy.

At the start of the war, in February and early March, the Russians rushed to buy dollars and euros to protect themselves from a potential collapse of the ruble. Over the next eight months, as Russian losses in Ukraine increased, they bought even more. Normally, this would have caused a significant devaluation of the ruble because when people buy foreign currency, the ruble plummets. Due to the sanctions, however, companies that imported goods before the war stopped buying currency to finance these imports. As a result, imports fell by 40% in the spring. One consequence was that the ruble strengthened against the dollar. In short, it was not that the sanctions did not work. On the contrary, their short-term effect on imports was unexpectedly strong. Such a decline in imports was not expected. If the Russian central bank had predicted such a massive decline, it would not have introduced severe restrictions on dollar deposits in March to avoid a plunge in the value of the ruble.

Economic sanctions, of course, had other immediate effects. Blocking Russia’s access to microelectronics, chips and semiconductors has made the production of cars and airplanes nearly impossible. From March to August, Russian auto production fell by an astonishing 90 percent, and the decline in aircraft production was similar. The same goes for arms manufacturing, which is understandably a top priority for the government. Expectations that new trade routes through China, Turkey and other countries that are not part of the sanctions regime would compensate for the loss of Western imports have proved wrong. The abnormally strong ruble is a sign that back-door import channels are not working. If imports flowed into Russia through hidden channels, importers would buy dollars, sending the ruble down. Without these critical imports, the long-term health of Russia’s high-tech industry is disastrous.

The Russian economy is destined for a long period of stagnation.

Even more consequential than Western technological sanctions is the fact that Russia is unequivocally entering a period in which political cronies are consolidating their hold on the private sector. Has been a long time. After the 2008 global financial crisis hit Russia more than any other G20 country, Russian President Vladimir Putin essentially nationalized big business. In some cases he has placed them under the direct control of the government; in other cases he has placed them under the jurisdiction of state banks. To stay in the good graces of the government, these companies were expected to keep a surplus of workers on their payrolls. Even the companies that remained private were essentially prohibited from firing their employees. This has provided the Russian people with economic security, at least for the time being, and that stability is a key part of Putin’s pact with his constituents. But an economy where businesses cannot modernize, restructure and lay off employees to increase profits will stagnate. Unsurprisingly, Russian GDP growth from 2009 to 2021 averaged 0.8% per year, lower than the period of the 1970s and 1980s that preceded the collapse of the Soviet Union.

Even before the war, Russian companies faced regulations that deprived them of investment. Advanced industries such as energy, transportation and communications – those that would have benefited most from foreign technology and foreign investment – faced the greatest restrictions. In order to survive, companies operating in this space have been forced to maintain close ties with government officials and bureaucrats. In return, these government pimps made sure these companies didn’t face competition. They have outlawed foreign investment, passed laws that impose heavy burdens on foreigners doing business in Russia, and opened investigations against companies operating without government protection. The result was that government officials, military generals and high-ranking bureaucrats, many of whom were Putin’s friends, became multimillionaires. The standard of living of ordinary Russians, on the other hand, has not improved over the past decade.

Since the start of the war, the government has further strengthened its hold on the private sector. Starting in March, the Kremlin has passed laws and regulations that give the government the right to shut down operations, dictate manufacturing decisions, and set prices for artifacts. The mass mobilization of military recruits that began in September is providing Putin with another club to wield over Russian businesses because in order to preserve their workforce, business leaders will have to bargain with government officials to ensure their employees are exempt from the conscription.

To be sure, the Russian economy has long operated under the grip of the government. But Putin’s most recent moves are taking this control to a new level. As economists Andrei Shleifer and Robert Vishny have argued, the only thing worse than corruption is decentralized corruption. It’s bad enough when a corrupt central government takes bribes; it is even worse when several government offices are competing for handouts. Indeed, the high growth rates of Putin’s first decade in office were partly due to the way he centralized power in the Kremlin, stifling competing predators such as oligarchs operating outside the government fold. . The emphasis on creating private armies and regional volunteer battalions for its war against Ukraine, however, is creating new centers of power. This means that decentralized corruption will almost certainly re-emerge in Russia.

This could create a dynamic reminiscent of the 1990s, when Russian entrepreneurs relied on private security, mafia ties and corrupt officials to maintain control of newly privatized businesses. Criminal gangs employing Russian war veterans in Afghanistan have offered “protection” to the highest bidder or simply plundered profitable businesses. The mercenary groups that Putin created to fight in Ukraine will play the same role in the future.

A long way to go

Russia could still get a victory in Ukraine. It is not clear what the victory would be like; perhaps the permanent occupation of some ruined Ukrainian cities would have been packaged as a triumph. Alternatively, Russia could lose the war, an outcome that would make Putin’s loss of power more likely. A reformist new government could hire and withdraw troops, consider reparations, and negotiate the lifting of trade sanctions.

Regardless of the outcome, however, Russia will come out of the war with its government exercising authority over the private sector to an unprecedented degree anywhere in the world aside from Cuba and North Korea. The Russian government will be omnipresent but at the same time not strong enough to protect companies from mafia groups consisting of demobilized soldiers armed with weapons acquired during the war. In particular, at first, they will target the most profitable companies, both nationally and locally.

For the Russian economy to grow, it will need not only major institutional reforms, but also the kind of clean slate that was left to Russia in 1991. The collapse of the Soviet state made the institutions of that era irrelevant. A long and painful process of building new institutions, increasing state capacity and reducing corruption followed, until Putin came to power and eventually dismantled market institutions and built his own patronage system. The lesson is sad: even if Putin loses power and a successor introduces significant reforms, it will take at least a decade for Russia to return to the levels of private sector production and quality of life that the country experienced just a year ago. Such are the consequences of a disastrous and misleading war.

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