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The Complex World of Russian Economics

In episode 3 of the Russia in Context series, host Jeff Hawn sits down with Nick Trickett, economy analyst and author, and Yakov Feygin, associate director of the Berggruen Institute. In addition to the modern state of the Russian economy, the trio discusses the evolution of the post-Soviet Russian economy, cyclic trends in its development, and how Russia has reacted to sanctions regimes.

Jeff Hawn:

Hello, and welcome to Russia in Context, a series of New Lines Institute for Strategy and Policy Contours podcasts. This is your host, Jeff Hawn. Three decades ago, the Cold War ended with the red flag being lowered over the Kremlin. The USSR was dead and Russia was reborn, but history did not end. And over the last three decades, Russia has once again become a persistent challenger to US global leadership. How this is happening and why it is happening is what we seek to answer on our new subseries of the Contours podcast, Russia in Context.

I’m your host, Jeff Hawn, and I’m joined today by two exciting guests, Nick Trickett, a senior mining and metals analyst from S&P Global Community Insights and author of the upcoming book “Empire of Austerity: Russia and the Breaking of Eurasia,” which covers the evolution of the Russian political economy since the 1990s, focusing on how the management of macroeconomic stability has intersected with, exacerbated, and in some cases, helped to drive Russia’s foreign policy and the steady drift toward a more aggressive and direct coercion at home since the 2000s.

With experience working in various commodities, consulting, and analyst roles, doing policy research and political risk, he has written for a variety of outlets, including Riddle, The Diplomat, Oil Price, FPRI, Freedom House, and runs his own daily newsletter on Russia and Eurasia, their political economy, and intersections with foreign policy and the rapidly evolving energy sector. Nick holds an MA in Regional Studies from European University in St. Petersburg and a Master’s of Science in International Political Economy from the London School of Economics.

Our other guest is Yakov Feygin, associate director at the Bergen Institute, working on economic policy. He holds a PhD in Economic History from the University of Pennsylvania. His book “Building a Ruin: The Cold War Politics of Soviet Economic Reforms,” will be released with HUP in June 2024. Thank you both for joining me today.

So the Russian economy, a lot of complexity, a lot of opinions, but you two gentlemen are probably some of the best experts on getting to the actual nitty-gritty of what’s going on. So let’s start with the historical context. And Yakov, I want to start with you. Can you explain to us why Russia underwent such a dramatic but poorly understood economic transition in the 1990s, away from the Soviet planned economy and toward the shock therapy, which we got the oligarchy, and some people say led directly to the rise of Vladimir Putin?

Yakov Feygin:

Well, I think the way you have to understand this process is you have to go to the late Soviet period, and really, the fact that the Soviet economy is incredibly over leveraged. It’s got a huge amount of capital stock, but it’s got a capital stock that’s both really inefficient and not really meeting the needs of the consumption side of the economy. It’s not, quote-unquote, profitable, it’s not generating enough goods to meet final consumption.

Because of that, from almost, if you think about it as a balance sheet, it has to be written down, right? You have to lower the value of these massive capital assets. And that’s the process that I think the 1990s is about, is how do you write this down? And writing down the value of an asset is very, very politically fraught, and it’s very difficult because you’re also dealing with a situation in which you don’t have much surplus. You don’t have a labor surplus, you’re not really producing stuff for the global market.

There’s this really famous attempt to export Soviet-style steel. It doesn’t really work that well because it’s not used… The grades aren’t used in a lot of these processes, and getting foreign capital in to upgrade your equipment isn’t really happening because of the political difficulties, and just because, again, lowering your exchange rate is just very difficult, because you’re, again, falling into inflationary tendencies that way, which are already pretty bad.

So you’re in a rock and a hard place. And there is this very famous way of thinking about the problem of like, “Oh, China did something right, so we did something wrong.” And I think that’s not the correct way to think about it. I think the right way, and I think an illuminating way is to say that the Soviet Union’s capital structure, it was a lot healthier in the ’50s and ’60s, and if you were going to reform, that’s when it would be more painless. But you all took two decades to lock this in, and now it really is a painful process, one way or another.

The other thing is shock therapy itself was not necessarily very linear. You still had a lot of conflict within, as Jeff, you actually know, from your work, right, within political blocs as to whether to keep supporting certain industrial blocs with subsidies, either directly or from the central bank, or not. And that these are really fraught processes. And they really don’t, I think, resolve until the mid-’90s, or really into 1998, where you have some elite consensus about how to deal with this very, very old capital stock and how to redistribute it and write down its value.

Jeff Hawn:

Thank you, Yakov. And Nick, that’s where your work touches on this emerging elite consensus that you call the Empire of Austerity. Can you pick up the thread there and tell us how the Russian economy evolved from the 1990s into the 2014 invasion of Ukraine, and the subsequent international sanctions?

Nick Trickett:

Yeah. And thanks, Jeff, for having me. I think building on what Yakov was talking about, I tend to think of the problem of inflation in the Russian context. It applies in other contexts somewhat universally, but in the Russian context, there’s a question of competition over resources, and whether it’s access to credit, whether it’s access to labor, physical plants, et cetera.

And really, throughout the 1990s, there wasn’t really any mechanism that was functioning to some extent. Obviously there were limits, aside from macroeconomic institutions, that adopted what would amount to an austerity program to some extent. I think part of what Yakov was touching on, I think, is also important to understand about the 1990s, was that the ruble was overvalued at a fixed exchange rate that was fairly strong. And actually, that had a ruinous consequence for a lot of industries that simply couldn’t compete with imports.

So part of the reason why the default in 1998 creates this elite consensus is because industry wants to be able to compete to some extent and actually function. Everybody is fed up with dysfunction and non-payments between businesses, non-payments of taxes, et cetera. And in a weird way, the banking sector was actually easier to clean up than so many expected because there were so many non-monetary transactions already taking place from banks, that writing them off was a bit simpler.

So to some extent, it was kind of like a massive stroke of luck. You had the right circumstances for every major elite group to have a reason to be invested in effectively adopting what I would call a default austerity framework for macroeconomic stabilization. You have to make sure that you always rein in spending. Greater spending is inflationary, debt is inflationary. Russia had to get out from underneath this large pile of external obligations it held. And they basically had to find a way to monetize all this activity that demonetized over the course of the 1990s for a variety of reasons.

And by about 1999, 2000, after about a year on from the default, you see very, very clear evidence of a fairly strong bounce back in industrial activity. Businesses now actually have a reason to use rubles because they better reflect the actual value of goods on the ground. And by 2001, 2002, the concern was that, and this is raised by Gaidar and other more liberal economists, essentially this boom of growth that happens after default was coming to an end because it was largely catch up growth. It was kind of an overhang from the 1990s, and that eventually, you would have to institute institutional reform, you’d have to change what you were doing.

Russia got a bit lucky in the sense that, starting in 2003, oil prices steadily climbed. They didn’t explode when Iraq was invaded, but they did actually steadily climb until they obviously shot up massively in 2007, 2008. And that windfall, which was basically captured through tax reforms, the oil sector, and a variety of other institutional quasi-reforms, I would say, because I think honestly, the tax reforms often get mandated about as evidence that this really successful quasi-neoliberal reform effort. But in reality, a lot of it was enforcement. And if people weren’t paying taxes anyway, you weren’t massively changing reality for a lot of people in practice.

But anyway, this oil windfall allows the state to stabilize its finances, but it reintroduces the same problem, which is that currencies tend to appreciate dramatically when you have a huge uptick in the monetary value of your main export. In this case, it would be oil and gas. And so, Russia has to find a way to simultaneously prevent its currency from overvaluing and leading to the industrial dysfunction you saw in the 1990s again, and crowding out of domestic industries with imports, while also not really spending too much money because they’re terrified that any spending will be inflationary.

And inflation is already running hot as it is because growth is relatively fast, wages are rising fairly quickly. And on top of that, you have these ad hoc populous measures to increasingly deal a lot more money into pensioners or to increase public salaries, et cetera, ahead of elections, things like that. The 2000s is an interesting time because, even though they did a fairly good job in terms of the kind of fiscal, not responsibility, fiscal stabilization and stabilization of the economy, they really didn’t do a lot structurally about underlying problems, including the dependence on these resource exports and exporting sectors, not only to generate export earnings and tax receipts, but also to generate demand for domestic industries.

Lots of the steel sector, to use the example Yakov was talking about, it was underwritten by demand for piping, et cetera, domestically. Domestic rolling stock often relies on these exporters, including coal miners, to sustain their orders, et cetera. And they didn’t really, frankly, spend enough money to unlock a lot of bottlenecks, including significantly expanding physical infrastructures, like rail, et cetera, to new markets, primarily in the east, significantly increasing their investments into research and education. These things didn’t really take place.

And what’s also even more strange about it, is that when you actually look in GDP terms and net national income terms, the debt burden that they actually had by 2003, it wasn’t that burdensome, to be frank. It wasn’t a massive problem that couldn’t be dealt with. Obviously, they were terrified of an oil market downturn. But part of the reason why the 2000s was this strange time in Russian economic policy-making was that none of them expected the upturn that happened. The actual tax code was not designed for oil prices to hit $100 a barrel.

And weirdly enough, in 2008, when oil prices hit the record highs of over $140 a barrel midyear, oil production actually declined because the effective tax rate on a lot of projects was above 100% and you had to find these weird fixes to ease that. So by and large, you essentially had a system that coalesced, that everyone had buy-in because it provided a stability, and it allowed the state to get out from under its external obligations, which it saw as a security risk, and a political problem. But it did not lead to the increase of an investment into productive uses that it really needed to figure out.

Jeff Hawn:

Thank you, Nick. Yakov, you had something to add?

Yakov Feygin:

Yeah. Nick, I think that’s a perfect summary of where we are. And as you were speaking, I just wanted to pull back and say, look how difficult a situation you find yourself, as Russia, as an economy, in the 2000s. Because let’s be frank here, even with the oil boom, most of Russian GDP and most of growth is actually coming from the consumer sector, which is somewhat benefiting from the oil boom, but it’s also because Russian consumers have built up quite a bit of savings, and suddenly, those savings are spendable and the ruble is stabilized and appreciating.

And it actually looks like a fairly, not even middle income, but fairly high income economy in some regards. But it’s not really competitive at anything, other than oil. It doesn’t have a large population surplus. If anything, it’s going the other way. It looks a lot like a European country in its population profiles. It’s technology R&D sector isn’t really there, and it’s not being invested in.

That’s probably a missed opportunity with IT and such. But even then, that’s kind of hard to compete with. And you’ve got a Chinese boom crowding out your traditional industries, which are much less greenfield than the Chinese industries. So what do you do? It’s a very hard situation to work in. And that kind of context is really important to think through as you try to understand what the Russian government is trying to do in the bank.

Jeff Hawn:

Yeah. Nick?

Nick Trickett:

Yeah. No, I completely agree with that. I was kind of offering, I think, probably overly simplified version. I think that it’s important to also flag the people who engineered the macro stability framework, including guys like Alexei Kudrin. I mean, their default policy preferences were largely to give money to the public to actually support consumption. So yeah, you’re right that the oil boom is really a consumption boom that is financed by this windfall that’s redistributed.

And it’s a really good point about China’s manufacturing boom really hammering away at the possibility of competing in terms of exporting sectors. I think where it gets interesting is that, by 2006, 2007, you essentially have this consensus building that the economy is overheating. And that’s largely down to physical constraints, and infrastructure is the most common one cited by most ministers as well as just lobbyists, business leaders, et cetera. But there really wasn’t a coherent effort to break that gridlock through public spending or public investment.

And I think it’s also important… The institutional side is important as well, because part of the reason why inflation stays higher throughout the 2000s is not just that Russia is growing quickly, it’s also that institutionally competition is incredibly imperfect, and the efforts that are made to improve it are somewhat limited. They’re often captured politically. It’s also that, to take road construction, the infamous example from Boris Nemtsov, and looking at Milov, construction costs per kilometer rows like fivefold between 2000 to about 2007, 2008. And obviously, road construction in real terms actually declined. They were building less new stuff every year than they had been when Putin first came to power.

So it’s not, I think, as simple as calling it corruption, but there’s definitely an element of which that’s happening. And I think also, there’s a broader ambiguity or lack of a coherent idea for how do you turn this current consumption boom that’s taking place, which is largely buying imports, and flip it into something that can sustain domestic investments into these selector consumer industries, industries that don’t necessarily have to export, but rather serve Russian end users or end consumers. And that’s… Unfortunately for Russia, the ’08 crisis happens when they ostensibly are at a point where they can, in theory, break that problem.

And the last thing I’ll hammer home about the inflation control problem is that, people forget this now, but before the invasion of Georgia in 2008, there’s a rather infamous episode in which Putin, after having moved into the prime minister position, he basically calls out the metallurgical firm Metro in public for what is essentially a transfer pricing scheme. It’s kind of like a way to lower your tax obligations in Russia.

But what’s funny is that, on the one hand, it’s a political move for him to assert his primacy over business. Fine. But what’s more interesting is that it was actually an attempt from him to get prices down, because inflation was running too high. And so, there’s a way in which you have this recurring problem of these interventions with business that are not just aimed at the resolution of a political problem, such as the control of an asset, but actually contributing in some way to macroeconomic stability because they simply can’t get the institutional structure right, and they can’t rely on it to work because of how captured so many aspects of it are.

Jeff Hawn:

That’s very interesting. And before we move into the post 2014 evolution, I did want to ask both of your opinion. It seems to me, from my study of Russian history, that there’s an almost cyclical nature here to how the Russian or Soviet economies evolve. You have a very big growth in particular sectors, but a reliance maybe on things like commodity exports.

And when you hit that boom period of commodity exports, I think we saw this under Brezhnev, there’s a failure to invest. You’ll see a rise in the standard of living. There’s a real failure to follow through and invest in things like infrastructure and stuff. And would you agree that’s a cyclical issue? And do you think that’s just due to the lack of strong Russian political economic institutions and a lack of understanding of economics among political elites?

Yakov Feygin:

I can start, I think, this off a little bit. I mean, I’m not someone who likes to think about these problems as a particularly Russian problem or something related deeply to some Russian cultural mythology. I think if you look at the history of the Russian Federation, really going back to the 19th century, it’s always been, or it’s always aspired to be an exporter, because it is a typical late industrializer. It is the typical late industrializer.

The literature on catch up growth, as in economics and economic history, is, until really the ’80s, a literature about the former Russian Empire in the Soviet Union. And the problem of catch up growth, as I would put it, is how the standard, how do you do catch up growth? Well, you invest in capital stock. And because there are, this is like what Gerschenkron, who is really, I think one of the fathers of development economics and history development, and again, he’s a Russian-American scholar, he comes at it through the history of Russia.

The way you do this is you invest in new capital stock, which is frankly new technology. And because someone else already knows this technology, because you’re a late industrializer, you’re getting huge bouts of growth. But how do you finance new technology? You need, the basic macroeconomic identity is savings equals investment. And what is savings? It is, if you run through the equations backwards, which is just showing the intuition through math, savings is just stuff you haven’t consumed, either as the capitalist who has gotten return on the investment, or the worker out of their wages.

So you have to form your savings, and you can do that in a couple of ways. You could consume less, and that means export out, and that means get cash, which can buy foreign parts and things to make your installs to S equals… Which is how the intuition for savings equals investment happens. And Russia has to do that over and over again, because it is constantly a little bit of a late industrializer. And every time you have these cycles, it’s because you are kind of falling back, you need to upgrade your capital stock. But you also have this political problem of a population that’s been since really, going through these waves of repressed consumption, to form that savings. S equals I, savings space.

That’s how it’s been done, and one that gets tired. So you do have these cycles. But that’s a Russian problem, but it’s not just a Russian problem. That is a problem of an emerging economy. It’s a problem of a middle income economy that’s, I think, very universal across cases. Russia’s case is just that, for a variety of factors, including little odd particularities, including the fact that I think Russia was really the first middle income economy, maybe you can argue Germany was, but I think much more, it’s definitely true for Russia.

And that it is a middle income economy that already is a military great power and locked into those internal geopolitical understandings. It’s just been at this for a lot longer. And now it looks demographically, and in preferences, and many other things, not like a middle income power economy, but one that is a developed economy, but still has middle income features. So that’s a little difficult. That’s what makes Russia a bit particular. But it doesn’t make it special or unique is the way I would put it.

Jeff Hawn:

Yeah, obviously not unique, but that is very interesting. Nick, what were your thoughts on this?

Nick Trickett:

Yeah, I also agree that I don’t like thinking of it as a uniquely Russian problem. I guess the one thing that I think probably sets it apart is simply that, because of the important role that commodity exports ended up playing in the formation of these reserves, not necessarily in previous periods, but in the last half century, and specifically oil and gas, and to a much lesser extent, coal, they’re also hostage… That’s not necessarily the exact same problems, but similar problems that more traditional, quote-unquote, petro states are also afflicted by.

So you also have incredibly high leverage in terms of your fiscal system, et cetera, off of a relatively small sector of the economy that is often heavily affected by external demand in ways that you can’t control. And to use that more recent example, OPEC+ is a good reminder of an intersection within the two. And I’ll let Yakov expand. I just want to make sure to make that point clear.

Jeff Hawn:

Yeah, Yakov?

Yakov Feygin:

I mean, Nick, I would actually even go back further about how much of a resource-dependent economy Russia, let’s say the big picture, geopolitical entity Russia, is than the last half century. Because if you look at pre Russian imperial industrialization, a lot of that is wheat export. If you look at Stalinist industrialization, there’s actually a really great dissertation coming out of Princeton looking at that.

They intended it to be wheat export, but it actually doesn’t work out because of global market conditions. But it winds up that they are a large metals and gold exporter. And that’s kind of how you wind… And frankly, Stalin does a relatively good job, by some standards, of reinvesting that into capital stock after capital stock. So it’s not wheat. It’s not like the classic story about starving peasants. But Russia is always a heavy resource exporter. It’s as far as it’s entered the global market.

Nick Trickett:

Yeah. No, I wouldn’t dispute that, I think. Especially if we go back even further, you look at accounts from the 16th century and the first exposure to European markets, it’s true that it’s always been exporting the low value added, unprocessed commodities for hard cash. I guess the point I’m more making is that there are just specificities to the degree of volatility on oil markets and the actual total number of people employed in the sector versus the actual leverage across the rest of the economy and the effect it has on currency movements, et cetera. But I mean, point very, very well taken that Russia structurally has always been exporting commodities to raise money to import the more technical stuff it needs.

Jeff Hawn:

So on that note, in 2014, Russia annexed Crimea and supported proxies in the Donbas region of Ukraine, and this led to a wave of international sanctions. And then these sanctions have only expanded and tightened since the escalation of the conflict in 2022 with a full-scale invasion. And also, now, Russia is having to economically support what has turned into probably the largest and bloodiest conflict in Europe since the Yugoslavian disintegration. How has that impacted the Russian economy? How is it managing? And is it actually enduring, as some people would have us believe? Or is it not? And I guess we can start with Nick. And then Yakov, we’ll hear what your thoughts are as well.

Nick Trickett:

So I’ll start just giving context for 2014 so that we can build into the rest of the conversation a bit more organically. I think you can’t understand the impact of sanctions on the Russian economy in 2014 without understanding what went wrong in the Russian economy after the financial crisis, which is really that Russia slowed down the same way Europe did. The causes are not exactly identical.

Russia also adopted what amounted to an austerity program, though not nearly as intense in the initial years, and it became more intense as a result of the Crimea shock. But basically these high growth rates that are sustained by the redistribution of energy rents and et cetera to the public that’s helped prop up consumption, it ceases to be an effective driver of growth after ’09, 2010.

And by the last part of 2015, you actually already had an emergent recession in Russia, prior to the annexation of Crimea, prior to the oil shock that year, because also, obviously, oil markets in 2013, 2014, 2015 were flooded by a surge of production in the U.S., largely from Texas, that was down partially to new techniques that were discovered in the… Or not discovered, but augmented in the late 2000s, but also just as a result of the fact that interest rates were so low, it was incredibly easy for these drillers to effectively operate at a loss. They didn’t have to generate much cash flow. They could just keep drilling.

And initial sanctions did not really… I would say they weren’t incredibly impactful. I mean, they obviously had a chilling effect on investment in the country. They scared off investors. But the real damage done was primarily from the fact that the oil prices tanked. And then, because inflation was high, the ruble weakened as a result of that, there was a banking crisis, et cetera. I mean, the government’s default response was to impose austerity to get through that shock.

And by definition, that basically means pulling back investment and consumption, because less money is going to households, less money is being spent by the state on various capital investments, and that has a kind of scarring effect. It’s also paired with an intensification of attempts to securitize more of the economy. And what I mean by that is going back to say inflation, using the commodities boom, ’07, ’08 as an example, commodities prices in the 2000s broadly rose, so it was referred to as a supercycle. Food prices were part of that problem.

And in 2007, there were actually protests organized with the Communist Party complaining about the increase in food prices outstripping wages, and that was a recurring fear going in 2008 during the handoff of power to Medvedev. So actually, the counter-sanctions regime that emerges against the imports of foodstuffs from Europe in 2014 and 2015 was also actually linked to this broader desire to have more control over the price of these goods to the extent that was possible. Obviously, there are limits to that.

And so, that kind of tendency is accelerated. And so, I would say that a lot of the damage that actually ends up happening as a result of the initial sanction shock has more to do with Russia’s response to it than it does the sanction themselves. Though obviously, the shock later on is much more intense and has a much more noticeable effect.

Yakov Feygin:

I think that’s right. I mean, I can tell you a really funny anecdote that probably I shouldn’t tell live about how I moved to Russia for a little over more than a year to do my field work, and I was doing my dissertation sometime in late 2014. And when I came there, the ruble was still trying to be pegged and still fighting for the 30 rubles to a dollar mark. And I had a grant to go there that was already very generous for a graduate student. It was the Fulbright-Hays, so they peg it like a salary for a first year junior embassy staffer, and it’s pegged at the old exchange rate.

And when I came to Russia, I looked at the exchange rate and I thought, “This is ridiculous.” There’s no way it’s staying there. And I got myself an apartment I really couldn’t afford, but I made sure to pay for it in rubles because I was getting paid for it in dollars. And within a few months, that exchange rate was down to almost 80. I think at the tops it was touching the 90s, and I was very well off. I actually kept some of the money over… I photocopied like a madman and all that stuff, because my expenses suddenly just collapsed.

And I think that’s very telling of how a lot of this worked out is that what Russian authorities did well in reaction to the sanctions is just let the exchange rate recede. And what that did was, in a less politically salient way, lowered the quality of life very slowly for a lot of people, because imports became more expensive. But when you do that, it’s gradual, and it gives you room to move and adjust. But on the other end, it makes it very hard to upgrade your equipment. It makes import substitution ironically harder because you need to have some things coming in to substitute them, and it leads you down the path of choosing stagnation a bit.

But what’s nice about stagnation, excuse me, is if you do it gradually, there’s this concept in political science I really like called the J-curve, which is if quality of life is rapidly improving and then falls a little bit, but quite rapidly, it leads to more political problems then if things are pretty steady and change very slowly. I think that’s kind of what 2014 to 2023 was about, and trying to find stability through stagnation.

Jeff Hawn:

Yeah. I remember being there in 2012, which was when I did my field work. And it was interesting, because this was just before that period. So I see exactly what you were talking about. Nick, you have some thoughts?

Nick Trickett:

Yeah. I think building on that, it’s also interesting because obviously devaluation theoretically makes domestic industries more competitive against imports. So part of the reason why the choice to devalue worked for them politically is that they didn’t care about the middle class anymore, and they’re the biggest consumers of imported goods. Those visible luxury items, et cetera, they’re the first ones hit, and then you see people who’ve been striving to reach that level of living affected by it, but not terribly, and it filters out.

But what I find interesting is that between, I think, 2015 and 2019, based off the raw stat data, when you look at the employment figures for which sectors are adding and losing jobs, the most steady gains were largely for retail employment, which is also funny, because obviously those are the, generally speaking, not very well-paid jobs. So you had this weird combination of a choice to stagnate attempts to pull off import substitution, which don’t really work for the strategic sectors, but ironically, are actually more successful when it comes to retail experiences, and farm to table, and nice restaurants opening up, et cetera. And I think that’s kind of a weird dynamic that has probably been underexplored.

But, no. I think that the other thing about it, too, which comes in politically in terms of oil is obviously that by the end of 2016, Russia essentially has to coordinate some degree of restraint about its oil production with Saudi Arabia to be able to provide the stability of export earnings and fiscal revenues while it figures out how to pivot away from its overdependence on oil and gas revenues for the federal budget.

And I would say also that, much of the time between 2015 and 2022, they were fairly successful at doing so. I mean, they didn’t eliminate the massive portion of the budget that they account for, but they did reduce it from, let’s call it 45 to 50%, to roughly 30%, maybe a little bit less if it’s an off year for energy prices. And that came through a couple things. I mean, there was obviously a bad tax hike. A lot of that was actually just better enforcement, and frankly, a reform of the tax services and being better able to track what businesses owed them and collecting it.

But it has a perverse effect in the context of sanctions in 2022 because, obviously, energy prices skyrocket, so that provides them a financial buffer. But because the citizens become more dependent on taxes collected off of incomes and consumption, corporate incomes as well, the nature of the sanction shock later on is much more extreme and actually has a bigger structural effect on that in a way that can be negative longer term, and make it harder for them to sustain what they have.

So part of the reason why the initial sanction shock was weathered as well as it was last year had more to do with the extreme degree of export earnings in the first half of the year, which then tail off once the price cap comes in from the G7. Obviously, it’s proven to be porous since. But the bigger lesson is that now if, as long as the oil market is oversupplied, if there’s not an absence of supply in the market, anyone buying Russian crude who is not an idiot can demand a large discount.

So the times that those discounts disappear now tend to correspond to when the market’s tight. And that’s something that Russia can’t really control, because increasing with the demand side of the equation of people buying EVs and so on, what China’s doing matter more. And so the stagnation that they opted for was manageable as long as they had the ability to adapt to a lower oil price environment while getting enough revenue else to stabilize the budget. That’s much more difficult to do now that they have to keep spending on the war, and I think that that’s one of the more interesting things that’s happening at the moment.

Yakov Feygin:

Sorry. Very quick thing, Nick. I think you were hinting at this, but I think we need to make this clear, actually. The budget sometimes likes the ruble to be going a bit to be undervalued and be higher because it means budget outlays are relatively low, right?

Nick Trickett:

Yeah. No, of course. It’s not just the outlays, it’s also the actual value of oil and gas revenues are higher in renewable terms, right? Yeah, so…

Yakov Feygin:

Exactly. That’s better said than I was trying to get at. That’s really important to understand, which is an interesting dynamic because now they’re defending it for political reasons. But from point of view of the budget, maybe you do want the ruble to go to like 200.

Jeff Hawn:

So in the last 10 minutes, I’d like to hear your thoughts on the trajectory of the Russian economy, and how well it will continue to endure sanctions, and whether or not we will see it continue to shoulder on, or whether we are headed for some sort of significant contraction.

Nick Trickett:

So I think, on the one hand, obviously the initial bounce back’s been better than many expected. I think in part, and I would argue, because the economy has been so starved of a demand for so long that any increase in state spending spurs this kind of surge. Not necessarily, I wouldn’t call it business confidence. I wouldn’t call these surveys confidence surveys, but businesses suddenly have new demand they can meet. I think where it falls apart for them, though, is it’s pretty apparent from the manufacturing data that we have available and from consumer data that more and more productive capacity is simply being sucked into the defense sector, or for the purpose of the war.

They can’t really replace consumer goods that are formally imported because they don’t have enough people to manufacture domestically, let alone necessarily expand the capacity to do so in the current conditions. And so, structurally what that means is the economy is slowly robbing itself of any ability to grow aside from what you would see on paper as a result of simply manufacturing more shells, more physical kits. But all of that also still relies on imports at various points.

And where I think it gets really, really difficult, to Yakov’s point about a weaker ruble, is obviously because so much is still imported for consumers, whether it be specific intermediate inputs for washing machines, or whether it’s the things that are used for bakeries, et cetera, whether it’s actual foods directly, obviously a weakened ruble sends inflation up again, and the problem is the only real tool they have at this point to fight that inflation is to raise interest rates. And that screws consumers. It makes it much harder for businesses to invest, et cetera. It also makes it more expensive for the state to borrow.

But at the same time, they’re now trying to mitigate that, when it comes to the strategic industries, by offering them subsidized credits that then worsen inflation. So they’re kind of trapped in, I wouldn’t call it an inflationary spiral, but in a terrible situation where there’s literally no way to resolve these inflationary impasses without making households materially much, much worse off in the next five to seven years. Obviously, it’s not going to be off a cliff, because wages are still nominally rising, but it’s going to be much more dramatically felt, I think, in the next 12 to 18 months and further out than it was in the first year.

Yakov Feygin:

Yeah. I mean, to Nick’s point, we’re really entering a war economy right now in Russia, whether the Russian state wants to do, which I actually don’t think it does. I think there’s no consensus about what a war economy is supposed to be like. But we’re getting there. We are seeing really high interest rates that are constantly going up. And at the same time we’re seeing quite a bit of state subsidy to these strategic sectors.

And in a standard economics textbook, that is a story about crowd out. I don’t love the term crowd out because sometimes that’s actually what you want to do. Let’s say, maybe, I don’t know, if you want to transition to a cleaner energy sector, you might actually have the situation in which you want to subsidize that industry in the face of higher rates to adjust the economy. That’s a different topic. But in the case… For the long run, to get efficiency.

But in the case of war economy is you’re producing stuff that’s going to be used up, that’s going to be literally blown up, right? There’s no huge direct value added from any of this new subsidized investment that’ll get you efficiency gains, that’ll get you price savings or whatever, from better productivity. You might in the long run, through the process of innovation that comes with it, but not directly. Not directly.

So you are entering a war economy. And a war economy is always one in which you have to lean on the consumer and ration on the consumer. And the question frankly is, what does the Russian consumer do? And we don’t really know. I think a lot of people, to a certain extent, myself included, were a little optimistic about the sanctions regime because we thought it would bite a little faster, but it clearly left a lot of holes open for energy earnings, and they didn’t adapt to, I think, the hardest edge of the sanctions regime as quickly as the Russians did, which is actually just starving the military production side.

I think that worked really well, actually, for the first year or so of the regime, and then the Russians adapted and the regime didn’t, and then I think the regime overemphasized certain trendy things, like chips, for other things that may be more important, like machine tools, et cetera. But I think it’s going to start biting, and it already is. The question is, what are the effects of the bite? I don’t know.

Nick Trickett:

Yeah. I think, I guess the last point to add to that is one of the starkest problems they simply have is a lack of manpower, the lack of available labor to do various things and to subsidy imports, et cetera. And so, I think it’s really interesting that we’re entering a period where, in theory at least, and you see it actually in some informal labor surveys, people basically saying that increasingly monetary compensation is not really the determining factor for where they choose to work.

The point being that the regime is operated for really a quarter-century in a market where, even when things were booming, labor didn’t really have that much bargaining power, or whenever it did, it could be very, very specific to one industry or one plant even. It could be isolated and dealt with fairly quickly. But when you have an entire economy that’s overheating because there simply aren’t enough people to do the things that they need for the war, it ultimately affects people’s relationship with their employers.

I don’t have a prediction. I don’t think anybody knows what to expect in the next 12 to 18 months. I just think that that’s a dynamic that is going to be very interesting, particularly from the perspective, I imagine… If you’re Ukrainian intelligence services, sabotage is going to be an interesting thing in an environment where labor actually has more bargaining power to demand things in return from their employers.

Yakov Feygin:

I mean, speaking of sabotage, it’s very funny, I was going to make another point that there are all these people saying, “Oh, look. There’s a fire here. There’s a fire there.” And I’m like, “Well, there’s always fires in Russia.” Definitely killed more of my lungs in Russia for various reasons, including industrial fires near where I lived than anywhere else. But it’s also just the lack of manpower, right? It’s going to increase the chances of an accident.

But the point I was thinking about when Nick was talking about that is, so much of the Russian labor market, especially the low end, that’s migrant labor. Russia is an extremely migrant labor-dependent economy. If you look at where the politics are now, it’s migrant labor for various reasons, including the need for military manpower. Migrant labor is getting pressed quite a bit.

And the question is, what happens when you are starting to lose migrant labor, or if that migrant labor might go somewhere else? I’m definitely not a specialist in that. But then, that migrant labor from Central Asia, that’s going to be a huge problem. Russia really needs the migrant labor. It is a very immigration/migration dependent economy.

Jeff Hawn:

Well, that has all been fascinating. Thank you very much both for joining us. This has been Russia in Context with Jeff Hawn. Remember to follow Contours and all of our other subseries for more information on the world around you, including Eurasia Connections hosted by Dr. Kamran Bokhari. Thank you very much, and have a good rest of your day.

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