Russia’s Road to Economic Destruction

After Russia’s invasion of Ukraine in February, the Russian economy seemed destined for a nosedive. International sanctions threatened to strangle the economy, leading to a plunge in the value of the ruble and the Russian financial market. Every day Russia appears ready for privation.

More than eight months into the war, this scenario has not happened. Indeed, some data suggests that the opposite is true, and that the Russian economy is doing well. The ruble has strengthened against the dollar, and although Russia’s GDP has shrunk, the contraction could reach less than three percent in 2022.

Look back at the moderate GDP contraction and inflation figures, however, and it becomes clear that the damage is in fact severe: the Russian economy is destined for a long stagnation. The state had intervened in the private sector before the war. That tendency is becoming more pronounced, and it threatens to stifle innovation and market efficiency. The only way to preserve the viability of the Russian economy is either through major reforms – which are not offing – or institutional disruption similar to the one that occurred during the collapse of the Soviet Union.

Sanctions Are Not Missiles

The misgivings about the impending sanctions against Russia can be explained in part by unrealistic expectations of what economic measures can do. Simply put, they are not the same as missile strikes. Yes, in the long run, sanctions can weaken the economy and lower GDP. But in the short term, the most we can expect is a big drop in Russian imports. It is only natural that the ruble strengthens rather than weakens as the demand for dollars and euros corresponds. And as the money that would have been spent on imports is transferred to domestic production, GDP should actually increase instead of falling. The impact of sanctions on consumption and quality of life took longer to pass through the economy.

At the beginning of the war, in February and early March, Russia rushed to buy dollars and euros to protect itself from a potential plunge in the ruble. Over the next eight months, as Russian losses in Ukraine mounted, they bought more. Usually, this will cause a significant depreciation of the ruble because when we buy foreign currency, the ruble plunges. Because of the sanctions, however, companies that imported goods before the war stopped purchasing currency to finance these imports. As a result, imports decreased by 40 percent in the spring. One consequence is that the ruble strengthened against the dollar. In short, this does not mean that sanctions do not work. On the contrary, its short-term effect on imports is unexpectedly strong. Such a decline in imports is not expected. If Russia’s central bank had anticipated such a massive fall, it would not have introduced severe restrictions on dollar deposits in March to prevent the collapse in the value of the ruble.

Economic sanctions, of course, have other direct effects. Reducing Russia’s access to microelectronics, chips, and semiconductors makes the production of automobiles and airplanes nearly impossible. From March to August, Russian car manufacturing fell by an astonishing 90 percent, and the decline in aircraft production was similar. The same holds true for the production of weapons, which is understandably a high priority for the government. Expectations that new trade routes through China, Turkey, and other countries not part of the sanctions regime would compensate for the loss of Western imports have been proven wrong. An abnormally strong ruble is a signal that the back-door import channel is not working. If imports flow into Russia through hidden channels, importers will have bought dollars, sending the ruble down. Without these critical imports, the long-term health of Russia’s high-tech industry is dire.

The Russian economy is destined for a long stagnation.

Even more important than Western technology sanctions is the fact that Russia is inexplicably entering an era in which political cronies are strengthening their grip on the private sector. This has been a long time in the making. After the 2008 global financial crisis hit Russia harder than any other G20 country, Russian President Vladimir Putin essentially nationalized large companies. In some cases, he placed them under the direct control of the government; in other cases, he put them under the purview of the state bank. To remain in the good graces of the government, these companies are expected to keep a surplus of workers on their payroll. Even companies that remain private in nature are prohibited from firing employees. This provides economic security for the Russian people – at least for the time being – and that stability is a critical part of Putin’s compact with his constituents. But an economy where companies can’t modernize, restructure, and fire employees to increase profits will stagnate. Not surprisingly, Russia’s GDP growth from 2009 to 2021 averaged 0.8 percent per year, lower than the period of the 1970s and 1980s before the collapse of the Soviet Union.

Even before the war, Russian businesses faced regulations that deprived them of investment. Advanced industries such as energy, transportation, and communications — that is, those that benefit most from foreign technology and foreign investment — face the greatest restrictions. To survive, companies operating in this space are forced to maintain close ties with government officials and bureaucrats. Instead, these government protectors ensure that these businesses have no competition. They banned foreign investment, passed laws that placed heavy burdens on foreigners doing business in Russia, and opened investigations against companies operating without government protection. The result is that government officials, military generals, and high-ranking bureaucrats—many of whom are Putin’s friends—become multimillionaires. The standard of living of ordinary Russians, on the other hand, has not improved in the past decade.

Since the beginning of the war, the government has tightened its grip on the private sector even further. Beginning in March, the Kremlin rolled out laws and regulations that give the government the right to shut down businesses, direct production decisions, and set prices for manufactured goods. The mass mobilization of military recruits that began in September provided Putin and other cudgels to carry out Russian business because to preserve their workforce, company leaders had to bargain with government officials to ensure their employees were exempt from conscription.

To be sure, the Russian economy has been operating under the stranglehold of the government for a long time. But Putin’s latest moves take this control to a whole new level. As economists Andrei Shleifer and Robert Vishny have argued, one thing worse than corruption is the decentralization of corruption. It is bad enough when the corrupt central government demands bribes; even worse when several different government offices compete for handouts. Indeed, the high growth rate in Putin’s first decade in office was due in part to how he centralized power in the Kremlin, eliminating competing predators such as oligarchs operating outside the government fold. The emphasis on the creation of private armies and regional volunteer battalions for the war against Ukraine, however, created a new center of power. That means decentralized corruption will almost certainly resurface in Russia.

That could create a dynamic reminiscent of the 1990s, when Russian business owners relied on personal security, mafia connections, and corrupt officials to maintain control of newly privatized companies. Criminal gangs that use veterans of the Russian war in Afghanistan offer “protection” to the highest bidder or simply rob profitable businesses. The mercenary group that Putin created to fight in Ukraine will play a similar role in the future.

Long Road Ahead

Russia can still get a victory in Ukraine. It is unclear what victory will look like; maybe the permanent occupation of some ruined Ukrainian cities will double as a triumph. Alternatively, Russia could lose the war, an outcome that would make it more likely that Putin would lose power. A new reformist government could take over and withdraw troops, consider reparations, and negotiate lifting trade sanctions.

No matter the outcome, however, Russia will emerge from the war with its government exercising authority over the private sector to a degree unprecedented anywhere in the world besides Cuba and North Korea. The Russian government will be omnipresent yet at the same time not strong enough to protect the efforts of mafia groups made up of demobilized soldiers armed with weapons they acquired during the war. Especially at first, they will target the most profitable businesses, both at the national and local level.

For the Russian economy to grow, it will require not only major institutional reforms but also the kind of clean slate that Russia left in 1991. The collapse of the Soviet state made the institutions of that time 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 patronage system. The lesson is dire: even if Putin loses power and his successor implements significant reforms, it will take at least a decade for Russia to return to the level of private sector production and quality of life the country experienced just a year ago. Such is the consequence of a disaster, a misguided war.

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