Holey patriotism. Professor Igor Lipsitz on how the war will bankrupt the Russian economy

Exchanging war for impoverishment

The Russian economy is not being saved by either the perceived saviors—the “system liberals” from the Central Bank—nor by the hopes of triggering a gas collapse in Europe or rushing into the arms of Eastern partners. The budget has incurred a deficit, amounting to over 7 trillion rubles in the past 12 months and 4.6 trillion rubles from January to May 2023 (exceeding the planned 2.9 trillion rubles for the entire year). However, the economy operates as a system of interconnected vessels, meaning that the lack of funds can be initially compensated for. For instance, reserves such as the National Welfare Fund, housing repair funds, or even the Cinema Fund—accumulated in previous years—can be utilized. Nonetheless, these reserves will eventually be depleted.

Additionally, the government has taken drastic measures against the oil industry. Although delayed, the reduction of oil damper payments, which previously helped stabilize gasoline prices in the Russian market, is being prepared. Artificial settlement prices for oil exports have been introduced, accompanied by increased customs duties. All of these actions have been carried out under the motto of “You'll survive somehow!”

The government is extracting funds from large corporations through the implementation of an excess profits tax. This approach follows the rather crude principle of “Are you a big business? Pay more! Do you earn over a billion? Pay even more!” Additionally, money is being diverted from the stock market through the sale of federal bonds. To attract buyers, the government has been compelled to increase the offered yield of these securities. Currently, it stands at approximately 11% per year and is expected to continue rising.

The next target in line is the population, which possesses tens of trillions of rubles. In the event of a protracted war, this reserve could potentially last for up to 10 years or even longer if the conflict evolves into a “Korean version” characterized by a temporary and everlasting ceasefire. However, living standards will inevitably decline, investments in the civilian economy will dwindle, and numerous businesses will struggle to remain profitable and ultimately shut down. The overall state of the economy will deteriorate, but funds will still be allocated to the military, military equipment, and law enforcement agencies. It is the people of Russia who will bear the most direct burden of these circumstances, enduring the consequences through taxes, inflation, and devaluation of the ruble. In fact, these effects are already taking place. The thinking of officials is straightforward: nothing will be spared as they search for funds for the primary objective—the military—and then deal with the aftermath. If they emerge victorious, they will focus on rebuilding what remains. However, if they fail, the responsibility to “fix” the problem will fall upon others.

However, Putin did not have any concrete plans for a prolonged war. Rumors have circulated suggesting that Nabiullina and Kudrin warned the Russian president about the potentially detrimental economic consequences, not even considering the “special military operation”, but solely related to the annexation of the self-proclaimed Luhansk and Donetsk republics. Allegedly, Putin responded with the belief that the economy would somehow manage to cope. Based on subsequent improvisations, it appears that this perspective has formed the foundation for the actions of the Russian state, with officials now attempting to navigate the situation to the best of their abilities.

Destroying the economy

Based on the first-quarter results, the agriculture sector stands out as the only thriving industry. However, even this seemingly positive situation could be disrupted by the halt in deliveries from abroad. It is important to note that even non-sanctioned products might face supply disruptions due to difficulties in making payments through banks that are disconnected from global financial systems.

The situation in other sectors is quite dire. The manufacturing and mining industries have contracted and are facing challenges in their recovery efforts. Furthermore, oil revenues have experienced a significant decline (with oil and gas revenues dropping by nearly 50% since the beginning of 2023). To counterbalance these setbacks, the Russian government is actively seeking new markets for metal exports. However, supplying ferrous metals to India is proving difficult as the iron and steel industry there surpasses Russia's in size and strength. India's ArcelorMittal, for instance, holds the top position globally in steel production, while Russia's largest producer, NLMK, ranks only 17th. To establish trade routes for exporting metal to Africa and Asia, transportation is necessary. However, the available ships are not owned by Russia, and they are not particularly inclined to carry Russian cargo. Consequently, Russian exports to Africa in 2022 barely exceeded $1 billion. Within the domestic mining industry, the notable increases are primarily observed in mining and the production of construction materials. This is logical, considering the demand for materials like gravel, cement, and other construction supplies needed for the creation of defensive structures.

Overall, the Russian economy is displaying a decreasing level of transparency, making it less amenable to analysis. The Ministry of Finance seems to be engaging in financial maneuvers, both concealing certain information and selectively disclosing others. They discuss advance payments and issues related to the new tax collection process. Consequently, comprehending the true state of affairs is becoming increasingly challenging. This situation is highly concerning and reminiscent of the Soviet Union, where a significant amount of statistical data was classified as “secret” or “for official use only,” requiring roundabout methods to calculate or estimate various indicators.

There is a belief that if we managed to endure in the Soviet Union, we can weather the current challenges as well. However, drawing analogies between the two situations does not provide a strong basis for comparison. The Soviet economy operated under significantly different circumstances. Firstly, the Soviet Union comprised all the republics, totaling approximately 285 million people—twice the current population of Russia. This larger population facilitated a relatively balanced labor market, with the labor-abundant Central Asian republics contributing to this equilibrium. Secondly, the Soviet Union was part of a socialist bloc, the COMECON, which included all of Eastern Europe. This close coordination with the Soviet economy does not exist today for Russia. Consequently, due to these substantial differences automatic parallels cannot be drawn between the present circumstances and the Soviet Union.

Furthermore, over the past three decades since the dissolution of the Soviet Union, a substantial amount of production capacity and expertise across a wide range of products has been lost. These were capabilities that the Soviet Union once possessed, allowing for the production of various items—albeit of lower quality, expensive, and often unprofitable, yet still functional. In the frenzy of a planned economy, operating amidst perceived adversaries, the Soviet Union attempted to manufacture everything internally, ranging from space rockets to sewing needles. However, such self-sufficiency is no longer feasible in the present era.

As a matter of fact, it is crucial to note that Ukraine was a significant industrial region within the USSR, playing a vital role in various sectors. The aviation industry, for instance, relied on Ukraine's capabilities, and it would be impossible to imagine Russia's aviation industry without that contribution. The Soviet economy was characterized by a distributed system of production across the entire country. As an example, IL aircraft were assembled in Tashkent. Presently, Russia is seeking negotiations with Uzbekistan to potentially assemble a new aircraft, the Tu-214. Additionally, Ukrainian enterprises such as Yuzhmash were responsible for the production and maintenance of ballistic missiles for the USSR. The current situation regarding the service and condition of these ballistic missiles in Russia is an intriguing question.

Healing oneself

For nearly three decades, Russia has been operating within a market economy. While the results may not have been as remarkable as desired, the country has not completely faltered. During this period, entire industries and market institutions have emerged, and people have acquired the skills necessary to navigate a market economy. Presently, what sustains Russia is not solely the state but rather private businesses. Without their contribution, stores would be empty, and the country would face a disaster. However, these dynamic managers possess expertise in operating within a market economy, not a planned (mobilization) economy—an economic model that Russia is slowly but gradually shifting toward.

There is a misconception that in 2022, the Russian economy was supposedly rescued by “system liberals” from the Central Bank and the Ministry of Finance. However, the reality is that the West chose to spare Russia during that period out of fear of inflicting significant harm upon itself. Initially, skeptical assessments made in early 2022 were based on the assumption that the impact of sanctions would be felt immediately. However, the major sanctions, such as the European oil embargo, did not take effect until December of that year. Additionally, the embargo on oil products did not commence until February 2023. Therefore, it is not solely the astuteness of figures like Nabiullina and Siluanov that accounts for Russia's situation. There was a period from February to December when Russia was able to sell oil at incredibly high prices and generate substantial profits. Russian economists even suggested that Europe should cease purchasing oil and gas from Russia, believing it would be more cost-effective. However, European politicians became apprehensive, allowing Russia to bask in financial abundance for nine months.

However, this “windfall” has come to an end. Currently, Russia is providing oil to India and China with the approach of “just sell.” Consequently, Russian exporters have accumulated significant amounts of rupees, and it is uncertain how to handle them. The Central Bank of India prohibits their conversion into rubles within Russia. As a result, the Indians have proposed that Russian companies utilize these rupees to purchase Indian government bonds as a desperate measure to become investors in the Indian economy. Despite this, oil companies still find themselves obliged to sell oil at a loss to avoid shutting down their wells.

Friendship with China has not yielded any positive results either. One example is the deviation from the previously discussed route of the Great Silk Road, approved by Shanghai. Originally, the railway was intended to pass through Moscow, connecting Shanghai to London. The plan relied on high-speed Chinese trains, capable of traveling at 300 kilometers per hour, transporting goods from Shanghai to London within 19 days. Russia expected significant profits from participating in this project, as it would have facilitated lucrative transportation through its territory. However, China ultimately signed a contract for an entirely different route, which traverses Central Asia, Iran, Turkey, Bulgaria, and then continues on to Europe. Russia was excluded from the equation. Furthermore, the new pipeline catering to the Chinese economy will not be the Russian “Power of Siberia-2,” but a pipeline originating from gas-rich Turkmenistan.

Finland recently made an announcement regarding the termination of its pipeline contract with Gazprom. They have positioned an LNG liquefaction ship near their shores, indicating that they no longer require gas supplies from Russia. This situation reflects the broader state of affairs across Europe, where the gas market has become inaccessible for Russia.

Nor should one hope that war can serve as a stimulus for the Russian economy. Those who advocate for this idea often point to the experiences of the United States and Japan. It is true that the U.S. experienced significant growth during World War II, particularly in its military industry, which subsequently benefited other sectors of the economy. However, it is crucial to note that the war came to an end in 1945. In response, the Americans implemented the Marshall Plan, effectively connecting the entire European market to American industry and securing a market for years to come. This strategic move prevented the American economy from collapsing once peace was established.

And Japan's economic growth was not solely reliant on orders for the American army during the Korean War. The country's economic transformation was fueled by investments in the development of civilian products, often based on licenses acquired from the United States, as well as Japan's own innovations derived from military technologies.

But in Russia, the transition from the military industry to civilian markets has historically faced challenges, and it is unlikely that we will witness a different outcome in the future.

Additionally, when discussing the military industry as a potential driver of economic growth, it raises the question of who bears the financial burden. Presently, Russia is increasing its orders for weapons and defense-related infrastructure, which are funded by the state budget. However, it is becoming increasingly difficult to generate the necessary funds to support these expenditures.

During World War II, Hitler had private companies collaborating with his regime throughout the conflict. Similarly, in Russia, private businesses are compelled to contribute to the “SMO”. The mobilization of the economy follows a straightforward logic: to produce weapons, a reliable supply of metal is necessary. The state imposes obligations on supplying metal to steel mills and establishes price limits. Subsequently, the next step involves mandatory supplies and price limits on various items that the steel mills themselves need to purchase.

Consequently, when the government implements the mobilization economy model, it gives rise to a state price system that can lead to conflicts. For instance, Sergei Chemezov, the head of Rostec, proposed a 10% increase in salaries for defense industry workers. He emphasized that their work, often carried out in three shifts, greatly influences the success on the front lines. However, when fulfilling a state order for the Defense Ministry, the price is determined and approved by the state. A dedicated officer, responsible for purchasing military equipment, analyzes the costs rather than negotiating the price. What is considered a trade secret in private businesses becomes open information in the state defense order. Consequently, the customer from the Ministry of Defense scrutinizes the costs and prohibits the proposed 10% salary increase.

This phenomenon is commonly known as the emergence of a mobilization economy, where the scope of state defense orders expands, leading to a wider range of state orders and subsequent increases in state-controlled prices. Initially, this entails setting prices for military equipment, followed by prices for the necessary metals used in its production. Eventually, similar price controls are imposed on iron ore and coal, often accompanied by keeping wages relatively low in the metallurgical industry. It's important to note that the entire economy doesn't undergo immediate mobilization, but rather this process starts in industries closely associated with the military sector and gradually extends to other sectors over time.

The effects of this mobilization economy gradually erode the framework of private market business, which played a significant role in Russia's economic stability in 2022. Consequently, it undermines the foundations of sustainability and the country's ability to provide its citizens with reasonably acceptable living conditions, without resorting to severe shortages of goods and the implementation of ration cards.

In general, if we attempt to depict the current state of Russia's economy, now confronted with a prolonged and agonizing military conflict rather than a short-term and successful military-police operation, lines from an old Vysotsky song about a sprinter-skater come to mind:

Long track will kill me for sure

Perhaps I will complete the first lap and hit the floor

But the coach said sternly, just do it, Fedya

The main thing is the will to win

The will to win is very good if you are strong

But I got carried away

I rushed ten thousand as five hundred

And ran out of gas

My stamina failed me

As I knew it would!

I completed only two laps and collapsed.

What a shame!

Insert the word “oil industry” instead of “stamina” and the picture of Russia's economy becomes painfully recognizable...