Look, we need to talk about Russia’s Economy.
It’s true that Western sanctions are wreaking havoc upon it at the moment. But, Russia’s economy has a bigger more structural problem.
This problem ensured that it never became a true economic superpower. Instead Russia’s economy has been characterized by cycles of stagnation, inflation collapse, and re-birth.
And, yes this also happened under Putin. after a period of tremendous growth, Russia’s economy stagnated. Never really reaching its full potential.
And with high inflation, even before the war in Ukraine, hard working Russians had seen their purchasing power drop by roughly a third since 2013.
So, why is Russia’s economy seemingly doomed to volatile cycles of stagnation, inflation, collapse and re-birth?
To answer that question, we need to go back in time.
2 Tsarist Russia
The year is 1916 and Russian troops are waging bloody war on a Western front.
On the surface, Russia’s economic position is really solid. Its economy is pretty self-sufficient. It does not rely on foreign capital. And, it has built up one of the largest piles of foreign exchange reserves in the world.
However, for the people of Russia, the picture is not as rosy. Their incomes have stagnated while at the same time average prices have risen by over 130% over the course of two years.
This combination of stagnation and inflation meant falling purchasing power for ordinary Russians.
And this was becoming a big problem for Russia’s authoritarian leader, Tsar Nicholas the second. Sure, the war had rallied sentiment initially. However, in hugely unequal Russia, as regular people saw their money evaporate, they started turning against the wealthy ruling elite.
3 Soviet Russia
And, as newly formed Soviet Russia was engulfed in revolutionary turmoil, inflation eventually turned into hyperinflation.
However, it was only during the 1950, that the Russian economy really came into its own. This period which came to be known as the Soviet growth miracle.
This growth miracle was so potent that Nobel winning economist Paul Samuelson, kept predicting that the Soviet economy would come to surpass that of the United States.
And here you though me predicting that Russia’s war chest would shield it from Western sanctions was bad.
On the other hand, if we follow the logic off free market economists such as Von Mises, and Hayek, the Soviet Growth miracle really shouldn’t have happened at all. You see, they argue that the bureaucratic state cannot grow an economy because it cannot possibly know how to invest in the millions of sectors.
And, I think that there, they have point.
After all, there are already more than 350 million types of products sold on the Amazon marketplace. How can government bureaucrats ever hope to find out which ones of these 350 million to produce and in what quantity to produce.
However, the thing is, after years of conflict and inflation, the Soviet Union was dirt poor. So, it didn’t need 350 million product categories. It just needed basic products such as food and heavy industry. And for that, it just needed basic institutions such as an education system, health system, and a transportation system.
And, as it turns out, these are exactly the type of basic institutions that the stabilised state of the Soviet Union had slowly but surely put in place.
If you look at it like that, it make sense that, the Soviet economy could grow rapidly in the 1950s. And, it also makes sense that the Soviet economy quickly stalled when it had almost caught up to Western economies.
After all, this is where the 350 million product categories on Amazon come in. After the economy has reached a basic level, further growth will become extremely difficult to oversee for a highly centralised state.
On top of that, in advanced economies, growth typically happens through innovation. And if innovation brings new businesses to the forefront, this likely means that some old interest lose.
However, in Soviet Russia, this process,
that economists refer to as ‘Creative Destruction’
was held back by powerful interest groups.
So, then how was the economy to grow now easy catch-up growth was depleted?
Luckily for Soviet Russia, and especially the elite’s of Soviet society, booming oil and gas exports provided relief. What is more, the state used the proceeds to build up a large war chest of foreign exchange reserves.
However, for the people of Russia, the picture was not so rosy. Their incomes had stagnated. And, sure, price controls prevented inflation. However, this then led to phenomena known as ‘repressed inflation.’
This basically means that because prices are prohibited from rising, massive shortages emerge.
So, as stagnation turned from bad to worse, the Soviet Union tried to modernise and let go of price controls, turning repressed inflation into actual inflation of roughly 8-9%.
And then, after trying to spend its way out if trouble, high inflation turned into higher inflation. And as the Soviet state collapsed this turned into hyperinflation and this is the situation which Russian federation started out with.
4 90s Hyperinflation
now, some influential scholars have argued that Russia made a crucial error in moving to quickly from a command and control economy to a capitalist economy. Because it happened so rapidly, this process is even known as the “Big Bang”.
However, Economist Branco Milanovic points out that, at the time, the Soviet economy was already in so much trouble, that its new president Boris Yeltsin, basically had no other option than to let go of price controls in a big bang.
The one thing where he did have a choice though… was whether or not to sell the state owned industries for pennies on the dime to his friends.
And, unfortunately for Russia, Yeltsin’s buddies got some pretty sweet deals.
<Yeltsin Dancing 0:50 - 055>
creating massive **inequality** in Russia in the process.
And while, in 1997 Russia’s economy, seemed to be on the right track, the Russian state was still extremely weak and pretty much unable to collect taxes.
So, when global capital got scared during the Asian financial crisis, a run on the Ruble followed. This led the weak Russian state to default on its debt and the Ruble to collapse once again. What followed was sky high inflation of roughly 85%…
And this is when a young ambitious new prime minister, with a new economic plan in his drawer, enters the picture
5 Putin’s Growth Miracle
Okay, sure, you could also argue that the eightfold increase of oil and gas prices at the time was rather convenient.
And while inflation was still quite high, average Dollar spending power of Russians increased from almost $1800 in 2000 to almost $16k in 2013.
Okay, sure, you could argue that the spending power of the average Russian didn’t increase by that much because many of the spoils went to Putin’s friends and associates.
As under Putin, Russia became one of the most unequal nations or earth.
But, still, poverty also dropped from well over 25% of the population in 2002 to roughly 10% in 2013.
And sure, you could argue that this was easy given that Russia still had its well-educated population, wealth of resources, and fertile land.
But, there was genuine effort to build better institutions that could help the economy work better for ordinary Russians. Under the so-called “Gref reform program’ barriers to opening a business were lowered. What is more is that the state’s tax collection apparatus was improved and so was its ability to provide crucial government services for them to be able to build their businesses.
So now, with both the right institutions in place and a more decentralised structure under which creative destructions. could take place, this was Russia’s moment to shine, right?
Well…. yeah, it certainly seemed that way at the time.
This is when Russia’s economy was globally recognized as part of the BRIC group of rising nations: Brazil, Russia, India & China… that would soon dominate the global economy.
As a consequence an influx of foreign investment flowed into the country, investment was booming, and the Ruble strengthened.
No wonder Putin became so popular.
And sure, the Russian economy was hit pretty hard by the financial crisis. But, it recovered quite rapidly until reaching an all time high in 2013 and then
6 Putin Stagnation & Inflation
In response to the annexation, the Russian economy was sanctioned. But, what was even worse, the price of oil collapsed. So, the Ruble fell, and because this meant all imports became much more expense, inflation soared to a whopping 16% in 2015.
Inflation and stagnation
In response, the Russian government hunkered down, pursuing extremely orthodox economic policy of reducing government spending and raising interest rates.
What is more, rather than investing in the economy, the proceeds of oil and gas exports would be used to build an impressive supply of foreign reserves insolating Russia from future sanctions.
The problem is foreign exchange reserves are invested abroad and not invested locally
Not only is this bad for future growth, investment at home represents income for the people. And people with income… buy stuff, giving other people more income and so forth.
After all the economy is a circular system. That is how macroeconomics is different from microeconomics.
The state got increasingly authoritarian and heavy handed, while at the the same time, promised reforms to help businesses stalled. The best state state contracts started going more and more to Putin’s friends, rather than the most competent Russian business.
And as a consequence of both corruption, incompetence, and underinvestment, the quality of Russia’s institutions started to deteriorate.
In that light, it is not surprising that some of Russia’s most talented citizens started to leave the country (elsewhere).
To make matters even worse, during the dark hyperinflationary days of the 90s, Russian women basically stopped having children.
Now in turn, this cohort will get fewer babies now.
Combine this with the Government’s mishandling of the Coronavirus crisis, and the Russian economy just lost almost a million people last year.
Putin apparently said a shrinking Russia haunts him.
7 Breaking the Cycle
So, how can the Russian economy break free from its cycle of stagnation, inflation, collapse, and re-birth?
Well, let’s see if we can find some common patterns in Russia’s previous cycles.
“However, in hugely unequal Russia, as regular people saw their money evaporate, they started turning against the wealthy ruling elite.“ (Tsarist)
“Luckily for Soviet Russia, and especially the elite’s of Soviet society, booming oil and gas exports provided relief. What is more, the state used the proceeds to build up a large war chest of foreign exchange reserves.”
“For the people of Russia, the picture was not so rosy. Their incomes had stagnated.” (Soviet)
“high inflation turned into hyperinflation and the collapse of the Soviet state” (Soviet)
“rather than investing in the economy, the proceeds of oil and gas exports would be used to build an impressive supply of foreign reserves”
“The state got increasingly authoritarian and heavy handed, while at the the same time, promised reforms to help businesses stalled.”
As we can clearly see, the Russian economy is doing the worst when the state is is disarray and weak.
With these experiences in mind, it makes sense that the Russian population chooses some pretty authoritarian leaders from time to time. And these strong leaders often are able to really bring some amazing periods of catch-up growth. However, the story typically ends with the stagnation and inflation, leading to a new collapse of the state and the story starting all over again.
So, how to break the cycle? Well, here I refer to the theory put forward in this book by world famous economists Daren Acemoglu and James Robinson.
They basically say that for advanced growth, a strong but constrained state is needed.
The state should be strong enough to provide the basic services and currency stability that any economy needs. At the same time, the state should be constrained enough so that it doesn’t hinder the process of creative destruction in the private sector.
And, so I would say that this is the real problem that Russia’s economy is facing. Unlike countries such as Japan, South Korea, and Germany, which started out with strong authoritarian states, the Russian state was never properly shackled and so it tended to get out of control, breaking down, starting the cycle again.
But, hey that is just my perspective on the matter.