Why the Russian War Economy is Stronger Than You Think

Is Russia’s economy about to collapse?

Russia’s economy is about to collapse. So far, these predictions have always proved wrong. But, now, with oil prices down, a new Russia collapse narrative has emerged which essentially says that:

“””war’s been a huge stimulus for the Russian economy. But, they can’t do this forever. The reality is they are likely to run out of money. “””

Therefore, as US Treasury secretary Scott Bessent recently said:

“””we are in a race now between how long can the Ukrainian military hold up versus how long can the Russian economy hold up. “””

So, despite getting it wrong earlier, lot’s of really good Western economists now AGAIN think Russia’s war economy is heading for a collapse. And, yet here you are listening to this economist on YouTube telling you that, if we look at the 4 main ways that historically economies have collapsed, there really aren’t many sign that Russia’s economy is about to collapse.

In fact, if you compare Russia’s war economies to historical ones like Nazi Germany, the Soviet Union, and even Vietnam era USA, it actually looks like Russia’s war economy is just getting started. To see why, let’s quickly do a recap of

Why Russia’s war economy has surprised most analysts so far

After all, we have now seen years of collapse predictions, and yet, since the war, Russia’s economy so far actually outperformed major European economies like the UK and Germany.

So, why did most analysts get it so wrong?

In my view, the most likely reason is that they have been trained to understand peace time economies, but not war economies. So, to see why Russia has outperformed so far, it’s time for a quick war-economics 101 lesson. Starting with a simple definition. What is a war economy?

In a nutshell a war economy is about doing what is necessary to support the military effort. Transitioning from a civilian to a war economy is therefore about changing the nation’s focus from what’s best for the people, to what’s best for the war. Of course, WAR equals destruction and death… that is not good for the economy…. in the long run. However, in the short run, which can last quite a few years, it’s actually very normal for war economies to see their GDP increase by quite a lot. For example, just before WW2, Britain and especially Nazi Germany got major boosts from rapid rearmament, while the US economy really started outperforming them all when it got serious about the war.

Even more strikingly, in the first phase of a war economy, regular civilians often even get richer. This can explain why, after Russia invaded Ukraine, average life satisfaction in Russia actually rose to an all time high.

JOERI Yes, that’s right, as Russia was hit by unprecedented sanctions, and hundreds of thousands of Russians were killed or fled the country, its economy was BOOMING… AND regular Russians were actually becoming better off, on average. This contradiction only makes sense, if we look at it through the lens of war economics 101.

To fully understand this story, I think it’s essential to look at Russia’s war economy through the lens of mobilizing local resources for war which is constrained by international limitations.

To start, it’s important to realize that, before the war, a significant portion of Russian workers were not working AND a significant share of Russian factories was not operational. In other words, Russia’s economy was operating BELOW its potential.

In times of war, this is NOT acceptable. Therefore, the first phase of the war economy is about activating unused resources. Russia did this by massively increasing state spending by drawing down its wealth fund, essentially releasing new money into the economy.

New money into the economy. Won’t that cause inflation? Not always. In fact, basic monetary theory teaches us that if new money helps to create new products, this new money does NOT HAVE to cause inflation.

New money spent on unemployed workers that are now working in factories that were previously idle means that there is now more money in the economy, but also increased production.

In Russia in 2022, we saw exactly these 3 things. A massive increase in spending by the Russian government, a massive reduction in unemployment, and a higher average level of industrial output,

This is exactly the same pattern we saw when major economies like the UK, Germany and the US got ready for war in the 1930s.

JOERI But, hold on a minute… Isn’t this strange? Why do countries only activate these unused resources in times of war? To answer this question we have to look at Russia’s pre-war economy through the lens of one of the most famous theories in international finance: the monetary trilemma. END JOERI

In the early 2000s, Russia was still trying to be a rapidly growing modern capitalist economy. It therefore strived to have an optimally activated economy AND give its citizens the liberty to attract foreign investments and to invest abroad. The monetary trilemma teaches us that therefore, Russia could not have a stable currency.

A flexible currency meant that the value of the Russian Ruble was primarily determined by market forces, by supply and demand. To see how this works, economists often use the balance of payments framework. It shows us that demand for the Ruble can increase in two ways. The first by increasing exports. Russian exporters may ask to be paid in Rubles, meaning that European importers have to sell Euros to buy Rubles first. Or they may ask to be paid in Euros. In that case, they will likely sell them for Rubles themselves soon because most of their costs are in Rubles. As a consequence the Ruble becomes worth more compared to the Euro. Similarly, if Europeans want to invest more in Russia, they will need Rubles to do so, raising its price. On the other hand, if Russians import from Europe, or invest in Europe, they will likely sell some Rubles to do this, driving the price of the Ruble down.

This situation changed drastically in 2013, when Putin promoted his economic advisor Elvira Nabiullina as central bank governor. One year previously, the US had just decimated the value of Iran’s Rial by sanctioning foreign investments, which in turn encouraged a run on the Rial.

Under Nabiullina leadership, Russia adopted the ‘Fortress Russia’ strategy to prevent this scenario at all cost. Thus, She essentially strived to make the Ruble more stable, moving Russia’s economy from here to here on the monetary trilemma.

The value of the Russian Ruble was now no longer fully determined by the free market. Instead, Nabiullina’s bank of Russia started intervening by buying any excess foreign currencies from either investment or exports. By doing so, she accumulated Putin’s famous war chest, which could then in theory be used to defend the value of the Ruble if it were ever hit by Western sanctions.

However, this strategy could only work if Russians consistently brought in more foreign currency than they spent. It’s extremely difficult for a government to massively increase exports or incoming foreign investments. So, if she wanted to build her war chest, and keep the exchange rate somewhat stable, and keep money flowing freely in and out of Russia, she had only one real option: reducing how much Russians import.

This is easier said than done. In a relatively free economy, imports are not directly controlled by the state. They are done by Russian companies and workers. However, they can only really import a lot… if they have enough money. Using this knowledge, Nabiullina and Putin essentially reduced imports by making Russians a little poorer than they had to be by severely limiting government spending and keeping interest rates really high.

Of course, we know with the benefit of hindsight that fortress Russia was a massive failure. In the modern world, “foreign currencies” held by a central bank are not bars of gold in a vault, but rather financial assets issued by other countries, like U.S. Treasury bonds or deposits in European banks. In other words, when Russia said “we have $300 billion in reserves,” much of that was actually in accounts outside of Russia, under Western jurisdiction. Nabiullina had gambled that Western and especially European countries didn’t have the guts to freeze these assets. She was wrong. Once Russia’s war chest was frozen, capital started fleeing Russia quickly, collapsing the Ruble.

Yet, it was at this moment that Nabiullina showed her pragmatism and skill as an economist. To save the Ruble, she knew there were only two options. Either she could reduce imports by making Russians even poorer by spending even less. However, given that this in conflict with spending more on the war, her only option left was essentially to introduce capital controls, moving the Russian economy from here to here on the trilemma.

The fact that she now directly controlled money flowing out of Russia enabled the Russian government to fully activate the Russian economy without collapsing the Ruble. After all, while Russian now had the purchasing power to import to their hearts content, they simply were not allowed to do so.

This move surprised many economic analysts because they were no longer used to thinking about capital controls as a viable option. It is however, the first crucial step to see

Why Russia’s economy will not collapse.

If we study historical economic collapses, we can essentially see four ways economies collapse. The most frequent one is sudden capital flight.

This may happen because a financial bubble pops, like what happened during the 1997 Asian financial crisis, 2011 Eurozone crisis. It may happen because a country has been importing too much for too long, like the Russian crisis of 1998, Lebanese crisis of 2019, or Sri Lanka’s 2022 currency collapse. Or it may be because of sanctions, such as the 2012 Iran crisis, or 2022 collapse of the Ruble.

Regardless of what the cause may be, Russia has essentially ruled out this type of economic collapse when it introduced capital controls.

This means that internationally speaking, Russia is now really only vulnerable to an economic collapse if crucial imports get squeezed suddenly, for example through a blockade.

Arguably, this is what happened to imperial Germany in 1918, where the Allied blockade at least contributed to severe food shortages which arguably led Germans to revolt and overthrow the Kaiser. Given that Russia has so many natural resources, produces all the food it needs, and has some pretty reliable trading partners in China and India, it’s economy does not seem particularly vulnerable to a collapse in imports or exports right now.

This leaves us with option 3: an internal collapse due to excessive debt.

Japan 1992, the US in 2007, in these crises local households were increasingly borrowing against ever increasing housing prices. When that stopped, the bubble collapsed, the banks collapsed, and the economy collapsed with it. Another super interesting example is the collapse of Russia’s predecessor, the Soviet Union, which famously collapsed after years of economic and political dysfunction, after which the government saw no other way out than to start printing money in order to keep paying all of its various powerful interest groups. If we look at Russia’s economy today, we can see that, while there are some signs of a housing price bubble AND excessive government spending running down reserves, both household debt and government debt in Russia are still exceptionally low, making such a collapse extremely unlikely… at least in the short-run.

Finally, there are some examples of crises where all of the previous factors played a role, but where the economic pain was unexpectedly too much for an already disgruntled population to take, making them demand change.

For example, while debt in Vietnam era USA was not out of control, and the US had plenty of resources, increasing loss of life and inflation still turned public opinion against the war. Similarly, while the Soviet Union arguably collapsed due to increased government spending and debt, this all happened way more quickly than people expected, potentially due to the public being unhappy about its decades of economic stagnation.

This could theoretically happen to Russia as well. In fact, there are some cracks beginning to show: inflation is still dangerously high, economic growth has come down.

So, the easy phase 1 of Russia’s war economy is now clear over. Russians are now going to be feeling more and more economic pain. This could still turn Russians against the war, right?

Yes. However, this is unlikely to happen quickly because…

Russia’s war economy is just getting started

The core of this argument is that yes, an ever increasing war economy IS ULTIMATELY unsustainable. But, Russia’s war economy is still quite far from that point for three reasons.

First, if we compare war spending to GDP between Russia other famous historical war economies, we can clearly see that actually, Russia’s war spending compared to the size of its economy, is actually still lower than that of the US during Vietnam, way lower than Soviet war spending in the 1980s and way wayyy lower than what the Nazi’s spent during the height of the second world war.

So, given that Russia’s economy is already at its maximum capacity, how were these other war economies able to spend so much more? This get’s us to my second argument, when it comes to main economic tools to control a war economy, Russia has only introduced 1 yet, capital controls. As we have seen, capital controls are extremely effective at preventing balance of payments crisis. But, they come at a cost of reduced freedom for citizens.

Historical war economies like the Soviet Union and Nazi Germany employed similar freedom reducing tools to control inflation. Specifically, they introduced price and wage controls to keep prices from rising too quickly while military spending got bigger and bigger.

This brings us to phase 2 of the war economy. In phase 1 everyone is happy. But, in phase 2 real sacrifices have to be made. Specifically, civilian industries will have to be sacrificed more and more to free up resources for the war economy.

Not enough workers to produce drones… do you really need movie theaters. Do you really need coffee shops? Not enough fuel available for tanks? Do you really need people to go on vacation? You catch my drift. Historical economies like the Soviet Union and Nazi Germany sacrificed civilian freedom for military might.

Russia has not yet started this process. But, there are some signs that it is starting. Nabulliana has already shown us she is pragmatic and willing to think outside the box when she introduced capital controls. Wage controls have not yet been introduced in Russia, but there are now credible reports that the Russian government is considering introducing sweeping price controls for essentials like food.

But, won’t this turn Russian public opinion against the war? Yes, of course. This brings me to my third and final argument. Russian public opinion is still at an all time high, and, as it showed us when the war just started, Russia’s authoritarian government can afford to let it sink quite a bit further.

Conclusion

So, this is why I think waiting for a Russian economic collapse is a naïve fantasy. Sure, as we have seen with Vietnam era USA or with the Soviet Union. Some economies that still look pretty fine on paper can ‘collapse.’ So, I could be wrong. But, if we look at all the main ways that economic collapses happen, by facing a run on their currency, being blocked from crucial resources, having too much debt, or very low public morale, Russia’s economy actually looks really stable.

This does not mean that Russia’s economy cannot be hurt. Sanctioning Russia may directly hurt its war effort by reducing its ability to pay for crucial war imports. Or that it does not have serious problems. For example, there are manpower shortages as well as some serious gas shortages right now in Russia due to Ukrainian drone attacks. However, given just how few really oppressive war economy tools Russia has used to this day, and given how flexible Putin’s central banker has shown herself to be, I think it’s in the interest of everyone to recognize that simply waiting is NOT ENOUGH to stop the Russian war machine. In fact, I think this analysis shows us that if the West wants to keep Ukraine free, it seriously needs to ramp up economic support.

But, yeah. That is my take. What do you think. Am I missing something? Let me know in the comments below.