Since Russia invaded Ukraine in 2022, it's economy has surpassed most expectations. Last year, Russia's economy grew more than the United States and Europe, and on top of that, Russian unemployment is at a record low.
Vladimir Putin and Russian supporters have hailed this as a great success, and as of evidence that Western sanctions didn't work, it's worth noting that the Ukrainian economy also outgrew the United States and Europe over the last two years, having grown 2.9% last year and 5 1/2% the year before. But of course, no one is trying to claim that business is booming in Ukraine. With some carefully chosen numbers, you can put a very positive spin on the growth of
the Russian economy. And the reason for this is that wartime economies are very different to these time economies, and so we have to analyze them differently. While wars are destructive of physical and human capital, these don't show up in national income accounting. Spending on weapons production and the vast spending required to reorient Russia's economy, which used to face towards the West and now faces towards the East, boosts GDP.
As impressive as the GDP growth rates in Ukraine over the last two years might at first sound, they come in the wake of a 30% decline in GDP in 2022 when the country was invaded. A huge amount of Ukrainian infrastructure has been destroyed by Russia, all of which will need to be rebuilt at great expense. According to an analysis by the European Parliament, if Ukraine was able to maintain its recent growth rates, it's real GDP would only return to its pre war
level by 20-30. GDP, or Gross domestic product, is defined as the total monetary value of all of the Finnish goods and services produced within a country's borders in a specific time period, usually a year. And it's often used as a scorecard of a country's broad economic help in wartime. When Russia spends, let's say, a billion dollars on tanks, economists would measure their value at the price the government paid for them, so that $1 billion worth of tanks would add a billion dollars to
Russian GDP. If those tanks were destroyed the next day in Ukraine, as many of them have been, this spending won't have added any real value to the Russian economy. But the waste never shows up in the GDP calculation. For this reason, a lot of the GDP growth is illusory.
As Sergey Guriev of London Business School described it in the FT earlier this year, this type of wartime spending on quickly destroyed tanks is equivalent to just printing a billion dollars and handing it over to the people who work in the tank factory or to it's shareholders without anything
being produced. So on paper it might look like Russia is producing a lot of GDP, but a lot of that GDP is destroyed weapon systems and payments made to either wounded Russian soldiers or the families of dead soldiers. He points out that all of Russia's growth since the start of the war is concentrated in the military sector. Russian defense spending went from 3% of GDP to almost 7% after the start of the war, a massive increase in spending.
But that's only the start. War costs are not limited to just paying soldiers and spending on weapons. Expenses for treating the injured show up as healthcare expenses. Expenses for debris removal and repair of infrastructure fall under housing and utilities. None of these are counted under the narrowly defined military spending section of the Russian budget. But a huge amount of this other spending wouldn't have happened
without the war. There have been huge costs associated with the switch from trading with Europe and the United States to trading with China and India, which Russia has been forced to do since Western sanctions were imposed. This is required building transportation infrastructure and reorienting supply chains. All of this spending shows up in GDP too, but without the invasion of Ukraine it would
have been unnecessary. According to the FT, compared with 2021, which was the last pre war year, Russian budget expenditures have increased by 20% and the state's share in the Russian economy has reached an estimated 50 to 70%. Russia's central bank identifies government spending as the main driver of GDP growth. War related spending in Russia rose from around 23% of the budget pre invasion to almost
40% by last year. Sergey Guriev argues that most of Russia's war spending has the same effect as helicopter money, as huge amounts of money were pumped into the economy while nothing of lasting value was produced. When there's more cash in the economy for the same output, this causes inflation. And Russian inflation has been so extreme that thieves have even been breaking into stores
to steal butter. While inflation has cooled almost everywhere else in the world, it's been roaring hot in Russia. Consumer prices rose 10.3% year on year in March, well above the central bank's target of 4%. The prices of fruit and vegetables have risen by more than 20% on average in the past year. Potatoes have almost doubled in price, and butter prices rose 26% last year, prompting some stores to keep it in plastic
boxes under lock and key. Russians on the ground don't appear to believe the official inflation rate, and while this can be the case everywhere in the world, there's maybe more reason to believe that people are right in Russia than elsewhere. Inflation is calculated using the prices of a fixed basket of goods and services. The basket is adjusted over time to adjust for changing consumer tastes, and when an item is no longer available, a similar
replacement item is substituted. But often the replacement item is of different quality, which can affect the calculation. Statistics agencies attempt to adjust for these quality differences, but that task becomes near impossible possible in a wartime economy like Russia's, where so many items previously imported from Western nations are now being imported from either China and India or being made at home.
It can be extremely difficult to compare quality differences like this, but a lot of reporting out of Russia indicates that the replacement goods are often of lower quality, meaning that people are spending more money and getting lower quality goods. The Russian central bank announced after their March meeting that while inflationary pressures are easing, they would still keep interest rates at 21%. There are a few factors that explain Russia's high inflation.
Firstly, with the West having tightened sanctions over time and with the ruble depreciating, imported goods were getting both more expensive and more difficult to acquire. Secondly, conscription. Russians fleeing the country to avoid conscription and soldiers dying on the battlefield have caused severe labor shortages which pushed up wages in all
sectors of the economy. The high wages being paid to keep munitions factories running around the clock, which produce goods that the average Russian citizen has no need for, has crowded out non wartime production. Civilian businesses had to pay higher and higher wages to attract workers, which increases their operating costs and gets passed on as more expensive goods and services.
In Russia, all of this means that unemployment fell to around 2%, which is the lowest on record in Russia, and last year nominal pay rose by 18%. While the central bank was hiking interest rates to slow an overheating economy, the government was implementing massive fiscal stimulus spending on defence, welfare and infrastructure.
Russian business owners, in particular those selling to the government who were making a lot of money from government procurement, found it difficult to travel abroad and began spending more money in Russia. This strong demand, according to the Russian central bank, still exceeds companies capacities to expand supply. So with more money chasing fewer goods, prices go up and up. The government stimulated other parts of the Russian economy, too.
When war broke out in early 2022, the central bank hiked interest rates above 20% and put capital controls in place so that people couldn't get their money out of Russia. In order to keep the people happy, the Kremlin introduced A Mortgages for Everyone program, which offered cheap loans for new construction that charged half the going interest rate. the FT says that the authorities had to demonstrate that despite all the shocks and sanctions, people would still be able to
buy an apartment. This massive interest rate differential put in place a huge incentive to borrow and build new homes, which drove record sales. The total value of mortgages held in Russia grew 35% in 2023 alone, before the government finally listened to the central bank and shut the programme down. This mix of huge fiscal stimulus, which is unevenly applied throughout the economy, combined with a tight labour market and then offset with extremely high interest rates
brought about a spending boom. The mix of contrasting policies left Russia with a turbo charged but extremely unbalanced economy. These economic stresses are not that unusual in wartime economies, where you see increased central planning and the military competing with the civilian sector for both workers and resources. The guns versus Badr economic concept is often used to describe this trade off between military spending or guns and social welfare spending, or Badr.
It illustrates the dilemma faced by governments when allocating limited resources between military and domestic needs. While Russia's low unemployment rate can be spun as a positive, it's really a signal that the civilian sector is short on labour. The Russian government has boosted the pay for volunteer soldiers so that they can avoid conscription. This caused all sorts of problems at the start of the war, when young Russian men fled to neighboring countries to avoid the draft.
The most recent pay increase means Russian volunteer soldiers now earn five times the average nominal income in Russia. Russian soldiers have never earned as much before, and on top of this, soldiers families have seen a boost in the compensation received for losing their sons, such that 6% of Russia's budget is estimated as being spent to pay families of the dead and wounded. Russia may have all the appearances of being in an economic boom, but it's not
driven by the market. It's instead driven by government spending. The high inflation means that the central bank has to keep monetary policy very tight, but with an interest rate of 21% it's extremely difficult for private non defence companies to do business. Even Russia's largest weapons manufacturer Roztech, which is benefiting from government contracts, is complaining about the high interest rates which make export contracts
unprofitable for them. According to the Moscow Times, corporate bankruptcy surged 20% in Russia last year and this trend is expected to continue. A recent report by Russia analyst Craig Kennedy highlights the huge growth in Russian corporate debt, which has soared by 71% since 2022 and dwarfs new household and government borrowing.
According to the FT, Putin has commandeered the Russian banking system, forcing banks to lend to chosen companies at preferential terms, and the result has been a flood of below market rate credit to favour businesses. They describe this as massive money printing hidden on the balance sheets of state controlled banks which may eventually need to be bailed out. This is all being done, they say, in an effort to conceal a growing budget deficit.
The Russian economy is struggling much more than it might at first appear to be, and the Economist reported earlier this week that it's rapidly getting worse. They highlight lower growth in military spending and high interest rates as likely to Ding GDP growth, but say that the biggest problem for Russia is the recent decline in oil prices combined with a slowdown in China, Russia's biggest export destination. In March, Russian oil and gas revenue fell by around 17% year on year.
On April 30th, the Russian Finance Ministry increased the budget deficit estimate for 2025 to 1.7% of GDP from 0.5% after reducing its forecast for energy revenues by 24%. There are a few ways that Russia's been paying for the war using oil and gas revenues, spending down the sovereign wealth fund, allowing government liabilities like pension costs and government worker wages to decline in real terms, while keeping military and police wages high to keep the
leadership safe. Last year, Russia announced large tax hikes and significant spending cuts on support for small businesses, education, and other social spending. As soon as Russia invaded Ukraine in 2022, approximately half of Russia's foreign currency and gold reserves, which amounted to over $300 billion, were frozen by Western countries. It's hard to know what will happen with those reserves in the long run.
No interest is accumulating on the frozen reserves for Russia, which amounts to billions of dollars that they've lost out on, and it's unclear as to how, when and under what conditions the reserves will be returned to Russia.
Losing access to these reserves was a big hit for Russia, and if they had access to that $300 billion, they could have spent it on soldiers and weapons and would likely have been far more successful in attacking Ukraine. Russian spending, shown here in the orange bars, hasn't led to much debt, as government spending has mostly been offset by federal revenue, shown here
with the blue bars. This means that Russia's budget deficit is under 3%. When we look at how much oil and gas has brought in, you can see how important energy exports are to the Russian economy and also how harmful a fall in the price of oil would be. Russia is the third largest oil producer in the world, just behind the United States and Saudi Arabia. My friend Minosha talking heads Macro argues that before the Russian invasion of Ukraine,
Russia suffered from what economists call the Dutch disease. This term originated from the economic impact of the discovery of vast natural gas reserves in the Netherlands in the 1960s. This discovery caused a surge in the Dutch economy's income, leading to a rise in the value of its currency and a decline in the competitiveness of other economic sectors. Countries rich in natural resources, like Russia, often struggle to translate this wealth into widespread economic prosperity.
The Dutch disease can worsen this problem by concentrating wealth in the resource sector while weakening other parts of the economy. Because a lot of goods can be manufactured anywhere in the world, a strong currency which was brought about by factors other than high productivity, makes all other production within that country
internationally uncompetitive. When a country has a natural resources windfall, the best thing to do is to invest that wealth into productivity enhancing goods so that all sectors of the economy can grow. The goal is to focus on economic activity that can lead to even greater economic activity. Russia has instead mostly focused on oil and gas production or on energy intensive industries that take advantage of the availability of cheap energy within the country.
Although Russia has an educated workforce, there's been very little focus on making the most of those workers by let's say, making higher tech products, as it's simply easier to focus on oil and gas production, which doesn't really require a lot of innovation as the underlying technology for commodity extraction hasn't changed very much over the years. Because of the Dutch disease, Russian productivity was never great and the economy wasn't very impressive before the war.
But Minoj points out that the transition of Russia's production resources to wartime use was much easier than the transition to a services driven economy would have been. In a country that needed to produce high tech or more complex products to bring in money to pay for tanks and soldiers, it would have been more difficult to finance a war when cut off by the international community.
It would also be more economically harmful to shut down those types of businesses and send highly productive workers to the front line to fight. Russia was able to continue producing oil and selling it, working around sanctions with a shadow fleet of oil tankers and selling more to China and India than they did in the past. Before the war, India bought 1% of its oil imports from Russia. Today, they source between 35 and 45% of their oil imports from Russia. So a massive change.
While the transition to a war economy may have been easy for Russia, the question we're left with is how quickly can Russia return to a normal economy when the war ends? The place where the sanctions have been hurting Russia the most is that no one really wants to invest in Russia anymore, or is able to invest in Russia even if they wanted to.
The country has been cut off from the inflow of new technology, capital products, new investment and new ideas, and should a peace deal be struck, all of that will need to be restarted. Having been cut off from the rest of the world, Russian businesses have had next to no competition and thus have had no incentive to produce cheaper or better goods during that time frame.
Foreign businesses have had to compete and have been forced to improve, while Putin can quite likely use Russia's natural resources well to sustain his war for a very long time. As time goes by, a slow decay occurs in the quality of Russian businesses. Productivity gets worse and worse over time and the economy hollows out as the country just sells oil to pay for the war and the standard of living slowly
declines. The longer this war goes on, the more Russia stands still while the rest of the world moves forward with real growth rather than growth driven by government spending and where new technologies are developed that boost productivity. While Russian oil and gas might be needed, buyers who used to source other goods from Russia before the war have now found new suppliers and have no reason to start buying from Russian firms again.
As Russia stagnates, it's smartest and most productive workers who haven't left yet will leave for opportunities in the rest of the world. The type of GDP that Russia has generated in recent years has been entirely driven by military spending, and in peacetime Russia can't grow its way out of its problems as that spending will stop when the war ends and there are no sustainably profitable businesses left.
Often when wars end, you see a reconstruction boom, but very little Russian infrastructure has been destroyed, so not much needs to be rebuilt. While Russia isn't as militarized as the Soviet Union was during the Cold War, the demilitarization that occurred when the Cold War ended brought about a huge economic shock as nothing replaced the military economic activity when it abruptly ended. It took years for munitions factory workers to retrain to
work in other businesses. Putin will struggle to normalize the Russian economy after the multiyear lending boom where state control banks were forced to finance defense companies at subsidized rates. Preferential loans to defence companies, agricultural businesses, construction companies and mortgage borrowers now make up about 16% of banks total portfolios, according to the Bank of Russia.
This raises the prospect of a post war wave of defaults if defence spending falls and the economy slows. The Russian economy has already started slowing and can be expected to struggle if energy prices fall any further. The IMF expects growth of 1.3% this year and 1.2% next year.
While the US government has discussed lifting sanctions on Russian energy sector, the European Union and the United Kingdom don't appear to be planning to follow suit, at least not until Russia is no longer seen as a security threat. Thanks for tuning into this week's podcast. If you found it interesting, I'd really appreciate it if you sent a link to a friend, as podcasts tend to grow by word of mouth. Thanks, as always to my supporters on Patreon. Talk to you again next week. Bye.