Is Russia's economy 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 has been a huge stimulus for the Russian economy.

But they can't continue doing this forever.

The reality is, they're 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 Ukrainian military hold up versus how long can the Russian economy hold up?

So despite getting it wrong earlier, lots 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, no less, telling you that if we look at the four main ways that historic economies have collapsed, there really are not many signs that Russia's economy is about to collapse.

In fact, if you compare Russia's war economy 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 do a quick recap of why Russia's war economy has surprised most analysts so far.

After all, since the war, Russia's economy so far has actually outperformed major European economies like the UK and Germany.

So why did most analysts get it so wrong?

Well, in my view, the most likely reason is that they have been trained to understand peacetime economies, but not war economies.

To see why Russia has outperformed so far, it's time for a quick war. Economics 1 or 1 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 actually can be 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 World War two, 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 as well.

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.

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, and how it can explain why war boosted Russia's economy initially.

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 then 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 and 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 three 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 that we saw when major economies like the UK, Germany and the US got ready for war in the 1930s.

But hold on a minute. Isn't this strange?

Why do countries only activate these unused resources in times of war?

Can't they do this in times of peace?

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.

In the early 2000, Russia was still trying to be a rapidly growing modern capitalist economy and therefore strive 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 is 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, Russian exporters will likely sell these euros for rubles soon because most of their costs are, of course, in rubles.

As a consequence, the ruble becomes worth more compared to the euro. If there are more Russian exports.

Similarly, if Europeans were 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 adviser, Elvira Nabu Lena, as a central bank governor.

When the year previously, the US had just decimated the value of Iran's riyal by sanctioning foreign investments, which in turn encouraged a run on the Iranian riyal.

Under neighborliness leadership, Russia adopted this so-called 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, neighborliness Bank of Russia started intervening by buying any excess foreign currencies from either investments 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 Russia was ever hit by Western sanctions,

however, this strategy could only work if Russia consistently brought in more foreign currency than they spent.

It's extremely difficult for a government, however, to massively increase exports or incoming foreign investments.

So if Nabi Polina wanted to build her war chest and keep the exchange rates somewhat stable and keep money flowing freely in and out of Russia, she had only one real option. Reducing how much? Russians imports.

This is easier said than done, of course, in a relatively free economy.

Imports are not directly controlled by the state.

They are done by Russian companies and workers.

However, crucially, they can only really import a lot if they have enough money to do so.

Using this knowledge, Polina and Putin essentially reduced imports by making Russians a little bit poorer than they had to be by severely limiting government spending and keeping interest rates relatively 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 anymore, but rather financial assets issued by other countries like the US Treasury bonds or deposit 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.

Maybe Yelena had gambled that Western and especially European countries did not have the guts to freeze their 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 Nabih Olena 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 making the government spend even less.

However, given that this conflict needed more and more government spending on the war, her only option left was essentially to introduce capital controls moving the Russian economy from here to here. On the trilemma.

Now, the fact that she now directly controls money flowing out of Russia enabled the Russian government to fully activate the Russian economy without collapsing the ruble.

After all, while Russians now had the purchasing power to import to their heart's content, they simply were not allowed to do so.

This move surprised many economic analysis, 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 happens during the 1997 Asian financial crisis or 2011 eurozone crisis.

It may also happen because the country has been importing too much for too long. Like the Lebanese crisis of 2019 or Sri Lanka's 2022 currency collapse.

Or it may happen because of sanctions such as the 2012 Iran crisis or 2020 22 collapse of the ruble.

Regardless of what the cost may be, though, 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 then arguably led Germans to revolt and overthrow the Kaiser.

Given that Russia has so many natural resources, produces all the food that it needs, and has a pretty reliable trading partner in China and also in India, its economy does not seem particularly vulnerable to a collapse in crucial imports or exports right now.

This leaves us with option three, an internal collapse due to excessive debt.

Japan 1992.

The US in 2007.

In these crises, local households were increasingly borrowing against ever rising 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 that supported the government.

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, yes, of crises where all of the previous factors played a role, but where the economic pain was just unexpectedly too much for an already disgruntled population to take, making them demand change through protesting, for example, that in the Vietnam era in the US 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 very, very quickly, much more quickly than people expected, potentially due to the public being unhappy about its decades of economic stagnation.

This could, of course, 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 quite a bit, so the easy phase one of Russia's war economy is now clearly over.

Russians are now going to be feeling more and more economic pain.

This could yes, it could still turn Russians against the war.

Right?

Yeah it could.

However, this is very unlikely to happen quickly because Russia's war economy is just getting started.

Now, the core of this argument is that, yes, an ever increasing 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 and other famous historical war economies, we can clearly see that actually Russia's war spending compared to the size of its economy, is actually even lower than that of the US during Vietnam, and it's way lower than the Soviet Union.

War spending in the 1980s had way, way lower than that of the Nazis 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 then able to spend so much more?

Well, this gets us to my second argument.

When it comes to the main economic tools to control our economy, Russia has only really introduced one.

Yet the capital controls that we've been talking about.

As you have seen, capital controls are extremely effective at preventing balance of payments crises, 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 controls and wage controls to keep prices from rising too quickly, while military spending got bigger and bigger and bigger.

This brings us to phase two of the war economy.

If phase one, everyone is happy, we've seen that.

But in phase two, real sacrifices have to be made.

Specifically, civilian industries will have to be sacrificed more and more to free up resources for the ever expanding war economy.

Not have 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 Germany sacrifice civilian freedom for military might.

Russia is only at the start of this process.

But yes, there are some signs that it is starting to go down this path.

Now, Lana has already shown us she's pragmatic and willing to think outside the box when she introduce 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 was shown to us when the war just started.

Russia's authoritarian government can afford to let public opinion sink quite a bit further.

所以 these three arguments are why I think waiting for a Russian economic collapse is a naive fantasy.

Sure, as you've seen with the 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 collapse has happened 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.

Crucially, sanctioning Russia may directly hurt its war effort by reducing its ability to pay for crucial water imports.

It also does not mean that Russia does not have serious problems.

For example, there are manpower shortages as well as some serious gas shortages right now in Russia. Don't you?

Ukrainian 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's my take.

What do you think?

Am I missing something?

Let me know in the comments below.

And if you are interested in more balanced analysis of the Russian war economy and war effort in general, I highly recommend you check out our advertising sponsor, The Economist.

Specifically, I recommend you cross-check my analysis with theirs about Russia's besieged economy.

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