11 min read

Конец Совета

It's getting harder and harder to divine what exactly to make of each successive announcement coming out about the economy and, equally, the real state of the Russian state's capacity to wage war in Ukraine. In the last 2 weeks, another wave of mobilization has been rolled out for an additional 350,000 conscripts and a formal council for all matters pertaining to mobilization has been formed by executive decree despite earlier claims that it was, in fact, over. In successive waves, that's 700,000 men conscripted for combat and being plugged in to cover the attrition experienced on frontline units likely under-resourced and under-manned to effectively conduct offensive operations. By state order, personal data is now being handed over to the military in an administrative maneuver intended to establish the resources and coordination necessary to continue mobilizing the public indefinitely, even if the age profile shifts higher as defense minister Shoigu and others go back and forth behind closed doors. Economic policy is finally starting to bend to outright militarization by formal channels and practical means, even if not truly reflecting mass mobilization as I have argued before. In Putin's own words speaking to the Ministry of Defense on Dec. 21 in place of the usual end-of-year public hotline:

"I want to bring to the attention of the Ministry of Defense, head of the general staff, all commanders who are represented here, we have no constraints on financing. The country, the government will give all the army asks for. Everything."

Add to this the latest news that Dmitry Medvedev has wormed his way back into semi-relevance with a post on the military-industrial commission overseeing major coordination efforts and a recent visit to Beijing in place of Putin and one can see the year ending with a very different political landscape within Moscow, one that will structure, at minimum, developments in the year ahead.

On December 20, Putin asked Pyotr Fradkov, son of former primer minister and director of the SVR Mikhail Fradkov, to use Promsvyazbank (which Pyotr Fradkov heads) to direct more resources and help towards defense firms trying to diversify their production onto civilian markets. At present, the bank's diversification portfolio is a measly 200 billion rubles and there's much room for growth helping SMEs in this endeavor. These ideas and policy initiatives were first formally initiated from internal deliberations and debates in 2016-2017 led by figures like Sergei Chemezov, head of Rostec, that picked up slightly in 2018 but largely vanished from public discourse. Their thinking was inspired by austerity. As the bump in defense spending that coincided with the annexation of Crimea, war in Donbas, and intervention in Syria began to normalize and fall off, US sanctions policy began to go after export earnings of Russian defense systems that had underwritten domestic armaments programs by generating profits that are contractually impossible to realize on domestic orders. Most domestic procurement contracts for defense systems impose a hard price ceiling fixed against costs of production. Since domestic spending was planned to fall – part of the compromise policy framework struck by the 'liberal' technocrats and the ruling caste's fear of inflation – sustained increases in exports were necessary to maintain the gains realized before CAATSA and other risks took effect. Sanctions closed that door, and the only window open to those sitting in the sector who knew that things could only get worse after 2016 with the US was to move into civilian markets where they could eventually substitute imported goods at a markup using subsidized credits and trade policy instruments to restrict competition. But this vector of development went nowhere for 5 years. Now it's being revived as the government seeks out ways to reorient existing businesses towards light-industrial production in support of the military.

On the one hand, this is a nothingburger. It's not shocking that pressure is increasing to merge civilian with military productive capacities and incorporate a growing share of the economy into structures that are dominated by defense-industrial firms. On the other hand, it points to an abrupt acceleration of two underlying political logics for business and elite politics that began with the annexation of Crimea, one that goes beyond making business dependent on the state towards something more problematic for regime politics, the balance of power in Moscow, and succession more generally.

We can begin to unspool the problem looking at statements from first deputy minister Andrei Belousov, a long-standing 'fixer' alongside Dmitry Kozak on economic questions with big business. Over the last 5 years, Belousov has been at the center of repeated attempts to raise the tax burden for the metallurgical center, part of the cadre that sprung into action around Mikhail Mishustin to create a system of standing price and export controls to dampen inflation, and more as economic policy has lost all coherence. Interviewed on Rossiya 24 recently, Belousov let slip the following:

"A mobilization economy doesn't exist . . . I think that for us to create a   mobilization economy in such a way doesn't make sense and simply wouldn't work. But we have enough reserves and levers that we can deploy to solve the problems set for us by the president and life."

Though the regime has done much to avoid the word 'war' until recently and frequently speaks at cross purposes with its intentions, I think we can take this statement at face value. Most economic policy handlers are well aware that the system is simply not designed for that kind of mobilization, and doing so creates huge economic costs and political risks they're not confident they can manage. But refusing to mobilize is akin to kicking the can down the road in terms of generating something approximating positive economic activity and a stabilization or increase in real incomes for the public. Word from the Ministry of Finance that the G-7 price cap on Russian crude oil exports may force the federal budget deeper into deficit past 2% of GDP, early evidence that the complaints it was impossible to administer were misguided, points to the problem. The state is not going to spend its way into the productive capacity it needs to wage the war effectively. The Bank of Russia is already signalling it may raise interest rates in response to the pro-inflationary factors present in the economy (read: conscription of nearly 1% of the formal workforce, impending losses of remote labor as the Duma changes tax rules for IT specialists and others, as well as the weakening of the ruble as export earnings decline). Sanctions pressures are forcing policymakers to adapt to the logic already present in the defense sector from 2017 onwards to a widening number of sectors and policy areas. In March 2021, it was Putin trying to exhort private business to mobilize its resources to launch an investment boom. Now it's about cannibalizing healthy demand, a fact amplified by an executive decree slipped in under the radar before year end formally eliminating the requirement that state bureaucrats announce their earnings. Theft and personal graft at the expense of the public are being legitimized to buy loyalty, and in the process blinding the political system to its own excesses that will inevitably kill more investment, demand, and potential for income growth.

One of the oddly less appreciated dynamics of the Russian economy after the annexation of Crimea in March 2014 was that almost all nominal GDP growth came at the expense of domestic incomes. In other words, 'growth' was generated by exports and the devaluation of the ruble rather than domestic demand. Whenever stories about increases in machinery exports or sales of agricultural equipment abroad popped up, the real question was why that wasn't being consumed within Russia given the immense productive capabilities that remain untapped across the country. The defense sector's discussions about moving into domestic production dovetailed with this phenomenon, doubling the cost any new industrial policy since subsidies would be necessary to avoid significant goods inflation for substitutes being passed onto consumers whose incomes were already falling or stagnant. Imagine doing the same now with a much larger, sharper shock that is likely to worsen next year as firms' reserves of imported components that are now more difficult and expensive to source run out of what they stocked up and the ruble weakens. On a market that's shrinking, growth is achieved by some – in this case, theoretically defense firms – at the expense of existing civilian producers or through consolidation. Through the worst of the pandemic, for instance, larger food retailers often sought mergers, benefiting as well from the informal price control arrangements the government tried to strong-arm them into as a response to rapidly rising food prices from late 2020 onwards. The 'growth' from 2015-2021 that was achieved was only possible because Russia remained an open economy reliant on exporting sectors, and therefore could use foreign demand to offset increasingly hollowed out domestic consumption. Financial sanctions, import bans, and reputational risks have put an end to that. Foreign demand used to provide a boost for corporate profits and can no longer do so. As corporate profits fall, so will investment as financial sanctions back in 2014 pushed the Russian banking sector towards a greater reliance on deposits to back lending, compounding the downturn.

These dynamics go a long way towards explaining why regime politics have become zero-sum over the last decade. As state spending has pulled back and investment levels generally lagged real-terms peaks last seen in 2013 – the brief capex boom in late 2021 that is exaggerated by constant meddling with inflation indices was notable in that the Bank of Russia explicitly saw it as a problem – large state-owned enterprises and the state/regime managers have tended to swallow up their competition when possible. Igor Sechin and Rosneft are the most infamous example grabbing firms like the briefly nationalized Bashneft or notching regulatory changes to benefit their own position or vanity projects and seem intent on striking yet again. Though it's unlikely to get very far, Sechin apparently tried to lobby Putin to hand Rosneft a monopoly over all crude oil exports as part of the national policy response to the G-7's oil price cap. Putin has yet to accede to the request, and for now it's a moot point. But it speaks to the rules of the game as the economy continues to muddle through a significant downwards adjustment in its productive capacity and the ability of exporting industries to underwrite domestic demand. As imports of technology and, more importantly, higher-end software and technical knowledge dry up for the oil sector and the price cap curtails profits, rising costs of production and dependence on Soviet-era oilfields are a huge liability. Rosneft specifically is a company that has grown largely through acquisitions and by working Soviet-era fields that used to be part of Yukos' portfolio to death, now with a gracious set of tax breaks from the Ministry of Finance. As I've noted before per the Ministry's own reporting, over half of Russian crude oil production received tax breaks by 2019. Sechin knows the company has never been good at growing output organically and cannot do so now, even with the Vostok Oil megaproject ostensibly proceeding (I'm very skeptical of any positive news about it). That leaves consolidating control over trade at everyone else's expense instead, something he's tried actively to undo regarding Gazprom's pipeline export monopoly for years. Similar problems are likely to emerge in other sectors.

There are no clear ideological groupings when it comes to the largest industries in Russia at this point. Instead, it's a matter of manipulating the political system to extract concessions from the state to remain profitable while delivering something in return. Where export markets used to provide a growing market for the creation and distribution of rents, there is now nothing to replace what has been lost. Oil is in an interesting spot because its set for what is likely permanent decline relative to the pre-Covid or pre-invasion world, but remains the biggest workhorse of the fiscal system at a time when revenues generated by consumption and income taxes are falling. We might expect the same logic to apply elsewhere. Path dependencies lead to more intense pressures to either extract resources or preserve employment on political grounds. Consolidation, however, concentrates more and more effective power in the hands of fewer state managers, networks organized through middle management and state bureaucracies, and economic sectors.

Prior to 2022, the comparative diversity of the Russian economy (despite its reputation) made it easier for Putin and the regime apparatus around him to prevent any one sector, individual, interest group, or ministry from becoming too powerful. Since all major disputes requiring a resolution between major elite blocs require Putin's involvement, no grouping of elites could emerge to challenge his position, nor could any industry truly be "too big to fail" in a manner that would generate significant leverage over the Kremlin. What's changing under accelerated consolidation pressures is the degree to which this is no longer clearly the case, even if the inertia of the system is such that it would be foolish to imagine regime change is a serious possibility (for now). Where past iterations of the regime could use anti-corruption activities to weed out egregiously bad apples and make symbolic gestures to the public, the decision to cease the mandatory transparency around state officials' earnings drastically undermines the surveillance capacity of the state to keep its own excesses in check. A smaller circle of security officials now have greater power over enforcement and raiding spoils that can no longer be easily offshored. At the same time, there are fewer options to offer one industry a carrot and another a stick to achieve major policy outcomes. If industrial production isn't geared towards the war and boosted by state spending, the odds of a Ukrainian victory rise. The worse that Russia performs in the war, the angrier the class of business elites now unable to get any answers out of Putin or resolutions to their problems become. They may be powerless for now, but what happens when they ally themselves with specific elements of the security state or military?

Putin and those closest to him in age and experience at the upper echelons of the regime learned from the mistakes Gorbachev made reforming the Soviet system. The liberalization of trade in 1987 and corporatization of the economy that began in 1988 concurrently with banking sector reforms created countless avenues for the security services to profit off of economic reforms. Many may have been politically conservative and skeptical of markets, capitalism, and democracy but they had a vested interest in preserving the gains made in the late Soviet and early post-Soviet period on their own account. Without a functional condominium between them and the liberal reforms in 1998-1999, Russia's economic technocracy could never have established itself as it did. These relationships came about, however, in the context of a system facing major economic decline that was opening up in various ways. There were new ways to make money, new opportunities to establish import-export businesses, no functional way to redirect the kind of resources to the military that hardliners wanted, nor had the aftershocks of the Soviet collapse and other regional and global crises so completely fractured Russia's grip on its imperial periphery yet. Today, there is no such correlation of forces. The system is closing, not opening, and as the pool of rents available diminishes alongside Russians' incomes and aggregate state spending, the centrifugal forces of 1987-1998 are replaced with centripetal forces. The only way to generate rents now is for the existing players to loot and steal from each other or the state, which means the further consolidation of power in fewer hands. Putin's power stems from having designed a system in which he is, at all times, the ultimate veto player, someone who makes it impossible for institutions to supplant personal power or otherwise constrain his decisions. The more the economy militarizes, the more difficult it is to maintain that balance, especially as he has publicly committed himself to prioritizing the military's needs above all else. If the current system cannot meet their needs or otherwise the needs set forth by Putin's own decision-making, then questions about the relationships between different parts of the security services, the military, and business re-emerge. Most of this will happen "under the rug" so to speak. Still, the political consequences of economic decline for elite competition in the middle of a war going badly are destabilizing. Centralizing power in fewer hands is well and good until someone disagrees and is willing to fight over it or too important to be ignored or compromised with. Russian politics is always haunted. Parties and players that are otherwise virtual in service to the regime can suddenly gain prominence when public opinion erupts or something breaks. We need only look at the sudden alignment between the systemic opposition parties and Navalny and other opposition figures over the pension reforms in 2018. Putin isn't going anywhere, nor is a state collapse in the offing. How the system adapts will be the key question of 2023 for domestic politics, one that will likely reverberate in the following decades in Russia domestically and across Eurasia.