From carrots to sticks: How the militarization of Russia's economy is changing
From carrots to sticks: How the militarization of Russia's economy is changing
Russia's economy needs structural change to sustain the war against Ukraine. This transformation has created many winners - but who will be the losers?
For millions of Russians, the war has been an incredible bonanza. Suddenly there are opportunities everywhere, even in the most disadvantaged regions. You can join the army and become a ruble millionaire overnight, or you can work in the booming industrial cities of the Urals. Wages are skyrocketing. Unemployment is at an all-time low. Economically, life for many has never been better.
This is the consequence of the massive fiscal stimulus caused by war spending. Military spending in the federal budget alone has increased by 4% of GDP (from 3-4% before 2022 to 7-8% now). The total is higher: War spending now permeates all budgets (think of the regional signing bonuses for new recruits). State and private companies also contribute, making the assessment of actual military spending more difficult.1
Moscow faces the daunting task of retooling Russia's economy for war. People who used to work in the civilian sector are now needed on the front lines or in weapons production. Capital that could be invested with high returns in civilian businesses must be diverted to building tanks, or factories that build tanks.
If military spending had increased by just 1% of GDP, these changes could have been achieved by activating or better utilizing existing capacity or by bringing additional people into the labor market. But the war in Ukraine is too big for marginal changes.
The Russian economy must undergo structural change. To sustain the current intensity of the war economically, civilian sectors must shrink to free up capital and labor. Some businesses will have to close. Some people will have to relocate to the industrial cities with large defense contractors.
There are two ways this shift can occur: A businessman may decide to stop investing in his civilian enterprise, or even shut down parts of it, because his capital can earn even more producing drones or metal goods. This is the voluntary "carrot" variant of structural change, where he is better off than before. Or he may be forced out of business as labor costs, interest costs, or taxes become overwhelming. This would be the "stick" variant of structural change.
Similarly, a Russian worker may decide to go to war or move to another city to work in the defense industry because it will make him richer than before. This is the "carrot" militarization for workers: new opportunities that are much more lucrative than the old job. But there is also a "stick" variant of militarization for the worker: His salary at the old job could shrink in real terms, or the old employer could go out of business. This would force the worker to look for work elsewhere.
So far, Russia's transformation to a "wartime economy" seems to have been driven by carrots alone. Almost everyone is better off than before the war. If someone switched from civilian employment to military-related work, it was a voluntary move, a clear upgrade of the economic status quo ante.2
The problem is that when everyone is earning more and economic output is not growing at the same rate, this is almost the definition of inflation. The "carrots only" model of wartime transformation is too good to be true. And if something is too good to be true, it is probably not true - or at least not sustainable.
This is why the "stick" side of economic transformation is now becoming more and more visible. The economic militarization stick can take several forms: The natural form is rampant inflation, which erodes the real incomes of workers in the civilian sector, while only the defense contractors can up by increasing salaries.
The government can let this process continue - or it can decide to replace the “inflation stick” with other sticks: These could be super-high interest rates that make it impossible for civilian businesses to operate and make credit so expensive for the population that it dampens civilian demand. This would also free up workers and capital for the defense industry. Alternatively, the stick could be tax increases.
Given these three options - inflation, high interest rates, or high taxes - which stick will the Russian government choose? With real interest rates at 10% (9% inflation and 19% key rate), it seems that the government is most afraid of letting the inflation stick get out of hand, and would rather suffocate the civilian economy with high taxes and worsening financial conditions to make space for the war.
There are historical reasons for the Kremlin's allergy to inflation. Low-debt-low-inflation is part of the Putin regime's political DNA, shaped by the inflationary 1990s and Russia's 1998 default. Arguably, this regime DNA has allowed Putin to stay in power for the past 24 years.
From a political economy perspective, inflation is dangerous because it creates a large, uniform group of losers in the country, which theoretically increases the risk of collective action. Human psychology also makes inflation more dangerous than economic analysis would suggest. Perceived inflation and inflation expectations are usually higher than actual inflation in Russia. Moreover, high inflation makes people angry and is seen as a problem even if their nominal wages are increasing at the same pace.
Conversely, the downside of high interest rates and high taxes is less risky. If certain companies fail or certain regions suffer, the pain is more localized. Business owners will not get public sympathy. The slogan "I am unemployed because the Central Bank raised interest rates too much and taxes on business are too high" has yet to be seen at a protest. As a result, Putin would scold “incompetent businessmen” and perhaps “ineffective governors” in suffering regions.
That is why the Central Bank has Putin's backing, even if it seems hell-bent on driving Russia's economy into recession if that is the price of reducing inflation. Russia's structural economic shift to a war economy requires that some people and companies be economic losers. High interest rates create just the kind of losers that Putin's authoritarian regime can deal with.
For example, Russian banks are forced to give preferential treatment to soldiers. The costs of these preferences can be seen as a hidden tax on banks, and the benefits can be seen has hidden (extra-budgetary) spending on the war.
Note that the decision to join the army is often not rational even from a strictly economic perspective, despite huge signing bonuses. The recruits usually don’t price in the economic risk of getting killed or injured, which leads to a drastic loss of future income.