Yakov Feygin joins the debate on whether the Russian government can withstand an economic storm of high interest rates and inflationary pressures.

In his recent article, the economist Vladislav Inozemtsev takes aim at those arguing that Russia faces an imminent economic crisis due to an unusual combination of high interest rates and inflationary pressures: a situation economists refer to as “stagflation.” Instead, he sees the situation as ultimately manageable; with reference to Dmitri Nekrasov’s recent article in the Moscow Times, Inozemtsev compares Russia to other emerging markets which have maintained growth despite high interest rates and inflation.

There is a lot to admire in Inozemtsev’s analysis, including how he navigates the confusion surrounding most debates on Russia’s political economy these days. Indeed, as the Nekrasov article points out, it does not make sense to refer to Russia’s economy as on the verge of stagflation. Moreover, Inozemtsev is right to question the depth of any supposed economic crisis, stressing that the Russian economy will not implode overnight but rather muddle through and adjust, just as it did in 2022.

That said, I believe we can’t dismiss the seriousness of Russia’s economic impasse for several reasons. First, the combination of high rates and stubborn inflation might not lead to classical stagflation defined by unemployment, as in a market economy, because Russia is no longer a market economy – it is a war economy. Secondly, the distributional logic of a war economy under pressure – the political economy that undergirds its winners and losers – may give the Kremlin less cushion to adjust than it had in 2022. Finally, with this distribution and cushioning in mind, we can see how pre-2022 Russian economic policy succeeded in preparing the country for a certain type of war at a very high cost, yet it is more questionable now whether its dividends can still be depended upon.

Russia’s economic conundrum

After remaining stable for several quarters, inflation in Russia began to tick up in summer 2024, and strongly accelerated after the government’s projected budget showed that high spending on the military industrial complex would continue, offset in part by increases in taxes and rising prices for government services. In response, the Central Bank of Russia (CBR) raised interest rates to an eyepopping 21%. These high rates have elicited howls of protest from Russian business groups – especially exporters and the military industrial complex itself – about their ability to continue to be competitive and profitable at such a high cost of capital. High rates, they argue, will not succeed in lowering inflation but will kill Russian business competitiveness. Interestingly, many opposition economists agree.

Inozemtsev argues that these warnings are misplaced because, while Russia has a very high interest rate, it also has a very high rate of inflation. In turn, the real interest rate (the interest rate minus inflation) is a high, but reasonable 12% (or even lower if, as some suspect, the real rate of inflation is even higher than official numbers). Such a rate is high but compatible with keeping inflation under control and sustaining modest economic growth. The problem with such an argument is that there are several assumptions about the interaction between the real economy and the interest rate which do not hold for Russia, or most other economies.

In theory, a high interest rate should lower inflation by reducing excess demand relative to the potential output (supply) of goods and services. A higher cost of borrowing will lead to less discretionary spending by households, lower investment plans from businesses and higher unemployment, which in turn also reduces household demand. A deft central bank can find an interest rate that targets an inflation rate that minimises harms to the labour market and allows the productive powers of the real economy to grow to allow for improvements in the long run quality of life, while watching for signs of overheating demand in the short run.

The problem in Russia – and many other economies – is that unexpected increases in the price level are not the result of suddenly rising excess demand alone but also of changing costs to firms. Rapid shocks to inputs, including labour and financing costs, can induce firms to raise their prices to sustain their profits and pay off their existing commitments. Under certain circumstances, such pressures can result in firms absorbing some costs by increasing their capacity utilisation, or investing in new productive capacity, substitutes or technologies. On the other hand, if they are sure of their market power, producers can double down on higher prices. In short, inflation is often the result of distributional conflict in response to a change in the availability of a factor of production. Inflationary pressures can spiral as conflicts between workers and employers, different branches of industry – for example, between the military industrial sector and the consumer goods sector – cause firms and households to take actions in anticipation of more price changes. At its core inflation is part of a breakdown in social coordination.

Russia’s inflation is largely due to the impact of the war with Ukraine and the political responses to its challenges by the country’s leadership. Russia’s labour markets are extremely stretched thin due to the high prices being paid for contract soldiers. The military has effectively put a price floor under the labour market because the alternatives are either giving up Russia’s material advantages in population on the battlefield, or pursuing politically unpopular mobilisation (in other words, using coercion to recruit soldiers without paying high wages). As a result, Russia is facing a labour shortage so severe that even the police and internal security services are losing workers to the military industrial sector. Another source of price pressures comes from sanctions. Despite not stopping the Russian economy in its tracks, they have added significant friction to transactions, which has resulted in price increases to critical inputs. For example, a recent Bloomberg investigation found that circumventing sanctions on relatively cheap and abundant microchips resulted in a 40% markup on world prices. In the face of higher costs Russia must continue to pour scarce resources into the military industrial sector, which does not produce consumable goods, nor goods which will be sold abroad for currency which can buy such goods, since they will be needed at the front.

Ultimately, it is the job of the state to use its policy mechanisms to arrest price growth. However, the effective use of such mechanisms requires a state strong enough to force a redistributive outcome. The interest rate is one such policy tool – a particularly blunt one that will often work through the creation of unemployment and slow economic growth.

Inozemtsev recognises that the state has other options to arrest inflation. For example, he suggests that the Russian government can pursue policies which aim at stabilising utility prices, reduce the monopolisation of sectors of the economy, and use interest rates on reserves to encourage firms to invest out of earnings rather than take on expensive debt or place these earnings into high yielding accounts instead of directly expanding capacity. These are excellent policies, but would push against the war-oriented biases of Russian economic policy. However, they are too little, too late. The scope of the wartime shock to Russia’s capital stock – wear and tear on Russia’s already underinvested railways, roads or heating systems – and the depletion of the blue-collar labour force means that the state can choose stable utility prices, a shift in budgetary expenditures away from the conflict, or more rolling blackouts. De-monopolisation would threaten elite support and most likely will result in smaller firms more vulnerable to sanctions and high transaction costs. The same problems apply to policies that try to force firms to continue invest out of earnings. Even if firms could be encouraged to place every cent of their profits into expanding the supply of consumer goods, would they be able to make a return without either pre-emptively raising prices to account for costs, or take away scarce resources from the war effort?

Instead, Russian economic policy seems to be signalling that it will continue inflation in consumer prices by directing already limited real resources to the military industrial sector, even if the war in Ukraine freezes, at the expense of the provision of consumer goods.

The problem of the Russian state is that it politically committed to a war economy, thereby limiting its options. In a war economy, resources must be pushed to the production of materials and the sustainment of a workforce – soldiers – who do not create added economic value. Thus any new capacity does not add to the supply of consumable goods. In other words, the war economy is paid for out of the wages of the working population.

Contrast these policies with those of Inozemtsev’s example of an economy that can continue to grow under high interest rates – Brazil between 1999 and 2011. In 1998, Brazil’s central bank committed itself to fight persistently high inflation via a regime of strict inflation targeting, resulting in high real interest rates. This policy seems to have worked with stable inflation between 1999 and 2011, with a particularly strong run between 2004 and 2011. More astounding, as opposed to some expectations, during a period of real interest rates as high as 12%, Brazil experienced falling unemployment combined with historically low inflation.

However, if we look under the hood of Brazilian fiscal and monetary policy, the story is more complicated. First, Brazil pursued policies of de-monopolisation and fixed government directed health and utility prices. Secondly, Brazil experienced a very healthy trade balance due to high demand for its natural resources and falling prices for Brazilian imports, facilitated by an increasingly open economy. These factors helped offset the effect of high interest rates on the Brazilian labour market and GDP growth, and in fact, likely were also more responsible for its price stability.

Russia, on the other hand, is not only increasing prices on publicly directed prices but is pursuing a policy of supporting state-connected monopoly. Moreover, Russia, while a natural resource exporter, is both under sanctions, resulting in high import prices, and is either now unable or unwilling to support the purchasing power of the ruble. In fact, some believe that the policy of letting the ruble’s value tumble (to the extent of whether there is any established market value of a ruble due to the isolation of Russian financial markets) is connected to supporting the economic viability of export monopolists.

Russia’s economic policy paradoxes

Where Inozemtsev is right is that Russia will not face a classic stagflation scenario. Stagflation, as described in textbooks, is based on the experience of Western, and especially the US, economies in the 1970s. Stagflation in the United States came from a combination of price pressures caused by the Vietnam War and its subsequent end and the oil price shock. As a result, Western economies came to have both high unemployment and high inflation. Russia will not suffer high unemployment if it is at war, even if it has high inflation. But it will not have growth either. In fact, to understand what a war economy might hold for Russia the correct parallel is the Soviet stagnation of the 1970s: low real growth, full employment, and slowing or even falling household consumption.

Of course, contemporary Russia is not the Soviet Union: it is a market economy, which means that prices are relatively flexible and thus create incentives for substitution and innovation. Of course, the extent to which this price flexibility exists is also why inflation is the main threat to the Russian economy. Inflation is the result of a coordination problem. If all goods were 100% elastic, then high prices would solve high prices by either encouraging more entrants into a market or consumers to adopt substitutes. What is worrying about persistent inflation is that the price mechanism is not working to solve the issue and is, in fact, making it worse over time: there is some kind of bottleneck or unavoidable constraint on resources.

When an economy hits such a bottleneck that markets cannot clear, it is a policymaker’s job either to clear it or ration the scarcity – ideally a relatively painless combination of both. However, if it chooses to continue the war at its current intensity, it will be left with few tools other than explicit or implicit rationing. Inflation and who takes its brunt is a policy choice. The requirements of war and rearmament, the pre-war state of the capital stock and the pressure of sanctions and global energy markets will narrow the policy space that even the most competent economic policy makers can provide Putin. The choice he will face is either ignore the problem and let the Russian household take the brunt of inflation via higher prices, or move to an explicit state-led, mobilisation economy, where more and more goods are rationed at the household’s expense.

The empirical question is just how much capacity Russia has to spare to put off these choices or introduce them slowly enough to avoid a massive political shock. This question is very hard to answer. When the war began, many had hoped that sanctions would quickly collapse the Russian economy. Instead, Russia’s economy grew as wartime spending raised incomes and supercharged Russia’s consumer. High energy prices and years of accumulating reserves meant that Russian economic officials could deftly handle the impact of higher transaction costs.

Does that mean that past is prologue and Russia has hidden reserves of strength? Maybe. However, it might also mean something else about the longer course of the Russian economy: it has been operating below potential since 2014. In this context, Russia’s conservative fiscal stance was the equivalent of preparing the country for war. Russia’s real disposable incomes never recovered from their 2013 peak, and despite this drag on growth the government focused on economic stability via higher reserves than it did economic recovery. Despite several series of “May decrees” announcing of major infrastructure programs and wage increases to public employees, money has been sluggish in getting out the door as has growth and technological upgrading. The revealed preference of Russian government policy has been instead to build up strong hard currency buffers and budget surpluses. At the start of the war, despite the seizure of its foreign currency reserves in European central banks, Russia still had extensive sources of foreign exchange in its sovereign wealth fund and cash flows from commodity exports.

These sources of hard currency gave it a cushion against the effects of sanctions on its import and export prices. However, they are not forever, since falling energy prices and high spending are drawing them down. However, the fact that Russia’s economy could absorb so much stimulus and generate growth with low inflation hints at the fact that if Russia had not not chosen the path of insurance against foreign shocks and, correspondingly, limited its imperial ambitions, the average Russian could have been better off. If the government had spent more gradually on productive investments and improved household budgets, it could have harnessed its untapped economic potential for the long run instead of burning it up.

This article first appeared in Riddle Russia here. Riddle is an independent media outlet focusing on independent analysis of Russia and a bne IntelliNews media partner. Follow on Twitter @RiddleRussia

Yakov Feygin is the author of “Building a Ruin: The Cold War Politics of Economic Reform” (Harvard University Press, 2024). He currently works as a consultant in public finance and holds a Ph.D. in economic history from the University of Pennsylvania.