Lacking decisive defeats similar to Ukrainian counter-offensive operations in Kharkiv last year, tired media narratives about the failure of sanctions have re-emerged in recent coverage. A piece last week in the Wall Street Journal leaned on several points that risk becoming established fact. First, that Russia’s resilience to sanctions due to its military spending can be considered a form of ‘military Keynesianism’ merely because of a large increase in defence spending. Second, that the failure of sanctions to cripple Russia’s economy offers a cautionary tale of their limited viability. Both misdirect attention from a variety of difficult and painful dynamics and tradeoffs facing Russian policymakers.

Why Keynesianism?

Military Keynesianism is a convenient label for a readily observable phenomenon in Russia: defence spending is up, and aggregate demand seems to be up with it. As of late June, budgetary defence and security expenditures were slated to exceed RUB9 trillion, reaching 6.2% of GDP by year end and almost a third of total government spending. Expenditures were reportedly up 282% year on year for January-February alone. Defence spending for January-June amounted to RUB5.6 trillion, 12% greater than the budgeted spending for the entire year. These are massive sums, including a more than doubling of payments of military salaries; the share of GDP may exceed the 6.2% figure.

Russia’s notional ‘military’ Keynesianism largely rests on the following formula. Fiscal policy of any kind has a so-called demand multiplier, an expected volume of additional investment, borrowing, and consumption generated by every ruble spent. The level of total employment in an economy is therefore dictated by the level of expenditure on investment into production and capital goods, consumer goods and services.

During downturns or shocks, governments can spend to sustain employment levels and thus avoid the crippling effects of sustained deflation, leading to longer-term high unemployment, low levels of investment and political discontent.

Since the Russian economy underwent a large negative shock in 2022 from sanctions, the loss of European gas export markets, and a downward correction on oil markets in the second half of the year, the government resorted to higher levels of borrowing and spending on the military to spur investment and demand.

The Ministry of Finance has admitted budget targets are a guide figure, not exact, but current plans are to hold the annual deficit at 2% of GDP, akin to directing all additional spending to the military. As spending continues to exceed planned levels, the go-to fix proposed by Finance Minister Anton Siluanov in July was to slash ‘unprotected’ discretionary spending by 10%. This allows wiggle room to hand more money out to those serving in the military or pensioners, but completely undercuts the logic of ‘Keynesian’ stimulus spending. Invoking the concept elides the degree to which macroeconomic orthodoxy in Russia has created a fundamentally brittle economy incapable of sustaining full-scale mobilisation without something breaking.

The dog that didn’t bark

In a Keynesian world, there is no iron law that an economy naturally escapes periods of stagnation due to a ‘natural’ business cycle. Economic behaviour is social. Just as trauma may emotionally scar an individual, extended downturns or conditions of weak demand discipline businesses and households to focus on survival, holding onto profits or savings defensively rather than using them to invest, back borrowing, or spend on goods and services. Much like Pavlov’s dog, entire ecosystems of producers, retailers, wholesalers and consumers are conditioned on a long-term basis in response to shocks and market environments shaped by conscious policy choices.

Between 2008 and 2022, Russia’s PPP adjusted GDP in constant terms grew a miserable 13.4%, a figure barely beating out the anaemic 11.9% growth experienced across the Eurozone and massively lagging global PPP adjusted GDP growth of 50%. Using constant ruble values, the consolidated budget ran a collective net deficit of just 0.7% of GDP between 2011 and 2022 despite a large recession, sanctions shock, and banking crisis from 2014-2016, the COVID shock in 2020, and the additional sanctions and export-related shocks of 2022-2023.

Last year’s deficit only covers approximately 17% of net deficit-financed spending in that time. This year’s may, of course, be a more substantial contribution. Over the same period, official data suggests real incomes grew less than 8%, meaning that consumption and related domestic demand have lagged the expansion of output. Much of the pre-invasion increase came from extractive sectors, which, led by oil, gas and coal, now face long-term decline.

Overall, the economy has been systematically starved of demand for 15 years through the application of punishing austerity measures in the name of ‘stability’ at the expense of productivity, productive capacity and public welfare. The comparative boost from spending on the war seen in the last 18 months underscores a longer-term crisis of underconsumption, akin to training a dog through starvation, only to see it binge at the first sight of food. The latest data showing 4.9% GDP growth y/y for 2Q points to this dynamic, not necessarily an underlying expansion of productive capacity for consumer goods and services, despite the rise in wholesale turnover.

What proponents of the ‘military Keynesianism’ thesis miss is that a policy of sustaining consumption and investment into industry to foster growth hinges on the availability of real resources. The ‘binge’ associated with rising demand for metals, electronics, military-use vehicles, construction projects and consumer goods works if the economy’s productive capacity expands. But decades of under-consumption and underinvestment, worsening effects of the war on the workforce, and the direct and indirect costs of sanctions make this a tall order. Economies are complex ecosystems and, after an extended period in which demand and investment underperform, their capacity to quickly expand production or adapt to higher levels of both without large surges in inflation can atrophy.

HR for the war economy

Labour shortages are an issue. Even if we make the highly contentious leap and assume there are enough workers, labour is not perfectly fungible. A mechanic in Tyumen is not going to suddenly work an assembly line in Nizhny Novgorod if their business goes under and so on. Central Bank surveys show businesses’ perceptions about the availability of labour are at 25-year lows, over 1% of the workforce has been mobilised or relocated abroad, the available workforce aged 16-35 fell by 1.3mn in 2022, and as of last year, over 18% of all retirees were still working and living off wages, a figure that has likely inched up despite some adjustments to pension payments as the cost of living has risen.

As wages rise because firms compete more for labour, there is a transitional period whereby many Russians may see their earnings climb in real terms compared to 2022. Yet last year, declines in real incomes were almost certainly larger than the 1% published by RosStat given retail turnover was down 10% for much of the year. Incomes are still lower in real terms than they were in 2013. As of April, the number of people employed in the informal economy had dropped by 1.3mn, lower than the worst of the pandemic. While some of this may reflect the stronger pull of formal work linked to labour shortages, it also reflects weaker demand for services locally.

There are also efforts underway to raise the cost of migrant labourers’ advance payments for work permits 4-fold from RUB1,200 to RUB4,800. The increase would effectively raise the annual cost of a work permit in Moscow from RUB6,600 to over RUB26,000, with increases of a similar magnitude in every region per the relevant coefficients determining final cost. This will undoubtedly push migrant labourers to reconsider coming to Russia at all or otherwise considering the costs of violating the law. That spells trouble, particularly given the nature of the GDP growth currently taking place is often driven by labour-intensive sectors like construction.

What’s in a number?

GDP is an aggregate measure of money changing hands in an economy, a way of capturing the collective value of spending, investment and production at a high level. It is a social construct. As Yegor Gaidar once joked citing English economist Arthur Pigou, “if you divorce your wife and she keeps washing your shirts, [GDP] will grow. If you get married again, it falls.” GDP growth linked to deficit spending is a necessary, but not sufficient condition for ‘military Keynesianism’ in Russia for this reason.

Negative economic shocks can create ‘positive’ indicators linked to surges in spending. Let’s take RosStat’s 2Q figures of 4.9% y/y growth seriously. Annual provisions of official budget transfers to the four new regions annexed in September in eastern Ukraine amount to approximately 0.3% of GDP (assuming they are held at RUB410bn). These expenditures were frontloaded to H1 such that about 75% of that has already been spent. January-June alone saw defence expenditures reach RUB5.6 trillion – approximately 3.5-3.7% of GDP vs. topline spending just shy of RUB15 trillion, or almost 10% of GDP.

Unsurprisingly, these sums point to large increases in demand for munitions, food, clothing, and other rudiments needed to equip the military to continue operations that underscore a burst of growth. That means more munitions plants and vendors running flat out to meet state demand, paying more, hiring more, buying more inputs from their respective supply chains. That provides support for consumption, but in a manner that steadily redirects resources away from civilian uses towards the war itself. Further, we have to ask ourselves what effects the pursuit of autarky, sanctions and marginal reductions in efficiency are having.

Breaking windows

To borrow a Keynesian analogy, a government can theoretically stimulate demand by breaking windows. New windows are made, contractors are paid to install them, insurers write policies, and so on. But the windows are still broken, and the process of fixing them may be negative for growth in the face of resource constraints.

Take the oil sector. Drilling activity across the oil sector was up 8.6% for January-May and some analysts believe that demand for hydraulic fracturing equipment will rise as much as 30% annually out to 2030. But this activity comes with a relative decline in output and ongoing commitments to ‘voluntary’ cuts co-ordinated with Saudi Arabia to try to lift oil prices. If that equipment is imported, it won’t add to GDP; if it is not, it will do so in the short term. In both scenarios, the implication is that it’s taking more work to maintain output levels or replace losses from ageing oilfields.

Automakers rolled out almost 30% fewer light automobiles for H1 2023 than H1 2022 amid a larger decline for trucks and buses as well. Many factories have effectively suspended assembly operations from lack of imported inputs with no end in sight, replaced by surging imports from China. For January-May, costs of imported inputs for medications rose 40−100% y/y depending on the product. Substituting imports with localised production can boost short-term growth, but also come at the expense of quality and increase prices for consumers. Domestic clothing production rose 44% y/y in H1, but replacements of Western brands with domestic equivalents similarly creates cost risks if firms struggle with finding as many willing partners abroad to supply key inputs due to reputational or potential sanctions risks in the future. If more is made domestically, that requires yet more labour. Whenever a goods producer wants to set up a new factory, they typically rely on some imported machine tools and capital goods to produce domestically, putting yet more pressure on imports as well.

Construction remains the main indicator that the current growth is imbalanced. Demand for construction services in 2Q grew 149% during 1Q. As of July, take-up for mortgages is up 69.5% y/y. Despite some bounce back in retail turnover, more Russians are clambering into the housing market to put their money into a safe asset – a home – that is not at risk of a potential bank run or other shock. Last year, construction accounted for nearly 10% of GDP and this year, it is likely to provide a similar or greater contribution, depending on how much military expenditure effectively underwrites construction activity boosting demand in Russia.

The current surge of interest in home ownership parallels fears of interest rates rising once more as the Bank of Russia worries about inflation and the ruble, putting homes that are already far more expensive today than they were several years ago out of reach. Evidence that a growing number of Russians are turning to mixed loan structures – taking out mortgages alongside personal commercial loans – as well as regulatory concerns about pre-sales of units to finance the completion of buildings also raise questions about who will be left holding the bag when interest rates rise again, never mind that if anyone wants to furnish these homes, they’re likely going to buy imported appliances.

The autarky trap

The problem of managing inflation is key. Over the summer, the ruble has weakened to roughly RUB100 to the dollar. This is not just a result of lost gas exports to Europe or lower prices for crude exports, but also the effect that stimulus in the economy has on imports. Prior to the invasion, as much as 75% of the monetary value of consumer goods used by households in Russia was imported. A weaker ruble quickly translates into higher prices for consumer goods as well as higher prices for Russia’s industrial firms that frequently rely on imported components or machinery. Higher inflation then forces the Bank of Russia to raise interest rates, squeezing the ostensible ‘boom’ that’s propelled the Russian economy towards recovery until the economy reverts to a lower demand, lower investment equilibrium.

‘Military Keynesianism’ requires a co-ordinated fiscal and monetary policy structure that does not exist at present given these competing policy imperatives. Some sectors can be insulated better than others substituting demand for Russian exports with domestic spending. For instance, steel demand is up 8% y/y for H1, offering some reprieve from the frequent discounts quoted by importers since the invasion. Coal has similarly benefited from greater domestic use for power generation. However, most cannot. The fact that inflation has come down as much as it has, if we are to believe official data, suggests that household consumption is weaker than meets the eye, especially in the informal economy.

These forms of consumption are mostly driven by policy support, spending that must compete with the growing needs of the war, or depend on surges of imports that weaken the ruble. Since June, road construction contractors have been pushing the government to delay procurement requirements that stipulate that companies who use domestically manufactured equipment for less than 30% of their needs will not be eligible for state contracts from the start of 2025 onwards. These arguments are eerily like previous attempts to achieve import substitution through regulatory fiat for shipbuilding and other strategic sectors prior to COVID. The combined preferences of Russian elites and sanctions necessitate a higher level of autarky to avoid the pitfalls of these trade-offs, but achieving that autarky is impossible without a combination of a large decline in living standards, high inflation and outright coercion.

Deficit spending in Russia is not strictly ‘Keynesian’ merely because the state is borrowing and spending more. There is no coherent strategy or policy apparatus effectively expanding the economy’s ability to produce light industrial goods and consumer goods domestically, there is not enough labour to do so, capital-intensive investments into manufacturing still depend on imports, and businesses have no reason to believe in the economy’s long-term growth potential. Even if the Russian economy ‘returns to trend’ in 2024, it will be growing at less than 2% annually, and prior to the invasion, the Bank of Russia was considering revising its own assumptions about the level of unemployment needed to quash inflation.

The more economic activity depends on spending for the war, the greater the hit will be if the war comes to an end or mobilisation ramps down unless that spending is maintained and transformed. There is no evidence that is possible given the political system’s constant preference to use economic dependence or precarity as a tool to discipline the public and parts of the regime. Instead, today’s deficits create a sugar-high for imports and reallocation of resources to ends that do not sustainably create growth, but give rise to a shorter-term burst of activity that appears ‘positive’ based on GDP accounting before becoming a net drag on consumption and investment.

Nick Trickett is a commodities analyst.

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