Putin’s Prism: Russia’s Problems Cannot be Solved by Policy Tinkering

By Ian Pryde and Suzanne Stafford

For the Letter to Investors published by the Diamond Age Russia Fund

As 2014, an unusually eventful year, drew to a close, Russia was yet again in the global headlines for all the wrong reasons. The collapsing oil price dragged down the rouble, leading to domestic fears of 1998 redux, when the masses learnt a new foreign word – “defolt“.

Russian and Western analysts have penned countless policy recommendations to “solve” these problems, but few understand not only why these recommendations will not be implemented, but will not work even if they were.

According to many analysts, the Ukraine/Crimea crisis and Russia’s gas deal with China exposed the weakness of Russia’s economy. In late April, the IMF said that the country was already “experiencing recession” – despite oil costing over $100 per barrel. If so, this would have been Russia’s second recession in five years. As of October 2014, however, Russia had apparently escaped recession, but most experts were forecasting stagnation and increasing  inflation.

Then Russia was hit by what many call a “perfect storm”, but the real reasons for Russia’s current condition are not understood by most observers. On 26 March 2014, for instance, the World Bank stated that

In the past, the lack of comprehensive structural reforms was masked by a growth model based on large investment projects, continued increases in public wages, and transfers – all fueled by sizeable oil revenues. Recent events around the Crimea crisis have compounded the lingering confidence problem into a confidence crisis and more clearly exposed the economic weakness of this growth model.

This is flat wrong. The World Bank fails to understand the term “project” – a temporary endeavour done over and above normal business – and nothing was “masked” since it was obvious all along that in Russia’s case, such projects did little, if anything, to diversify the country’s economy, let alone solve Russia’s deep underlying structural problems. That is why genuine Russia experts long since forecast looming problems – even during the go-go years between 2000-8.

In fact, Russia’s weak economy and failure to reform are deeply embedded in centuries of elite rule and the country’s counter-productive policy choices since 2000, especially after about 2004-5, when an initial burst of reform ground to a halt.

British historian Geoffrey Hosking observed in his 1997 book Russia: People & Empire 1552-1917 that

What is striking is not that Russia was economically backward in either the sixteenth, eighteenth or early twentieth century, but rather that every attempt at reform and modernisation in the long run tended to reproduce that backwardness… the economic policies deemed necessary to sustain the empire systematically held back the entrepreneurial and productive potentialities of the mass of the people.

Plus ça change!

In his 2003 article ‘The Russian Conundrum‘ for the Cambridge Review of International Affairs, co-author Ian Pryde stated that

Russia has resumed many of the reforms that were put on hold during the instability following the crash of August 1998 and is seriously attempting to create the conditions for sustained economic growth. However, implementation will prove difficult, and policy slippage will be costly.

Why? Because implementation in Russia is always difficult and meets tough resistance – recall Peter the Great cutting the beards of his boyars – because if a large and sustained drop in oil prices were to occur, Russia would be in serious trouble, and because hitherto, investment in the non-energy sectors had remained far too low. The Russian elite also recognised then that major reform was needed if the country were to avoid slipping to Third World status.

The ideology of “Resurgent Russia” has since replaced the fear of Third World status, but right up until the global financial crash in 2008, we continued to warn in both English and Russian that Moscow was failing to carry out meaningful reforms when the going was good. [Our warnings are in many articles reproduced on this website].

The subtitle of the 2005 book by economics professor Steven Rosefielde at the University of North Carolina, Chapel Hill, explains why.

In Russia in the 21st Century: The Prodigal Superpower, Rosefielde updates Hosking’s argument to the Soviet, Yeltsin and Putin periods, noting that Russia’s “deep structures” and solutions dating from the rise of the “Muscovite Model” in the post-Mongol period now appear in a modernised, liberally autocratic form: patrimonialism, rent seeking, networks of mutual support, plunder, protectionism, subjugation and extreme inequality. The rule of men continues unabated and property rights are just as alienable as ever, as Mikhail Khodorkovsky and many “lesser lights” have found out. The latest high-profile case was that of “oligarch” Vladimir Yevtushenkov, who was placed under house arrest in September 2014 and released in December 2014 after his oil company Bashneft had been nationalised.

Rosefielde also argues that in the 2000s, the economy’s potential was hardly any greater than during the Soviet period and remained structurally militarised, i.e. it is

a productive system with a large embedded military-industrial sector capable of persuading political leaders to provide sufficient resources to deal with worst-case security threats in the long term.

In short, the economy remains dominated by the security concerns of the leadership, general staff and military-industrial complex. Put more simply, security and power considerations trump the economy. If this did not change, forecast Rosefielde, Russia would have to chose between guns and butter.

Russian economist Yevsei Gurvich, a member of the Presidential Economic Council, duly echoed Rosefielde’s view in an article appropriately entitled ‘Guns or Butter‘ on 23 April 2014 in Vedomosti, a joint venture between the Financial Times and Wall Street Journal and one of Russia’s leading business newspapers.

Gurvich pointed out that at 4.5%, Russia’s military budget as a percentage of GDP is nearly twice as high as the global and NATO average of 2.5% and that while defence spending is set to increase by 61% during 2014-6, spending on health and education would only rise by 22-23%. This is against the background of a largely stagnant economy down to 2030, as Russia’s Ministry of Economy forecast in 2013.

Gurvich also noted that the Russian public remained unaware of these costs since they had hardly been discussed on TV and radio, the main source of information for most Russians. Instead, Russian TV had focused on the much narrower issue of sanctions.

Pressures against the Russian economy have of course mounted considerably since Gurvich’s April article, but Western views that broader sanctions could bring Putin to reverse direction could be wide of the mark.

As the failure of the demonstrations showed a few years ago, Russia’s middle class is still small, or at least too apathetic to protest, while – as Russian liberals point out – much of the Russian population can easily survive on its traditional diet of “vodka and potatoes”.

A Russian friend recently returned from two years working in the U.S.A. reported in summer that her mother expressed the widespread view here that “annexing Crimea was necessary, no matter how much it costs.”

In short, Putin has reversed Yeltsin’s priority of getting the economy right and dialling back Russia’s great power claims – something most Russians support – at least for now.

The collapse of the oil price and rouble will test that assumption. Doubtless all will depend on just bad things become.

It is, however, also false to assume, as many analysts do, that sanctions are not working. As German defence minister Ursula von der Leyen has pointed out, without sanctions, Russia may have gone much further than it has.

Many in the West – virtually none of whom are Russia experts – compare Putin’s allegedly dynamic moves with the “wimps” at home, but parts of Russia’s political and business elite thought Putin’s chess move to “castle” Medvedev in order to reassume the presidency was extremely unwise due to the country’s huge structural problems, most of which are insoluble even in the medium to long-term and indeed forecast to get even worse. As a result, Putin has virtually no exit strategy politically. Indeed, that is precisely the reason that many in Moscow believe he annexed Crimea, although the Russian president hardly reckoned on serious sanctions, serious Ukrainian resistance or a collapse in the oil price.

Russia’s huge problems include its unreformed – and perhaps unreformable – energy-based economy and the threats to it not just from shale oil and gas, but from increasing alternative sources, its demographic crisis and its declining human capital.

Take energy. In December 2011 and again in December 2012, we warned of the huge threat to Russia’s economy from both shale oil and gas and breakthroughs in alternative energy. Some experts are now saying that renewables could render hydrocarbons obsolete in the next 20-30 years, as could a breakthrough in nuclear fusion. In mid-2014, Toyota announced that it was launching the production of cars running on hydrogen, which obviously require no fossil fuels and whose only waste product is water. In December 2014, when Bloomberg magazine featured the story on its cover, the cars were slated to sell for just $62,000, already $5,500 down from the earlier price of $67,500.

20-30 years might sound like a long time, but a few years ago, German Gref, formerly Minister of Economics and Trade and now head of Sberbank, told the journalist Vladimir Pozner that the Russian car industry would take 10-15 years to develop – and that assumes that it would be successful.

Russia’s elite says that western sanctions now give the country a chance to develop its own industry, but this has more to do with hubris and wishful thinking than reality, and developing internationally competitive sectors and modern businesses under the “Muscovite Model” will be extremely difficult. Russia’s most famous export is probably the Kalashnikov – a technology developed in the 1940s! That is just one illustration of Russia’s deep problems. The authors have been involved with the Soviet Union, Russia and the CIS since the 1970s and 1980s and have heard repeated claims of breakthrough science, technology and products that “have no analogues anywhere in the world”. We know of none which has been successfully commercialised globally.

Russia’s aging population has dropped drastically since the early 1990s, and although it has seen a bump since 2009, the population growth rate has fallen, while the Muslim population is rising rapidly. Central Asian and other (im)migrants “top up” the population, but work as builders or cleaners in shopping malls and lack the qualifications Russia desperately needs to modernise. Ten million people are due to retire in the next ten years, and the brightest and best are leaving the country in droves – 40,000 Russian computer programmers work in Silicon Valley alone. Last year, a National Bureau of Economic Research paper put Russia’s fiscal gap (the difference between the present value of a country’s future expenditures and its future receipts) in 2013 at a whopping $28 trillion! Russia’s “uni-polar” moment after Crimea was always going to be fleeting and is ebbing away already.

The Soviet Union/Russia has been a power in decline since the mid-1970s, but Putin cannot solve the problems not only because the “correlation of forces” are moving ineluctably against the country, but also because any more democracy and economic efficiency would endanger elite rule à la Hosking and Rosefielde.

Russia’s commodities-based economic bounce has long since run its course, but instead of urgent reforms, ever-increasing autocracy has undermined Russia’s new and fragile democratic institutions, while ever-increasing bureaucracy and corruption suffocate SMEs in the cradle, the mainstay of every advanced economy.

Russia thus remains deep in its centuries old cul-de-sac, irrespective of any current bump in presidential popularity, and has failed utterly to even begin building a trust-based society, a concept wholly alien to the country and a leadership which thinks in terms of zero-sum games.

In addition to the Kremlin’s fear of losing control, the country’s schizophrenic mentality also hinders its progress.

Russia continues to swing constantly between two extremes – indeed these extremes co-exist, despite their logical incompatibility. On the one hand, Russia has a huge inferiority complex born of its constant awareness of its own backwardness combined with its astounding inability to get its politics and economy right at the same time. On the other hand, it has a deeply-ingrained hubris born of its imperial past – most Westerners are unaware that Russia’s imperial period lasted far longer than those of the maritime powers of Portugal, Spain, Britain, Holland and France.

Russia’s own leaders let slip occasional glimpses of these extremes.

Speaking about the government’s botched monetary reform, the then Prime Minister Viktor Chernomyrdin uttered in 1993 what instantly became a “winged phrase” typifying Russian reality in general:

хотели как лучше, а получилось как всегда

literally: we wanted (to do) it better, but it ended up as always

Vladimir Putin gave vent to Russia’s typical hubris, denial, and touchiness at Davos in 2009 when dismissing an offer of help to expand Russia’s economy and help it out of the crisis from Michael Dell, CEO of the eponymous company:

The thing is, it isn’t necessary to help us. We are not invalids. It is necessary to help the poor, invalids, pensioners, developing countries…

Russia is thus certain to continue cutting off its nose to spite its face – far better that than to lose face by admitting weakness to the West.

Russia remains a nuclear superpower and the largest country in the world territorially, but if existing trends continue, Russia’s population will fall to between 100-107 million by 2050 and the country already lacks the population to exploit its resources and increase production, while the ongoing rise of China, India, Indonesia, Brazil, Nigeria and other countries with larger and faster growing populations and more dynamic economies will see it fall behind relatively and increasingly sidelined from international affairs in coming decades as its economic growth will be lower than the global average.

Moscow’s only “correct” policy solution remains modernisation, not adding more territory consisting of poor and backward regions such as Crimea or Eastern Ukraine which require huge investment and subsidies and involve huge opportunity costs. Astonishingly, Russia’s elite, it turns out, thought these were affordable, but as early as March 2014, one western estimate put the cost at some $440 bn in the first year alone – not including sanctions.

Hitherto, Russia has always sought modernisation from the West, but has been ignoring Western advice for centuries, while at the same time trying to catch up – and always failing because of its rulers’ insistence on empire and autocracy.

In short, as Rosefielde points out, Russia has modernised, but not westernised. Many Russian and Western analysts now argue that Putin has not only rendered ineffective Russia’s already feeble institutions, such as its political parties, parliament and the judiciary, but achieved an unprecedented concentration of power in his own hands – with all that that implies for the post-Putin period, whenever it might begin.

Russia still utterly fails to understand the vastly superior flexibility and resilience of western economies and democracies compared to other types as explained by Adam Smith, Alexis De Tocqueville, Karl Popper and many others. Their self-correcting ability stands in marked contrast to authoritarian regimes, which continue making the same old mistakes over and over again. Russia’s inability to produce sustainable, high-quality growth since at least 1913 is a case in point.

Had Russia in 1990 or 2000 made an unambiguous decision to join the western club – by far the richest, healthiest and safest group of countries in global history, despite their current problems – it could have not just modernised, but also westernised its society, industry, science and technology, increased its exports and put its growth on a more sustainable footing – and finally put to rest its paranoid security concerns since liberal democracies do not fight each other.

In short, it could have helped create what Anatoly Chubais once called for – a “liberal empire” stretching right around the northern hemisphere, although even here, Russia just cannot give up its imperial thinking.

Instead, Russia still prefers the failed policies of the last 300 years and the associated relative poverty. Moscow is therefore now stepping up its own long-mooted “pivot to Asia”, but its Ukraine policy has made itself a hostage to its former pupil China – a much more dynamic country with a much greater imperial hubris than Russia itself. But this could have failed before it started. Independent Russian energy experts say China does not need Russian gas – even at below cost price – and as German Greff admitted recently, the Asians are not queuing up to throw money at Russia either.

Ian Pryde, Founder and CEO, Eurasia Strategy & Communications

Suzanne Stafford, Senior Advisor, Eurasia Strategy & Communications

Note by Slava Rabinovich, Head, Moscow Branch, Diamond Age Investment Advisors Limited:

The article ‘Putin’s Prism‘ by Ian Pryde and Suzanne Stafford at Eurasia Strategy & Communications was initially written several months ago for the Letter to Investors published by the Diamond Age Russia Fund, but since the Letter has not appeared since June 2014 and instead the Investment Advisor now writes frequently on Facebook, the piece has not yet formally appeared until now.

In the summer of 2014 it was clearly impossible to predict the “perfect storm” that has now hit Russia: the rapid fall in oil prices and the attendant collapse of the rouble have compounded the problems of an already stagnant or declining economy and international sanctions.

The authors show, however, that these problems and the inability to respond to them are almost wholly due to Russia’s own failings, despite Moscow’s claims: as the economists say, Russia’s problems are not exogenous, but endogenous.

As 2014 drew to a close, Ian and Suzanne’s article remains important since it is one of the few analyses published in English or Russian this or last year which takes a broader view of Russia’s past and the country’s longer-term prospects.

The authors have undertaken only minor updates since subsequent events have vindicated their analysis and forecasts.


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