Russia’s path to a twin deficit

Vladimir Putin, still hailed by many in Russia for their successful transition from socialism to ‘state capitalism’, is facing much more economic instability than he did in his first two terms (from 2000 to 2008). 

To remind the readers, the Russian transition from socialism in the 90-ies was characterized by a booming number of oligarchs who controlled most of Russia’s oil and gas resources and which were to a large extent responsible for increasing criminalization and impoverishment of the country. In such a desperate situation which has seen Russia slipping from the world super-power to a bankrupt economy dependent on Western aid, the people longed for a leader who can set the country straight again. After all, one has to bear in mind that the Russians got used to having dominant leaders in the past, even much before the Bolshevik revolution in 1917. Never has Russia experienced true political freedom and democracy (especially not in the oligarch-controlled 90-ies), so the sudden transition followed by the formation of a new extractive elite inflicted a lot of pain onto the country. Then Putin came along. He was quick to do everything the people expected and, in general, wanted him to do. He imprisoned the oligarchs or forced them to (cooperate) sell the natural resources back to the state. Once in full control of Russia’s oil and gas, he enjoyed a rapid growth of the economy and state revenues based on a boom in oil and gas prices on world markets. Having control over energy not only helped Putin sustain his power, it made Russia once again a political giant, substantially increasing its bargaining power. Putin held a strong grip on Europe as well, being its main gas supplier. The decisions to export gas to Europe were no longer profit oriented – they became political. Any tensions between Russia and Ukraine would be followed by pipe closures leaving Europe freezing over the winter. It was the zenith of Putin’s and Russia’s newly acquired international power. 

Domestically, Putin was a perfect benevolent dictator – gaining a lot of money, wealth and influence back to Russia, thus healing the Russians’ hurt pride, but also distributing this new wealth to the people as well as investing into the country. Between 2000 and 2011, having seen a quadruple increase in oil prices, Russia’s total budget expenditures grew 9 times, its surpluses accumulated to $785bn and even real wages trebled (FT has the story). Naturally most of the voters were satisfied (albeit some protesters demanding more media freedom and political rights, but during the boom, these people were highly marginalized).

Crisis redux 

Then came the crisis and his second rise to presidency in 2012, following a charade he made with Medvedev, who served as a PM under Putin, while Putin served as a PM under Medvedev. Now Russia is facing an uncertain future and is unable to rely on oil and gas exports to keep it going, at least not to the extent they used to. 

Easy money and social spending, like in much of Europe, have come to a close. Even though it’s hard to call Russia a classical welfare state, Putin’s vote-buying of various interest groups is precisely what characterises an extractive, rent-seeking welfare state. Resource exports made this model possible and somewhat sustainable – at least in the short run. But this has come to an abrupt end following the current crisis and contagion. 

The IMF predicts that the current account surplus will turn into a deficit by 2015 (imports will overtake the exports), pushing Russia into an era of the 'twin deficit' (both budget and CA deficit – a standard occurrence in the West today). This was unimaginable during Putin’s first presidency which saw a persistent 10-year CA and budget surpluses.

Source: "IMF Country Report: Russian Federation",
September 2011, pg. 16

This may not come as a disaster though since it could signal that Russia is becoming more attractive to foreign investments, but as in the case of twin deficits in peripheral eurozone, this is highly unlikely.

Having a twin deficit and no more big exports to make the welfare state model sustainable, the government will have to turn to politically unpopular moves to cut public sector wages, cut entitlements and cut defence programs. Or they could borrow which wouldn’t be a problem to a country with only 15% of debt to GDP. But this is not particularly sustainable in the long run as we have seen in Europe. Also, policy-making in that case would be subject to a bigger scrutiny from foreign investors which will become more reluctant to invest under any sight of political uncertainty.

Reforms?

Some claim this is good news and that it may encourage Russia to cease its dependency on oil and gas exports and switch to institutional reforms – starting from government bureaucracy, the legal system, cutting red tape etc. This would encourage foreign investments since Russia does indeed have potential for high-profit investment projects. But it doesn't have the structure to support them. 

In order to do this, as I have stressed out many times before, political and individual freedom are a necessity. No one will be prepared to invest in a country if he or she is worried about their wealth being expropriated and their business shut down due to local inefficiencies. These can be fixed, but in order to do so, the most important thing is to undergo a political reform guaranteeing fair elections, free media and more political freedom. However, all these seem highly unlikely under Putin who will regard this as a threat to his political power. 

There is a way out. If the country does undergo a change the government and starts reforming the system it may curtail public anger by offering more concessions to the public in terms of more political rights and more media freedom. As in the case of a gradual post-industrial revolution shift to more political freedom in 18th and 19th century England, Russia can benefit from having to do the reforms (like privatization or the delicate pension reform) and at the same time gradually increase political freedom in the country. One would offset the other. This would end the resource dependency of the country and the dependency on the government to control the economy and at the same time it would create incentives for the people to innovate and generate more wealth by and for themselves. If this is done carefully during the course of the next 10 years, it would make Putin more popular than ever. If he resists change and chooses the borrowing path to sustain his vote-buying extractive welfare state model (a more likely scenario), the anger among the people will grow and political uncertainty and instability will increase, further discouraging any chance of foreign investments and creative destruction to drive the country forward.

Jobs? 

It is crucial to address the business dependency as well. In Russia’s opening to the WTO, domestic production could initially suffer as they are heavily protected by a series of tariffs and subsidies and tend to be highly inefficient. Only in a global market can Russia’s businesses become more competitive, having to do without the hand of the state helping them every step of the way. But they need to be prepared for this change which is likely to initially cause a series of job losses and a lot of voter dissatisfaction, increasing political instability and the pressure for more freedom. That’s why a gradual reform approach would be a better solution. 

Even if initial jobs are lost, this is only a signal that they have been allocated in wrong sectors to begin with. With a more diversified and innovative society, new patterns of specialization will occur. This will, accompanied with more individual and political freedom, lead to more innovation and new jobs being created. This is the path to a sustainable growth model that can be applicable to any country today. 

Finally, the World Economic Forum makes a suggestion how to start:

“Strengthen the rule of law and the protection of property rights, improving the functioning of the judiciary, and raising security levels across the country would greatly benefit the economy”.