“Such an experiment has never been conducted on a country before.” How will the “special operation” end for the Russian economy?

The blockade of the Russian economy by sanctions will give rise to not one or two, but many shocks at once. The main ones will be the disappearance of goods, unemployment and problems with energy exports, says Oleg Itskhoki, professor of economics at the University of California at Los Angeles and one of the most famous Russian economists in the West. We spoke with him about how the economy will adjust to these shocks and what it will mean for the population.

Three shocks for the Russian economy

— Because of the sanctions, the Russian economy is waiting for a number of shocks: inflationary, currency, technological, capital flight and reduced demand. Which one will be the main one?

- This is an experiment on the Russian economy and on the Russian population, which has never been carried out anywhere on such a scale. An experiment on a country that was generally economically prosperous, in which the level of income, by world standards , was above average. For us economists, there are simply no analogies for comparative analysis. It is difficult even to imagine the scale of the crisis, and the word itself is hardly adequate to the situation.

Indeed, there will be various shocks. When an economy of this magnitude shuts down, there are many different sources of crisis change. And now it is difficult to say which of them will be the most sensitive. But it can be assumed that the main shock will be that goods will begin to disappear from the economy. Everything that is happening now with the currency, inflation, capital flows is, in a sense, secondary. The main problem is the lack of goods and services in different parts of the economy.

And here several things will happen at once. The first is, of course, that the import of some key components will be closed. Such components may play a relatively small role in terms of cost (it can be 5-10% of the cost of goods), but without them it is impossible to complete the assembly process to make the product complete. This means that the lack of these components may be key and some goods will simply disappear. And such shortages will provoke a cascading effect, because if one good disappears in the economy, this often leads to problems with the production of other goods.

Do you mean technology shock? The embargo on the supply of components, microelectronics, chips and other goods - all this leads to the fact that we will have a drawdown in the automotive industry, in industry, and aviation.

- Right. But it's hard to see the whole picture now. Imagine that there is a conveyor on which completely Russian production. And this conveyor works, but there is some kind of breakdown. And if some components of this conveyor are made, say, in Germany, then it will not be possible to quickly replace them - as a result, one simple detail can stop all production.

We do not know in which industries such failures will occur, it is difficult to predict. Everyone is talking about the automotive industry, aviation, but this will also happen in a large number of other industries.

It is the process of adjusting to such challenges that makes this shock so unusual, because usually the economy smoothly and slowly adapts to various kinds of shocks. Covid is one example of such a big shock, but then only some separate parts of the process failed, some supplies stopped first from China, and then from other countries. But imagine that Russia closes itself from almost the whole world at the same time - this is a shock of a much larger scale. It will take a long time to adapt - it may take several years. This is about the fact that many things can be produced in Russia - and eventually they will be produced in Russia, but the process of primary adaptation will be lengthy. This is the second thought.

And the third is that a lot of companies left the market. And this is also a unique situation - it's not just about limiting imports, but about stopping factories, shopping centers, restaurants, downtime or laying off workers. And this is also an unprecedented shock, it is a huge rarity when companies simply leave capital and refuse to continue to work. They promise to pay workers salaries over a period of time, but if they don't come back soon and start working, it's clear that Russia is in for a massive wave of layoffs.

When we talk about a recession, it is usually a decline of 1-2% of GDP, and in such situations, we expect unemployment to rise about twice as much as the decline in production. % in 2022, former chief economist of the World Now, as you know, there is a wide range of forecasts for a fall in Russia's GDP for the current year - from 10% to 30% (the pro-government Russian CMASF expects Russia's GDP to decline by 6.3-6.6 Bank Branko Milanovic estimates the fall of the economy in 2022-2023 at 8-12 %, the IIF expects a decline of 30 % in 2022. — The Bell).

At the same time, it is clear that the Russian economy is very different from Western economies in that a large share of jobs - close to 50% - is directly or indirectly linked to the state. The state will not fire people from these jobs. But in the private sector to avoid mass layoffs, as it seems now, will not work.

The consequences may be different. First, when a person loses a salary, the state pays unemployment benefits, but in Russia it is very low, and the state will have to try to raise these benefits (the latest government draft plan to support the economy does not involve raising unemployment benefits. - The Bell). In any case, if there is an unemployment crisis that Russia has never actually faced before, the state will have to somehow adapt. We don't know how - maybe it will stop businesses from laying off people, compensating businesses to keep them employed, or raising unemployment benefits.

But one way or another, it is important to understand that when there is a drop in income - either as a result of unemployment or because wages in real terms are falling - this leads to a strong drop in demand. The first step in adapting the economy will be expressed in the fact that people will greatly change the structure of their consumption, give up many things that are not vital. This includes a large part of the service industry - an area that employs a huge number of people. This is precisely the reason why the rise in unemployment is usually greater than the fall in GDP. Because there is such a cumulative effect. One person loses his job, reduces his expenses, and this leads to the loss of someone else's job - usually in the service sector. How the process of adaptation will take place here is a key question, because Russia has never encountered this.

— Could it be that the Russian economy will not be able to adapt? Can it be that the restrictions imposed, the withdrawal of Western companies from the country will really destroy the economy?

- This is an interesting question. Economic equilibrium always exists in one way or another. It can be very bad, catastrophic in terms of the loss of the population's well-being, but one way or another, economic equilibrium exists. Interestingly, the same cannot be said about political equilibrium. It may turn out that the economic downturn will be so strong that the political regime will not be able to survive it. The analogy suggests itself: the economic problems of the late USSR led to the destruction of the political regime. Let's remember what happened in the 80s, and then in the 90s, when there were a huge number of government jobs, and wages were not paid for months. Economic equilibrium existed even then, but people were forced to greatly reduce their consumption. And they began to protest, but not for political reasons, but because they were losing a lot of wealth.

Do economists expect that the current economic failure and falling incomes of Russians will cause a socio-political crisis in Russia?

“It’s very difficult to predict because there are a number of factors involved. On the one hand, there is [a “special military operation”]*, and we know that people are ready to endure when they are told that now they need to wait, to unite. In all countries there is such an effect - when cataclysms occur, people, due to uncertainty, rally around their leader, because they rely on him.

On the other hand, it will be an unprecedented decline in wealth, and at some point people may start blaming the political leadership. And it is difficult to predict how these two factors will collide with each other, but it is obvious that the longer the [“special military operation”]* continues, the more the second factor will dominate over the first.

- As for the well-being of the population. How long will Russia be able to maintain the declared huge social spending: from the indexation of pensions above inflation, child benefits to the payment of maternity capital, etc. How long will the budget system last?

This is the next question to be discussed. But, if you single out, I would first single out two shocks - the inability to produce and import a whole range of goods, and the second shock - unemployment caused by the departure of companies and a decline in production. The third shock could be the problem with the sale of energy resources - if the "military operation" continues, we can expect Europe to refuse or reduce imports of Russian oil, which is already being sold at deep discounts. This will reduce foreign exchange earnings from Russian exports.

However, there is no complete autarky of the Russian economy yet, deliveries continue. In addition, there are always gray, black markets where you can buy foreign goods and components. You can always try to establish new supplies with China, India, other countries that want to trade with Russia. In this sense, export earnings should not be underestimated - they are still very important.

There are two mechanisms that can work under such a sanctions blockade. The first one is when there is export earnings that can not be returned to Russia, but at the expense of it, to establish some kind of delivery of goods. This is what we have seen in many countries that have come under sanctions. The second option is related to sending export earnings to the budget and using it within the country. Due to this, it is possible to obtain resources in order to continue paying salaries, benefits and pensions, using foreign exchange earnings, which plays a huge role for the budget against the backdrop of a strong devaluation of the ruble and demand for foreign currency from the population. It is foreign exchange earnings that make it possible not to resort to printing money in Russia. The loss of this revenue will cause difficulties in obtaining imports, for which you have to pay in foreign currency. And the second problem is that without it, the Russian budget will face a deficit.

It seems that the fork now is like this - if there is no European energy embargo, then there will be no large budget deficit, the state will still have the resources to pay salaries, pensions and benefits without printing a lot of money.

If we switch to a more autarkic regime, where there is no such foreign exchange earnings in the budget, then it is obvious that the budget becomes deficit. In this case, the state will face the fact that it will not be able to fulfill its social obligations. Then we expect the government to force the Central Bank to start monetizing these obligations, that is, actually printing rubles to pay salaries and pensions. I must say that this is something that Russia has never done before. Despite the failures of other institutions, political or judicial, financial and monetary policy in Russia remained at a high level. From a macroeconomic point of view, there were no significant problems in Russia.

The key problem is that the volume of goods and services that the Russian economy can produce is shrinking sharply. And further adaptation will occur either due to unemployment, or the state will reduce social payments, or there will be inflation and the real purchasing power of wages and pensions will fall. But in any case, this is the result of a decline in the ability of the economy to produce goods and services. You should always push back from this.

The Printing Press, Nationalization, and the Cost Shock

- All these three options that you voiced inevitably lead to the impoverishment of the population.

- Obviously, this will be a decline in prosperity, which Russia has not experienced since the beginning of the 90s. When we talk about the policy of the state - what it can do and what it cannot - we need to understand that it is simply impossible to prevent this decline in the incomes of Russians, it has already been laid down. We will see how it unfolds in the coming weeks and months, but it is set and the state has no tools to stop it. The state can use some tools to smooth it out. And there is a risk that the state will use these instruments incorrectly under political pressure on the Central Bank and the Ministry of Finance.

? Could you give an example of such tools

— The state can simply start printing money. The mandate of the Central Bank is not to do this, but under political pressure it will be very difficult to avoid this, and the emission will inevitably lead to an acceleration of inflation. The question is what is worse for the economy: adjusting to shocks without inflation or adjusting to inflation. This is actually an open question. Perhaps some significant level of inflation is right now for the economy. The alternative is the failure of the state to fulfill its obligations to pay salaries and pensions, and perhaps this is the worst alternative.

When you say the word "impoverishment", the question immediately arises - usually we are talking about the most vulnerable segments of the population, who already had low salaries, did not have significant savings, here the state can really choose who will be hit harder by the crisis. If there is significant inflation, but the state continues to pay salaries, pensions and unemployment benefits, then this may be the right use of tools. If the state refuses to do this, it can lead to disaster. And we don't know what would be politically easier to do: waive payouts, lower them, or go for inflation by printing money. The correct policy of the state in these conditions, if it cared about people, should first of all think about the most vulnerable segments of the population and make sure that they do not lose their income. During the coronavirus, the state did not care much about this problem. But we must understand that the shock will now be much greater.

There is also a way of price restrictions. Economists consider this measure one of the most inefficient in normal times, but in wartime, countries resort to price controls. I believe that political pressure will be directed to solve the problem of inflation with the help of this tool. But price caps do not solve the problem of inflation. And if the Central Bank prints money, and the government tries to use price controls in parallel, this can lead to disastrous consequences. But politically, this combination may seem the simplest. For example, what happens when companies are forced not to change prices? They will lose money, which will lead to business closures, and this is an additional loss of jobs. Another consequence is scarcity. One can imagine that supermarkets will not close, but a number of goods will simply be unavailable. And finally, the final chord of such a policy is the nationalization of business. Nationalization in the sense that the state with limited competence will nevertheless take over the direct economic management of enterprises that have fallen into a difficult situation.

- But the chairman of the Central Bank, Elvira Nabiullina, has already publicly stated that she is against artificial price containment and that the Central Bank will not print money.

- Absolutely fair. But Russia has not yet entered the phase of an acute crisis.

- And when will it come?

— It is difficult to say, since it is not clear which production chains and at what point will begin to fail. It's more of a matter of weeks or months. But by the summer, for sure, many effects will begin to be felt acutely. The question is how long the enterprises that are not working now will be ready to pay salaries to their employees. We need to look at the failure of production chains and mass layoffs. I think it's a matter of a few months. And by summer, at this moment, the moment of difficult decisions will begin, when doing what is right will become politically impossible.

- And the government and the Central Bank can do something to not bring it to this edge? How can Russia provide a basis for import substitution in conditions when everyone refuses to deal with it?

“There is the experience of the Iranian economy and other economies that were sanctioned. It is obvious that there will be a search for some gray schemes, counterparty countries that will, despite the sanctions, trade with Russia. In this sense, it is fundamentally important to preserve foreign exchange earnings from the sale of oil, because it can be used to deliver goods through third countries.

An example to remember well is Belarus, a landlocked country with natural resources that has simultaneously become a major exporter of (Russian) oil and a major exporter of seafood to Russia. Belarus bought seafood in Poland and sold it to Russia, thus avoiding counter-sanctions. But Western countries will monitor the implementation of sanctions quite clearly and impose secondary sanctions on counterparties. And if we are talking about China, large Chinese companies are afraid of secondary sanctions, but there will always be a huge number of smaller companies that want to profit from it and trade with Russia for a while until they fall under sanctions.

Russia will overpay two or three times to bypass primary and secondary sanctions, but one way or another, this market will improve over time. Somewhere the control will be more serious: for example, the supply of Boeing and Airbus parts will certainly be more difficult to implement than the supply of some relatively simpler components for conveyors - for example, for the production of agricultural products. Adjustment will occur, but it will also be a cost shock. If there is a shortage of goods or you have to pay twice or three times more for them, then this also leads to a contraction of the economy.

The role of China, sanctions and global implications for the global economy

- Can we expect restrictions on the travel of Russians abroad under the pressure of economic or demographic factors? Now educated Russians, in particular IT employees, are leaving Russia. In addition, the natural decline has accelerated due to the pandemic.

These factors cannot be underestimated. We know that several hundred thousand people have left Russia since the beginning of the [“special military operation”]*, but if we compare this with the number of people who were forced to leave Ukraine, this is an order of magnitude less, and the country is still more than three times more. Of course, on the one hand, this is a mass exodus, on the other hand, most Russians will not be able to leave, so there is no question of the loss of millions of people, which is important from the point of view of the workforce. But the people who leave are those who have the most resources, both financial and in terms of human capital. This is another source of problems, but at the moment the closure of borders for economic reasons is a secondary issue. However, it is important to understand that the people who make decisions in Russia are people with a Soviet way of thinking and memory from the USSR. The Iron Curtain was one of the tools back then. There is no serious reason for it (it will not be able to solve some economic problem), but if people are guided by what they remember, then it is possible.

An interesting question is who will suffer more in this case: the poorer or richer sections of the Russian population. Economists always say that the poorer sections of the population are hit harder by the economic downturn, but in the context of Russia, it is important to understand that the average Russian has never actually been a rich person. In the structure of consumption of the average Russian, imports did not play such a huge role: for example, the quality of medical services was not very high for the average Russian. Wealthy Russians - the top 10-20% - received better medical services and relied much more on imported components for those services.

In this sense, who will suffer the most? The poor always suffer, because they do not have the resources, savings, to smooth out the shock for themselves. For the average Russian, the share of imports in the basket of consumption is not so large; for him, the effects will occur due to the general decline in the economy. On the other hand, people whose lifestyle relied on imported goods, such as electronics, air travel, and medical services, will suffer greatly. The electronics industry is a separate issue, most of it is not assembled in Russia, electronics were imported as a finished product. Obviously, there will be a shortage of high quality electronics, which will be replaced by supplies from China.

- One of the most unexpected and deadly sanctions measures was the freezing of the reserves of the Central Bank. What is the rationale for the Central Bank to do now with the remaining gold and yuan. How adequate is the position of the Russian regulator now? Do you admit that Russia's gold and foreign exchange reserves can become an indemnity to Ukraine?

- Ukraine will sue Russia for the destruction of the country and the economy. The International Tribunal will decide on these matters. Clearly, Russia's frozen assets could be used as payback. This could happen within the next two or three years.

You quite rightly said that this [freezing of foreign exchange reserves by the Central Bank] was an absolutely unexpected measure, but, returning to what I said at the very beginning: everything that is happening now with the Russian economy is an experiment that has never been done before in the world economy. was carried out. And it is important to understand that Russia approached this experiment completely unprepared. I am not saying that this experiment should have been done. This is a cannibalistic experiment. Obviously, the financial and economic block of the government and the Central Bank did not know that there would be a full-fledged ["special military operation"]*. They were warned about being cut off from SWIFT, which is a relatively small measure compared to today's sanctions. They were preparing to cut off from SWIFT and could cope with it, in contrast to the sanctions against the Central Bank reserves. Now the situation is such that in the short term, no one wants to make transactions with the Russian Central Bank, since this is an institution that has fallen under sanctions. So far, no one knows how to deal with him. Over time, there will be gray and black counterparties who will not be afraid of sanctions and will make transactions, and it will indeed be possible to sell part of the gold and foreign exchange reserves that remained unblocked.

In this sense, everyone is looking at China. We discussed with you that the first key question now is whether there will be an embargo on Russian oil, gas and coal, and the second key question is what position China will take.

China is in a difficult situation: on the one hand, Beijing is absolutely shocked by the [“special military operation”] *, China obviously did not expect it, and besides, China always speaks for the territorial integrity of countries because of the Taiwan issue. China does not want other countries to declare Taiwan an independent state, like Russia likes to do with enclaves in different countries. For them, this part of the alliance with Russia is unacceptable. At the same time, China is now in a confrontation with the United States, and from a geopolitical point of view, Beijing does not want the Ukrainian conflict to end in the defeat of Russia, which for them will mean a victory for Washington. That is, on the one hand, China wants to support Russia, but on the other hand, [a “special military operation”]* seems unacceptable to them. No one knows what decision Beijing will make. Now there are talks between the US and China, which take place against the backdrop of a very hostile policy between the two countries in the past six years. One way or another, China understands the threat of the escalation of the Ukrainian conflict, the economic downturn in the global economy.

Beijing faces a dilemma: how to communicate with Russia in the coming weeks / months, support it openly, that is, give promises that trade will be established through China, it will be possible to sell the remaining gold and foreign exchange reserves to China, receive technology, etc. Or tell Russia that nothing there will be no such thing. This is a key open issue that needs to be monitored very closely, because China could become an economic tunnel for Russia through which transactions can be made, goods and technology imported, if politically Beijing decides to support Moscow.

Will this make Russia fantastically dependent on China?

- Absolutely fair. China thinks in terms of not months and years, but decades and fifty years. It is obvious that China has territorial claims against Russia, and if it is now beneficial for China to be in an alliance with Russia, then it cannot be expected that this will not change in 5-10 years, when Russia will be in a weaker position. In the long term, from the point of view of Russia as a country, an alliance with China is simply dangerous. And in the short term, as we have already discussed, Russia will pay double and triple for all the same goods and sell everything it has at a deep discount. When you depend so heavily on one big player, it leads to very bad economic deals.

“ Now Russia is under sanctions from almost all over the world. Do you think this can force the authorities to stop the "military operation" and change their foreign policy?

“Russia started this [“special military operation”]* without a serious analysis of what would happen to the economy. The economy has been handed over. As I understand it, the financial and economic bloc of the government and the Central Bank were asked: can you handle it? They said: we will cope, not knowing what will happen. The world is set in such conditions that it is impossible to close one’s eyes to what is happening, as one closed one’s eyes to the war in Syria, for a number of reasons - in particular, because this [“special military operation”]* is taking place very close to the center of Europe, [“special military operation"]* against a country that was on the path of democratic development. Because Russia has nuclear weapons, the world understands that it cannot be entered into this conflict militarily. And there is only one tool left - economic sanctions. Since it is very difficult to stop [a “special military operation”]* with such an instrument, there really is nothing left but to impose sanctions in full.

Voters in Europe are wondering: has their state done everything it can to stop [a "special military operation"]*? People in democracies don't like geopolitics, they love their wealth and vote for it. But as you can see, the protests in Germany have shown that the level of dissatisfaction among the population that the government is not doing everything possible to stop Russia is high enough, and this is becoming a serious issue even for a democratic country. Therefore, today a cutoff from Russian gas is being seriously discussed, which for Germany will lead to a significant loss of well-being. But the population sees what is happening in Ukraine and is not able to endure it.

Can economic sanctions stop the ["special military operation"]*, you ask. What we see is that decisions in Russia are made by a very narrow circle of people. It is obvious that the government has no formal mandate from the Russian population. Deaths on both sides are of no concern to anyone, as is the loss of well-being of 144 million Russians. The idea of ​​sanctions is that they work through the loss of the well-being of Russians and thus influence the decisions made in the Kremlin. But there is no such mechanism, there are no illusions. But there are two other mechanisms. In the medium term - 3-6 months - a social protest is possible in Russia, which may influence decisions in the Kremlin (at least, earlier they were quite sensitive to sociology and changing public opinion). The second mechanism is that the money that Russia receives for the export of energy resources is used, among other things, to finance [a “special military operation”]*. Therefore, in Europe it was decided to cut off funding to the maximum. It is because of this that sanctions against the Central Bank were introduced. And it is precisely because of this that a full or partial embargo on energy imports from Russia will most likely be introduced. This mechanism could stop the ["special military operation"]* within three to six months, especially if China does not supply arms to Russia. The lack of financial resources is a way to stop it, but unfortunately it does not work on intervals of weeks.

- How will the “ special operation ” and sanctions affect the global economy and inflation?

We see that the month of ["special military operation"]* led to a slowdown in global economic growth and increased inflationary pressures. Central banks will revise their price growth forecasts and raise interest rates. Obviously, fiscal resources will be used. For example, in Europe they will compensate the population for rising energy prices, which will eventually lead to an increase in global public debt, which has already grown so much during the coronavirus. The global economy is in a phase of rapid recovery after the pandemic. These rates will be reduced, and the unprecedented high global inflation of 6-7% will continue, which is clearly a bad development. But if the [“special military operation”]* drags on or, God forbid, spreads to neighboring countries, then this will be an economic crisis of a completely different scale within Europe, and the economic recession of Europe will lead to a recession in the world economy.

By his actions, Putin has rallied the countries of the West - this is a rather surprising effect. We have seen a long-term decline in US influence in the global economy over the past 15 years, and now there seems to be an increase in the role of the European alliance with the US, both political and military, and economic, which generally strengthens the US economy. ["Special military operation"]* in Ukraine is a colossal shock to the world order - probably the biggest in the 21st century.

* The phrase “special military operation” is used in the text at the request of the Russian authorities, under the threat of the “fake law” , which threatens journalists and ordinary citizens with 15 years of criminal liability.