Russia's war dividend

Putin's perverse incentive to keep fighting

Donald Trump may have dropped his pledge to end the Russo-Ukrainian war within “24 hours” but aides to the new US president, who takes office for the second time on Monday, still hope to negotiate a ceasefire within “100 days”.

Their optimism is admirable but naïve. Reliant on US military and financial aid, the Ukrainians have already scaled back their claims but the Kremlin’s maximalist demands are non-starters for Kyiv and its Western allies. But, don’t worry, say some observers. Deteriorating economic conditions from the dual stresses of a wartime economy and fallout from coordinated sanctions will incentivise Russian President Vladimir Putin to soften his geopolitical ambitions and pursue a peace formula acceptable to Ukraine and the West.

The problem with this confident assessment is that it glosses over structural changes to Russia’s economy since the February 2022 invasion that transform the Kremlin’s incentives to end the war. The Russian economy has unarguably suffered from Putin’s decision to launch a full-scale invasion three years ago but winding down the war will not undo the damage nor improve conditions.

Springtime for Putin

Most accounts of the economic impact of the war focus on changes to Russian overall demand. Wartime conditions have led to an economic boom; following a 1.2% contraction in 2022, the economy grew by 3.6% in 2023 and probably expanded by nearly 4% in 2024. Gross domestic product may grow by little more than 1% this year – closer to its potential rate before generating excess inflation – although the highly restrictive monetary stance imposed by Russia’s central bank (CBR) could tip the economy into recession.

This robust post-invasion expansion, despite an ongoing drag from sanctions, is due to a surge in wartime government spending; the federal draft budget for 2025 envisages national defence expenditure nearly four times its 2021 level in nominal ruble terms. More than 40% of federal spending this year is earmarked for national defence and internal security.

This above-trend expansion has been accompanied by a price shock. Inflation is running at nearly 9% (more than double the official target) – a pace that would be much faster if it weren’t for the CBR’s punitively high 21% policy rate, which in turn has driven inflation-adjusted short-term rates into double digits.

A perfunctory analysis of Russia’s inflation problem would suggest that a red-hot economy is fuelling price growth. However, inflation peaked a couple of months after the February 2022 invasion at nearly 18% after the ruble briefly plummeted in the wake of crippling sanctions. Furthermore, price gains slowed dramatically in 2023 even as growth outpaced its trend rate.

All about supply

Russia’s economic difficulties stem from supply-side imbalances rather than excess demand. A contraction in aggregate supply has made the economy even more fragile than it was pre-invasion. Demand for war materiel has fuelled a boom in Russia’s industrial sector, with some factories operating 24 hours a day and Soviet-era stockpiles cannibalised to sustain deliveries. Labour costs have spiralled as managers struggle to fill factory floors with workers. Wages increased nearly 20% last year.

This is a supply problem in disguise. An analogy to the traditional guns-and-butter model illustrates this. An economy that produces a lot of guns and not much butter, while consumers clamour for butter, doesn’t suffer from excess demand but rather a supply shortage. A shift in the composition of demand within Russia has left productive capacity inadequately equipped to provide the goods and services required. A tight monetary stance can tamp out excess demand but can’t invigorate an expansion of production capability to match its composition.

Labour shortages have exacerbated these supply constraints. More than 500,000 young Russians on the front lines in Donbas are unavailable to work at home, not to mention the hundreds of thousands of war casualties. A brain drain of young adults, fleeing conscription and seeking opportunities abroad, has worsened an already entrenched population decline. Increasing xenophobia has made Russia inhospitable to migrants and prevents the importation of sufficient workers to plug the shortfall.

Swords, please

Ending its war in Ukraine would not fix Russia’s economic imbalances. If the conflict concluded tomorrow, half a million young men would return to the home front with the same ambitions as demobilised soldiers from any country or time: to get a job and start a family.

But an inevitable post-war decline in defence spending would mean no more high-paying factory jobs in the military-industrial complex. Many workers now churning out weapons would also find themselves out of work as demand for ploughshares replaces that for swords.

Recessions following wars are common as a country reorients production from defence to private-sector demand; the US experienced economic contractions after the Second World War and the Korean War. Russia’s structural rigidities would make a post-war transition fraught in an economy more dependent on extractive industries than innovation and productivity enhancements. A post-war adjustment that might last quarters in a dynamic economy could last years in Russia.

If the Kremlin’s unrealistic demands of Ukraine and the West were negotiable rather than firm red lines, then perhaps rescinding sanctions could be part of a formula to end the war. The optics of a sanctions-relief-for-peace deal would be terrible in Kyiv and Western capitals and their removal wouldn’t even restore Russia’s economy to its pre-war footing.

Western hawks hope the weight of sanctions will hobble Russia’s economy and force Moscow to wind down its aggression. These measures have undoubtedly prevented the Kremlin from making full use of its cash stockpile to further its revanchist ambitions and may even deter other nations from taking similar actions for fear of the economic fallout. But sanctions have failed to stop Putin’s war machine, and the prospect of their removal will not bring him to the negotiating table.

The war has created economic headaches on the home front but a peace deal may make them worse.

Nick Stadtmiller (nickstadtmiller@gmail.com) is a policy and markets analyst at Medley Advisors and was previously an economist and trader with Merrill Lynch and Emirates NBD. He holds degrees in economics and mathematics from Northwestern University and King's College London.