It’s hardly news that in retaliation for its invasion of Ukraine, Russia has been targeted for harsh sanctions by the G-7 countries. Indeed, as this is being written in May 2022, it appears that the sanctions are likely to remain in place indefinitely — and may even be made more comprehensive.

So far, analysis of the sanctions has quite naturally focused on their short-term impact — in particular, whether they can persuade President Vladimir Putin to seek an end to the fighting on terms favorable to Ukraine or degrade Russian military capabilities sufficiently to allow Ukraine to prevail on the battlefield. I think these goals are unlikely to be met. But whether or not the sanctions achieve their short-term goals, they have set in motion forces that will shape the long-term performance of Russia’s economy. Sanctions have already taken a toll by sharply limiting imports, cutting off capital flows, halting technological transfers and triggering a brain drain. Russia’s GDP is expected to decline by 10 percent or more in 2022, while the annualized inflation rate in April reached 17 percent (measured year over year). And all this has happened before the full effects of sanctions on energy exports have been felt.

That is no small omission: resource “rents,” the difference between what it costs to lift and transport the minerals and the revenue they generate, have been critical to Russia’s economic growth in the Putin era (as they were in the Soviet era). And a big decline would have a severe impact on the economy’s future prospects.

Now, on its face, a European/American boycott of Russian oil would not be so problematic. Since oil is a fungible commodity, Putin should be able to switch sales from the West to Asia. However, fear of “secondary” sanctions — G-7 sanctions against other countries buying Russian oil — is making it harder for Russia to sell in alternative markets. For one thing, it is difficult for traders to obtain financing and insurance for tankers defying the sanctions. Indeed, prior to the invasion, the difference between the benchmark price for equivalent Western and Russian crude was just $1 per barrel. Since then, it reached almost $30 per barrel before settling around $25.

So far, the impact on Russian finances has been modest because the overall rise in oil prices as a result of post-invasion uncertainty in the global market has offset the discount Russia is forced to accept on oil sales. But this likely will not last: many experts predict that the demand for Russian oil will soon fall significantly..

Note, too, that the withdrawal of oilfield support companies with leading-edge technologies like Baker Hughes and Schlumberger will hurt both current and future production. Indeed, looking out several years, the denial of oilfield technology may prove the most consequential of all the sanctions.

Russia’s Uphill Climb

In a 2014 article in the Milken Institute Review, Clifford Gaddy and I wrote that, given the quality of Russia’s institutional setting and the level of investment, the economy was over-performing. The reason was that the bonanza from resource rents were more than compensating for the handicaps imposed by Russia’s history, geography and environment. Back then, those who were bullish on the Russian economy were betting that this dependence on resource rents would not last — that improving the business climate and attracting foreign investment would support sustainable balanced growth.

That didn’t happen. But Russia did catch a break from an unexpected source. Prodded by investors troubled by the climate consequences of sustaining oil production, Western producers turned away from new projects, leaving Russia and Saudi Arabia with a clear shot at selling a lot of oil at hefty prices. The sense of urgency for economic reforms that were needed to hasten diversification away from resources evaporated.

But the invasion of Ukraine has inverted the problem. Crash efforts to wean Europe from Russian energy threaten both current and long-term prospects for rents from exports. Even so, the environment for economic reform and diversification, which depend on investment, technological change and less government interference in markets, has worsened significantly. Russia’s isolation and its own perception that it faces hostile foreign forces is not an environment conducive to implementing market reforms.

By the same token, the self-sabotage entailed by Putin’s imperial ambitions — the brain drain of the highly educated — is hardly conducive to innovation of any sort. Nor, for that matter will import restrictions on machine tools and other state-of-the-art industrial equipment make it easy to improve the efficiency of high-tech production.

War-Making Capacity

Back to the short term for a moment. Will any of this prevent Russia from waging war? One goal of sanctions is to undermine Russia’s fiscal position. And while the increase in the global market price of oil has delayed this effect, it may be imminent. The real question is whether Russia can respond to reduced resource rents and maintain its military posture without putting unacceptable pressure on the civilian sector.

Foreign exchange earnings do matter. But the fundamental constraint on acquisition of critical military equipment in the near term is not hard currency but Western export restrictions. It may become impossible to produce some of the weapons the military wants because vital components can no longer be imported or made with imported equipment. That does not mean, though, that Russia cannot operate a defense industry based on domestic production that is adequate to the task of sustaining the war in Ukraine — perhaps with modest help, say, from China.

Adaptation

Moreover, while sanctions are certainly disrupting the economy and degrading military production, some degree of compensatory adaptation is possible. Indeed, there is evidence that Russia has been gaming ways to make sanctions less effective at least as far back as the annexation of Crimea in 2014. It’s also worth noting that the Central Bank of Russia is run by Elvira Nabiullina, who has a long track record of minimizing the dislocating impact of fluctuations in energy prices and foreign exchange earnings as well as sanctions.

In 2014, Russia’s primary response to sanctions was workarounds through import substitution. That was feasible because the range of sanctions was limited. Now Russia must cope with more pervasive shocks to the supply chain (coming on top of Covid-19-related disruptions), where critical elements are no longer available. This may be especially the case with regard to semiconductors and integrated circuits.

We, of course, don’t know how comprehensively Russia prepared for sanctions — the “military action” in Ukraine was expected to be brief — but a full accounting of which inputs would be missing from supply chains and how to replace them would be a gigantic task under any circumstance. It’s not just anticipating that, say, critical input “x” in missile production will be missing, but also knowing that in order for Russian factories to produce x, they will first need to buy or make machine “y,” which in turn needs input z, and so on.

The example of the Sputnik V Covid-19 vaccine is instructive. Russia was able to create an effective vaccine in relatively short time. But long before the Ukraine invasion, it was stymied in efforts to produce the vaccine to scale, partly due to supply chain problems linked to scarce equipment and materials.

Perhaps the most relevant case in point is advanced machine tools for cutting and shaping hard materials. Although the Soviet Union was the third largest producer of machine tools in the 1980s, it was falling behind the leading producers (Germany and Japan) in quality and performance prior to the Soviet collapse. And since 1992, the slippage has become a precipitous decline.

By 2007, Russia had acknowledged its extreme vulnerability in this area, especially given that the defense sector is a prime customer, and initiated programs to rebuild the domestic industry. Even the ambitious program adopted in 2017 envisaged that the share of domestically produced machine tools would only reach a 50 percent market share by 2030. Now, even that ambitious target seems inadequate.

Russia might eventually have to go without some domestically made weapons systems, forcing the military to revert to a simpler weapons base. This suggests that supply chain vulnerabilities could result in industrial “primitivization” — technological regress across a broad swath of industries, civilian as well as military.

It’s not always been this way. In the late 1940s, the Soviet Union was able to reverseengineer the American B-29 bomber (one had crash-landed in Russia during the war) without the proper machine tools for milling aluminum to American tolerances. Yet, the project was completed. And the plane, renamed the Tupolev 4, flew.

Moreover, the Tupelov 4 wasn’t the only example of reality-defying accomplishments. The isolated Soviet system managed to build thousands of nuclear weapons and match the United States in long-range rocketry. Putin has recently commented on how the Soviet Union, with even less access to the world economy than sanctioned Russia, was able to put people in space.

But that was then. In the USSR, once priorities were established, the system mobilized to complete the tasks. One of the central features of these campaigns was that cost was not a constraint. And it is relevant here to recognize that the success of the Soviet defense sector came at the expense of the rest of the economy. For example, the Soviet Union was never able to maintain consistent high quality in aluminum. But the Soviet defense establishment muddled through because it got first pick, leaving the civilian economy to deal with what was left.

Back to the Future?

Could Russia go back to that model for the long term? It is important to understand that the Soviet command economy was developed to cope in a very different environment, one in which much of the labor force was unproductive and scattered across the countryside. The problem was to industrialize a backward, agrarian country. And moving this labor to new cities where new industries could be created was the essential feature of the system. Today, the population is falling, and the low-hanging fruit offered by a truly underdeveloped economy is no longer there.

As important, the Soviet system created previously unknown career opportunities for scientists and skilled workers. And the pull of emigration was weak for that technical middle class unless they were strongly motivated by politics. Now, the educated know exactly what they have lost in being cut off from the West.

Putin’s Protection Racket

Another problem with the commandeconomy approach is that Putin is not really a believer in central planning. Putin has argued, going all the way back to the dissertation that he (or a ghostwriter) submitted for an economic science degree from the St. Petersburg School of Mining, that the planned economy was flawed because of too much micromanaging from the top. What was needed, he wrote, was a market economy overlaid with government-directed strategic management to make sure that the mix of production served the larger goals of the organization. For Putin, that organization was Russia Inc. And the oligarchs have been essential in Putin’s planning because he believes that they are the most efficient managers.

Putin’s system of choice is thus a peculiar form of market system characterized by highly concentrated private ownership of key strategic enterprises run by superrich individuals who owe their fortunes (and even their lives) to Putin. Putin’s protection racket, or PPR, evolved out of the bitter battles among the new oligarchs in the late 90s. He emerged as the mediator of the conflicts and established his authority through control of compromising material obtained by the secret police (the FSB, previously known as the KGB), which Putin led. After initial skirmishes, the oligarchs accepted the deal, which boiled down to the freedom to earn very large profits in return for subservience to the Kremlin.

The advantage of the PPR for Putin was that it is consistent with both his drive for absolute political power and his beliefs about what might be called strategic management. As long as he remains in control, it is almost certain that he will continue to rely on the PPR for long-term adaptation to a cold war relationship with the West.

This is not 1999, however, when Russia and the outside world welcomed the stability and relatively high productivity of the oligarch’s companies. The industrial sector will become more tightly controlled, with more demands placed on the oligarchs by the Kremlin in return for lower profits. The best guess is this will evolve into an economy that gets by with old-tech substitutes for missing high-tech systems, resulting in the production of simpler, lower-quality goods.

As noted before, the loss of foreign oil services firms like Baker Hughes (and their technology) is serious. But Russia does have long experience in managing energy extraction. And while Russian producers on their own are less efficient than their global counterparts, they should be able to keep the oil and gas flowing — albeit at higher cost and at the expense of wasting potential reserves.

Managing Declining Oil Earnings

To understand how Russia’s adaptations to sanctions will impact the economic system, it is important to understand the balancing role that resource rents play in the economy and polity. Putin’s challenge in coping with a decline in rents and critical imports while maintaining his military sector is difficult enough.

But threading this proverbial needle is further complicated by what I call the rent addicts: dinosaur enterprises left over from the USSR that survive only because, directly or indirectly, they are tapped into the flow of resource rents. Addicted enterprises have survived the post-Soviet period because the political cost of allowing them to fail in terms of lost jobs and regional income is very high.

The big problem for Putin’s protection racket, then, is how to cope with the fallout from withering rent income. Keeping the lights on in old industrial bastions has been a key element in consolidating Putin’s political support. Putin thus cannot abandon them. Nor can he expect to wean them from subsidies through reorganization or investment: many of these enterprises are hopelessly inefficient because they‘re located in places with extreme weather conditions thousands of miles from markets. This means even less resources to rebuild the rest of the economy to withstand the loss of critical imports from the West. It’s hard to avoid the conclusion that efficiency and dynamism will be sacrificed for regime survival.

New Virtual Economy?

In the first decade after the collapse of the Soviet Union, most of the valuable resource enterprises were privatized under the newly rich oligarchs, and government oversight was decentralized. This meant that the division of the rents/profits was not under strict central control. Power was divided between the oligarchs and the local officials who siphoned a portion of the rents to themselves and to the otherwise unsustainable addict enterprises.

One of Putin’s key tasks in centralizing political control of Russia was to centralize the control of rents — which, of course, he did across the past two decades with a combination of carrots and sticks. Facing sanctions and the dimming prospects for the economy, there is no way Putin could allow a reversal. Indeed, the role of the central allocator becomes more important when rents shrink.

Ironically, then, rather than undermining Putin’s relationship with the oligarchs, Western sanctions make them more dependent on Putin than before since their wealth outside of Russia has been either expropriated or frozen. The oligarchs are now forced to look inward for protection. This must facilitate Putin’s control over rent management and economic control.

One might ask whether the imposition of sanctions on the oligarchs is self-defeating in another way, too. Prior to sanctions, the oligarchs held a large share of their wealth abroad. The usual narrative is that their stolen assets materialized outside of Russia in the form of yachts, mansions and soccer teams — where it could not be used to support Russian industry, the Russian military or the Russian addict enterprises.

Presumably Putin’s tolerance of capital flight reflected his belief that it was part of the bargain. He was willing to indulge the oligarchs’ behavior in return for their contribution to keeping the rents flowing.

The oligarchs’ wealth held in Russia is now more secure than assets held outside of Russia — a truly remarkable development. This suggests that Western sanctions on the oligarchs will offset some of the decline in resource rents available to Putin to reorient the economy toward self-sufficiency. At this point, by the way, a reversal of sanctions probably would not restore the old patterns because the Kremlin would prevent the oligarchs from sending assets abroad

Dead End

The critical economic problem Russia now faces really has been evident since the break-up of the Soviet Union: making the transition from resource-dominated growth to diversified, productivity-led growth. But the problem is becoming more acute as Putin buttresses his regime against the consequences of isolation from the advanced industrialized economies.

It would be comforting to believe that the course Putin has set to ensure his own survival will undermine his legitimacy and eventually force him toward political pluralism at home and integration with the global economy. But Putin hardly seems inclined to buckle. And he may well be able to tough it out by stabilizing the economy at a lower living standard, reorienting trade toward Asia and accepting that Russia’s prospects for growth are very limited. What’s more, even if he did have second thoughts, it’s unclear how he could veer toward a market-driven economy and still redirect sufficient rents toward underperforming regions and workers.

Russia, then, will most likely become a hungrier bear. But still a bear with a vast nuclear arsenal and an enduring sense of grievance against the West that serves Putin’s interests.