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2022: Sad Results and Gloomy Prospects for the Russian Economy. How the Russian Government Lies – Paul Tolmachev

The results of 2022 in the Russian economy have already been defined and formulated by most Russian economists. This determines their quality. The common ground and consensus is as follows.

Firstly, the power elites have eased the pressure on small and medium business as much as possible, reducing levies of all kinds and reducing regulatory pressure. The purpose of this “unprecedented” generosity is obvious: it is necessary to preserve social stability and mitigate the negative socio-economic consequences of the new conditions for Russia as much as possible. Of course, this has nothing to do with a progradational liberal economic policy aimed at qualitative development, it is just a semblance of a new NEP. What followed after the NEP of the 20s of the 20th century we remember.

Secondly, the accumulated stocks allowed to significantly cushion the sharp decline in imports in the first half of 2022 and keep the product range from a critical shortage.

Thirdly, the adaptability of Russian entrepreneurs was higher than expected: the accumulated experience of 30 years of actual survival and relations with the state, continuously expanding its rights and claims, allowed entrepreneurs to find new opportunities almost immediately. Moreover, for those businesses whose interests are focused on deep domestic demand, there is perhaps an era of short-term prosperity: the state has loosened its grip, and the need to replace compressed imports with imports from other sources or own production allows sales to expand significantly even in the face of declining demand. The weakening of competition and, at the same time, the state’s actual acceptance of “parallel imports” counterbalances the bias toward higher production costs and contributes to maintaining and even expanding margins.

Fourth, “parallel imports,” which are, in fact, legalized smuggling, smooth out deviations in the supply of consumer goods and are a positive contributor to inflationary stability.

Fifth, federal transfers and support for big business, concentrated in rent sectors, first-order industries, the defense complex, and in one way or another affiliated with the state, have prevented open unemployment.

Nevertheless, this picture takes on a very different appearance as you go deeper into the details and nuances. Four points: a moderate drop in GDP, record high employment, maintaining the range of goods at the expense of parallel imports and not dramatic inflation – took on the arsenal of unbridled optimistic economists to repeat the mantra “the economy held, the economy survived, everything is stable, we made it”. But under closer scrutiny, these positive conclusions change and tell us a very different, far less optimistic story. And that story is this: the welfare of the population is steadily and intensely declining, and the outlook is losing all hopeful variables.

So, in order.

It is claimed that GDP will fall 3%-4% in 2022, versus consensus forecasts of 8-10%. To speak of this as a success is a true aberration. The consensus forecasts for Russian GDP growth in 2021 talked about 3%-4% growth on a post-consensus recovery momentum. That growth was manually curtailed, replaced by a 3%-4% decline. In the current environment, and for the reasons that led to it, it is fair to talk about an actual 10% drop in GDP, counting not from the 2021 base, but from the apparent growth potential of 2022, which, with high probability, would have been realized in the absence of special and other “operations.” This approach to determining the base of calculation is more adequate in the conditions created, or rather created, than the generally accepted way of determining the rate of change in GDP. We have to include in the calculation of GDP dynamics the obviously missed opportunities to get a real picture of the economic situation.

But what is even more important is that GDP in the current, to put it mildly, “extreme” conditions” of militarization and changes in the structure of economic exchanges is practically a low-relevance indicator. Why? Because GDP is the volume of all transactions in the economy. In the case of an autocracy focused on maximum rent and “intensive development of the military-defense complex,” GDP reflects economic specialization, but it does not at all reflect the growth and diversity of exchanges among economic agents. In other words, the production of meaningless goods, such as overalls or “cars with caterpillars and iron wheels,” which have no economic multiplier, will be counted in GDP. But in reality, this has nothing to do with inclusive growth.

In addition, the extraction and sale of minerals makes the most significant contribution to Russia’s GDP, but these processes involve a small part of the population, and the main beneficiaries of these revenues are political rent-seeking elites who control budgetary redistribution.

In an autocracy, GDP reflects a vertical rent-oriented structure of wealth redistribution. Value added is not created on the basis of sophisticated technological products and their widespread commercialization. The maximum number of economic agents does not participate in the creation of added value: in an autocracy they are busy extracting natural resources and providing budget services. Most of the GDP is created by a small part of the population, while political elites, bureaucracy, and other affiliates close to budgetary redistribution remain the beneficiaries.

If we want to look at the real economic situation and its dynamics, we must pay attention to metrics that show the real state of economic agents, their preferences and changes in these preferences, the rate of exchange of benefits. We need to look at deeper and more detailed metrics that show the real situation: tax receipts from the non-commodity sector, real disposable income, savings, retail sales and their clustering, transportation, profits and revenues of businesses by sector, etc.

For example, nominal personal income grew by about 1.5 percent, while real disposable income declined by about 2 percent in 2022, according to Rosstat. Already this figure does not look plausible: how, with 12% inflation and 1.5-2% of nominal income growth, does this optimistic value appear? Obviously – through manipulations in the methodology of calculation of mandatory payments, which constitute variables in the calculation of real income. Rosstat, as we know, is very good at this.

At the same time, savings in the form of ruble deposits increased on average by 15% to RUR 32 trillion. However, taking into account inflation, the real growth of deposit savings will be approximately 2.5%, which generally corresponds to the rate of decline in real disposable income. The growth of cash in the hands of the population grew by 4.8% and amounts to a little less than half of deposit savings – about 14 trillion rubles.

At the same time, the share of household expenditures is stable in the range of 75-78%. But how then, given inflation of 12%, can the growth of savings and the preservation of the share of expenditures at a decreasing real disposable income be explained? Obviously, the only explanation is a reduction and simplification of consumption: the share of expenditures relative to income is the same, but the range and volume of goods is much smaller.

If we face the truth and bring the nominal growth of income in line with inflation, you will get a larger decrease in disposable real income, which more or less corresponds to a decrease in consumer activity, that is, in the quality of life. That would be the real picture of declining welfare, not GDP, which takes into account, in the current situation, mostly non-multiple expenditures of resources. However, in the framework of the narratives of the primacy of state interests over personal interests, and hence the centralization of redistribution and the impoverishment of exchanges of goods, there is nothing strange about this.

Let’s take a closer look at how social welfare, i.e. the economy in reality, is falling.

Retail sales fell an average of 9% in April year to year and have remained near that level. Non-food sales as of October 2022 were down 14.3% year over year. Food sales were down 4.3% as of the same October. Given the significant drop in retail sales, primarily of non-food products, we can confidently say that the population is squeezing their consumer preferences and worsening expectations, going into savings, saving, and simplifying consumption mode. All this illustrates a real decline in consumer activity, which is inevitably reflected on the supply side and depresses economic activity as a whole.

Thus, a real decline in consumer activity, simplification of consumption and compression of income and savings due to inflation and deterioration of expectations (for obvious reasons) indicates a 9%-10% decline in economic activity, i.e., exchanges of goods. What is that but a real indicator of the situation in the economy?

Now about unemployment. Unemployment is estimated at about 3 million people, which is less than 4% of the labor force. But hidden unemployment, i.e., people on leave without pay, idle or underemployed, is about 5 million people. Cumulatively, official plus hidden unemployment is over 10%. Government statistics state that hidden unemployment in the manufacturing industry accounts for about 25% of the total workforce. Let’s take this without discounting it, although it’s difficult when it comes to Rosstat. But even a refinement of this official data tells us a much worse picture than the government agencies paint us.

Obviously, large enterprises, somehow working for the interests of state beneficiaries, have opportunities to hide or buy unemployment. But why haven’t there been layoffs and serious layoffs in small businesses?

The answer is not complicated. First, because the level of household spending remained the same. Secondly, spending itself was uniform and had a stable and uncomplicated composition: the majority of the population living outside large industrial agglomerations consumer preferences are not too sophisticated, they were not so much affected by changes in the assortment, which was quite primitive. Only inhabitants of megalopolises and cities with population over 500 thousand people felt serious changes of commodity composition of shelves and its variety. Such residents – about 25% of the population. Of course, the deterioration of consumer conditions and opportunities was felt by entrepreneurs, white-collar workers and highly qualified specialists, of which less than 15%. The rest of the population – 75% – is the population of small urban formations and the countryside, where there was not the abundance and diversity of choice that distinguished the big cities. As the Russian proverb says, you didn’t live well and you don’t have to start.

Small business found a way to earn, albeit small, in “deep Russia”, and in a situation where consumer preferences and opportunities are not too volatile even in extreme conditions, this small business continues to exist in the same mode, providing that very stability, so coveted by both the government and the population.

Now about the parallel imports. Parallel import is indeed established, but for all its other advantages, we must understand two things. First, it is obviously more expensive logistics and a corresponding increase in the final consumer price – the path is longer, new suppliers seize the opportunity and increase prices. Second, if these are alternatives to the retired products, the vast majority of the time they are of worse quality, compared to the former assortment. In the end, simplistically, you pay the same for less goods or for worse quality, or rather you pay even more for a smaller assortment of worse quality.

But in any case, parallel imports are a proinflationary factor. The population is forced to buy such goods of parallel import at overpriced or inadequate quality, because these goods cannot be replaced by domestic production, which simply does not exist, or its quality is even worse. The same domestic goods, which are comparable to imported ones by their consumer properties, under the reduced competition have practically the same price as imported goods – how inefficient, vicious and destructive is the concept of import substitution, protectionism and other state attempts at economic stimulation we know. Eight years of consumption of inedible domestic or Uruguayan Parmesan at the price of Italian will remain in the memory of generations.

The bottom line is that parallel, that is, actually smuggled imports are a definite factor in inflation. The fact that inflation has not accelerated to unthinkable limits is not the exclusive merit of the Central Bank with its harsh repressive measures in the first quarter of 2022, as it is commonly presented by Russian experts. The moderate inflation was ensured, oddly enough, by Russia’s Western partners and their policy towards Russian exports and imports. It is this policy that allowed the Russian government to generate a significant current account surplus. The second important reason is the unfavorable, if I may say so, conditions in which the population makes decisions as an economic agent, reducing and simplifying consumption, as well as shrinking planning horizons. These two reasons helped curb the inflationary gallop, stabilizing inflation at 12%, despite the sharp decline in imports in the face of a shortage of domestic production.

In conclusion, two words on the prospects.

With the reduction of export revenues of the budget due to the reduction of export volumes, and the simultaneous development of alternative imports, inflationary pressure will inevitably increase: the national currency will be more relative to the reserve currency, i.e. dollars, which will flow in a smaller volume due to the reduction of exports. Accordingly, the value of the national currency relative to goods will fall, making goods in general more expensive, and imported goods even more expensive because they will have to be paid for more due to the depreciation of the national currency. Inflation will inevitably rise, and inflation, as we know, is the main threat to any government in any state, regardless of the political regime.

On the other hand, if the alliance of countries, called “unfriendly” by the Russian side, begins to deal more tightly with secondary sanctions and buying opportunities for parallel imports, inflation is inevitable anyway, since a shortage of even bad or expensive goods will make them even more expensive, both imported and few domestic ones

That is why I do not see a disinflationary scenario for the Russian economy. The development of import-substituting industries is simply impossible, both because of the aggressive war unleashed by the Russian regime and because of the rent-oriented political system and its beneficiaries. Shrinking consumer preferences against the background of disappearing or rising prices for goods will not be able to have a significant impact on price growth, but rather will increase the share of expenditures against the background of falling incomes due to stagnant supply and inflation, triggered by falling exports and shrinking imports. Expansion of consumer preferences and opportunities due to some “miracle miracle,” such as an increase in export revenues, will still not even things out against the backdrop of limited and “very parallel” imports. The only disinflationary scenario is a total social and economic depression and a transition to a state … into which one would not like to go.

However, the transition to such an undesirable state of a depressive autarkic “vacuum” economy is a very likely outcome, because no one has cancelled the reverse “negative spiral. The increase in the price of goods against a background of tightening external economic conditions with a lack of domestic production will be accompanied by a decrease in purchasing power and income of the population. In the normal world, this is called stagflation.

So here we are in 2023. “Smile and wave.”

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Paul Tolmachev is an Investment Manager, Economist and Political Analyst. He is Certified Professional in Philosophy, Politics and Economics (PPE Program), Duke University. Paul is serving as a Portfolio Manager for BlackRock running $500 million assets under personal management. He also is a visiting research scholar at The Hoover Institution (Stanford University), where he researches political economy and social behavior, specializing in the analysis of macroeconomics, politics, and social processes. Paul is a columnist and contributor to a number of international think tanks and publications, including, Mises Institute, Eurasia Review, WallStreet Window, The Heritage Foundation, Investing.com, L'Indro, etc.