Will the Russian Economy Collapse? - AlwaysWealthy

Will the Russian Economy Collapse?

With the ongoing war between Russia and Ukraine, many people are wondering how long the Russian economy can stay afloat. It’s been over three months since the beginning of the conflict. Will the Russian economy collapse unless the war ends? How long will it take until the Russian ruble enters hyperinflation? In this article, I’ll explore some of these questions.

Table of Contents

Understanding War Financing

Before we can attempt to judge how long the Russian economy can maintain itself during this war, we have to take a closer look at how war financing works.

Prior to 1945, governments and emperors had to primarily finance their wars through taxation or debt. Since raising taxes is unpopular, governments mostly resorted to borrowing the money necessary to fund the war. When borrowing money, governments can issue bonds and sell these bonds to individuals, companies or foreign governments.

These bonds are usually known as war bonds. But sometimes they’re given fancy-sounding names like “liberty bonds” in the case of the United States during World War I.

Investors that buy these war bonds are betting on their country winning the war and being able to pay back the debt plus interest to investors who bought war bonds.

How Germany Financed World War I in 1914

When Germany started World War I, it issued war bonds. Since everyone was confident that German would win the war, raising money through war bonds wasn’t too hard.

Furthermore, usually war bonds are sold alongside heavy government propaganda. People that don’t buy war bonds are “shamed” into believing they aren’t patriotic or even traitors.

However, during World War I, Germany and other nations also temporarily went off the gold standard. They did this by halting redeemability of gold certificates and paper money into gold.

In other words, if you held a gold certificate or bank note, you weren’t allowed to go to the bank and exchange it for gold anymore. This prevented gold hoarding and allowed the government to confiscate its citizens money.

Miscalculation and Its Costs In Warfare

With gold convertibility halted, governments could expand the paper money supply beyond the gold reserves it held. Since nobody was able to redeem paper money for gold anymore, the government could just print more paper money.

Germany was so confident that the war would result in a quick victory for Germany that the government acted fiscally irresponsibly. Since everyone was sure Germany would win, the plan was to confiscate the enemy’s wealth, including their gold reserves.

The war debt and increased paper money supply could then be paid back with confiscated gold once Germany won the war.

The only problem? Germany massively miscalculated the situation. Not only was it not quick, the war lasted for four years. This resulted in Germany and other nations taking on massive debt and effectively ending the gold standard.

Economic Collapse in Germany After World War I

Germany turned out to be overconfident in its ability to win the war. After four years of gruesome war and fighting in trenches, the allies won.

During the Versailles Treaty, the allied forces made Germany solely responsible for the war. Germany was pressured to pay war reparations to the allies, particularly to France.

The only problem was that Germany already faced a huge mountain of war debt and an inflated paper money supply. There was no way it could make these war reparations to France, but it had no option.

If Germany didn’t pay, France threatened to occupy parts of Germany. Germany ended up reluctantly paying war reparations to France. But since Germany was already massively in debt, it could only pay these reparations by printing money and “inflating away” the debt.

As the post-war economic situation of Germany worsened, it spiraled into the German hyperinflation as the Reichsmark lost all of its value in a matter of a few months.

Will the Russian Economy Collapse Similar to Germany’s?

Sounds pretty similar to what happened to Russia in recent months. This begs the question: Will the Russian economy collapse in a similar way? Russia thought they could achieve a quick victory in Ukraine. They miscalculated the war and were overconfident, like Germany.

The plan was probably to take Kyiv as quickly as possible, in a matter of days or weeks. And they might have truly believed the Ukrainian population would welcome them with open arms.

But after three months the war is still raging. On top of this, Russia likely underestimated the sanctions of the West. Similar to Germany, Russia will have to pay for this overconfidence by spending more money than it had planned.

If the war went on for four years, like World War I, it would devastate the Russian economy. But as we will see later, even these short three months of war have cost Russia a tremendous amount of money.

Will the Russian Economy Collapse Due to its Dire Military Situation?

As the war in Ukraine showed, the Russian military is nowhere near as strong as experts had believed. While it is large in size, the Russian military is facing problems with its infrastructure and equipment.

Many of the missiles fired by the military have been reported to have failed. The military is losing tanks fast and wasn’t able claim authority over Ukraine’s air space.

Furthermore, some parts for producing more tanks and military equipment come from abroad. This means, the Russian military seems to face serious problems at multiple fronts. From supplying troops, insufficient missiles, poorly maintained tanks and armed vehicles to disorientation and lack of motivation among soldiers, the War in Ukraine is turning into a war of attrition.

How Expensive is Russia’s War in Ukraine

Russia spends tens of millions of dollars every day on the war with Ukraine. The total cost is estimated to exceed $20 billion for Russia after three months alone.

In comparison, the Vietnam War cost the United States around $111 billion in military operations. In today’s dollars, this equates to around $660 billion.

The Vietnam War lasted almost 10 years. It also resulted in the highest levels of inflation ever reported in the United States, peaking at 14.5% in 1980. This period became known as the Great Inflation.

However, unlike World War I and II, the Vietnam War was financed through the money printer. The war was unpopular, which made the sale of war bonds and financing the war through the general public difficult. Raising taxes was even less popular.

So the Federal Reserve monetized the war debt, which means the central bank printed money to finance the war and lent it to the US government.

This is convenient, since it doesn’t require the consent of a majority of the population. This is significantly different from World War II, which most Americans supported after the attacks on Pearl Harbor.

Modern War Financing 101: Monetizing War Debt

Russia, like the United States during the Vietnam war, will sooner or later have to finance its war in Ukraine through the printing press. This means, the Russian central bank has to print rubles and lend them to the Russian government.

Similar to the Vietnam War, the Russian invasion of Ukraine seems to be very unpopular in Russia. In fact, it isn’t even called a war, but rather a “Special Operation”.

Issuing war bonds and borrowing money from the population, or raising taxes, would blow this cover.

Using confusing terms and monetizing debt is a strategy also used by the West. A lot of modern warfare happens without consent, knowledge or support of the general public.

Modern warfare is highly undemocratic and obfuscated. Russia is no exception here. This is a blessing and a curse.

On the one hand, it allows governments to engage in wars with money it prints out of thin air. On the other hand, financing war through a government’s central bank is inflationary. And it will lead to heightened inflation, or worst case, hyperinflation in the long-run.

Will the Russian Economy Collapse as a Result of Hyperinflation?

At the onset of the war, and with Western sanctions taking effect, the ruble quickly plunged against other currencies.

It looked like the ruble was entering a period of hyperinflation. In response to the falling ruble, the Russian central bank quickly intervened.

The central bank raised interest rates to 20% and imposed strict capital controls among other things. These extreme measures were able to halt the ruble’s free fall. But the question is for how long.

Central Bank of Russia by Ludvig14

When a central bank raises interest rates, it makes borrowing more expensive. This also raises the cost of the government to service its existing debt.

With high interest rates, government debt becomes more expensive. And in the midst of a war, the last thing a government wants is high borrowing costs to service its debt.

The high interest rates and capital controls are only a temporary solution to the falling ruble. This is artificially propping up the value of the ruble, but cannot be sustained forever.

Will the Russian Economy Collapse Because of Western Sanctions?

The Western sanctions resulted in Russian foreign currency reserves being frozen, at least those denominated in currencies of “unfriendly” nations. Furthermore, a portion of Russia’s gold reserves was seized.

This means, Russia is fighting an incredibly expensive and prolonged war while quickly losing large parts of its military equipment.

Producing more of these vehicles and military equipment will take years and depends on parts that are manufactured abroad. At the same time, the cost of the war is rising every day by several hundreds of millions of dollars.

Why Monetizing Russia’s War Debt Causes Inflation

The financing of modern wars doesn’t come from investors buying bonds but from the central bank printing money. Financing wars through a country’s central bank is inherently inflationary.

Instead of drawing from the pool of existing savings through selling bonds to investors or raising taxes, the government prints money out of thin air to pay for the expenses.

This increases the money supply and leads to inflation. As we saw during the onset of the war, the expectation of inflation alone can lead to a loss of trust in a currency.

When Germany announced World War I, many Germans immediately lost trust in the Reichsmark and tried to exchange it for gold. This is one of the reasons the German government halted convertibility of Reichsmark into gold.

Russia is imposing similar types of capital controls, making it impossible to exchange rubles for foreign currencies or bitcoin.

But if the war rages on for long enough, and especially once it ends and the country attempts to return to normalcy, the inflation of rubles cannot be hidden anymore.

Inflation and hyperinflation usually only make themselves noticeable after the war, as governments sit on huge deficits and the additional money works its way through the economy without price controls and capital controls.

How Russia Is Barely Able to Hold Its Economy Together

Despite all these problems, the Russian government and central bank is doing a tremendous job at trying to keep the economy together.

Additionally to raising interest rates and imposing strict capital controls, it’s important to note that Russia has prepared for such an event since 2014.

With “event” I’m not necessarily talking about war, but decoupling Russia from the control of the United States and the ability of the United States to weaponize the US dollar against Russia.

Since 2014, Russia has consistently sold US Treasuries. In other words, Russia dumped its US dollar reserves and instead began heavily accumulating gold.

Gold, similar to Bitcoin, is a neutral reserve asset. It’s not issued or controlled by a specific nation, which allowed Russia to become more financially independent from the United States in the last decade.

Despite the West freezing large parts of Russia’s foreign currency reserves and some of its gold, any gold Russia holds in self-custody is hers.

This large exposure to gold has made Russia more resilient to sanctions. And it also made it easier to prop up the value of the ruble. While Russia doesn’t back the ruble with gold at a fixed exchange rate, such as during a gold standard, the fact that it holds large amounts of gold increases trust and gives the ruble more credibility through indirect backing.

Russia’s Most Valuable Asset to the Rescue: Commodities

As the West tried to weaponize its foreign currencies by freezing Russia’s reserves and cutting it off the international banking system, Russia still has one important advantage.

Russia has access to a vast amount of natural resources and commodities, including natural gas and oil.

Due to globalization, many countries including the United States and Germany are dependent on Russian oil and gas imports. Even with most Western countries falling away and looking elsewhere for natural resources, or returning to a higher level of self-sufficiency, Russia still has powerful trade partners.

The BRICS nations, consisting of Brazil, Russia, India, China and South Africa, form a powerful economic alliance. These and other “friendly countries”, can continue buying commodities from Russia.

Russia even stated that they can pay in their own currencies, in gold or even in bitcoin if they want. This might not seem like a big deal, but it breaks with a long tradition of pricing oil in US dollars.

How Russia Ended the Petrodollar System

This unofficial monetary system, which some people call Petrodollar system, allowed the United States to “print energy”.

Due to US dollar hegemony, largely maintained through the Petrodollar system, the United States could use its monopoly on the US dollar to buy gas and oil. Other countries had to earn US dollars by producing and selling goods and services. Or they had to exchange their currencies for US dollars to buy oil.

This created high demand for US dollars around the world. While the percentage of Euro-denominated oil trades increased in recent years, many see Western sanctions on Russia as the official end of the Petrodollar system and US dollar hegemony.

With Russia selling oil for anything but US dollars, and the whole world witnessing how a foreign country’s foreign currency reserves were frozen, other nations might become more reluctant to hold US dollars in their reserves.

To return to the original question of this article, will the Russian economy collapse? That depends on how all these factors play out in the near future and how resilient Russia’s economy turns out to be.

But the bottom line is: Financially, things aren’t sustainable for Russia the way they are right now.

May 30, 2022