Changing Course Before It’s Too Late

Little more than a year ago, Russia seemed to be on its way to reclaiming its position as a major power. Russia’s economy had been growing strongly since 2000 and, despite a dip in 2009 due to the global recession, in 2012 real GDP had doubled since 1998. The world was coming to Sochi to celebrate the Olympics and Russia’s rebirth. Even Russia’s demographics, long regarded as its Achilles’ heel, seemed to have turned the corner. Since 2007, a sharp rise in fertility and increased immigration had reversed Russia’s long-standing pattern of demographic decline.

Yet just a year later, this glowing picture seems quite distant. Following the return of Crimea and armed conflict in eastern Ukraine, the combination of global sanctions and declining oil and gas prices are producing a recession with no visible end. Economic decline is accelerating, as the economy contracted by 2.2% in the first quarter of this year and 4.4% in the second quarter. Demographic decline has returned, and looks likely to accelerate as well.

With the ruble’s collapse, Russia’s economy has shrunk in real international dollar terms to where Russia’s GDP is slightly smaller than that of Italy. With its current GDP of $1.86 trillion, Russia seeks to be taken seriously as an equal alongside three titans: the EU to the west (with GDP of $18.5 trillion); the United States across the ocean (with GDP of $17.4 trillion), and China to the east (with GDP of $10.4 trillion). Altogether, these three have economies not 10, not 20, but nearly 25 times greater than that of Russia.

Will Russia rise from this short-term reversal just by staying the course, as it did after the recession of 2009? Unfortunately, there are good reasons for believing that this time, economic decline will lead to prolonged stagnation. If that occurs, Russia will be left trying to nurse ambitions to be a global superpower on a weakening economic base.

Down the stairs

Let us start with population. Women in Russia, like those everywhere in industrialized countries, are having children later in life; most women now have their first child between the ages of 25 and 29. In 2015, the number of women in Russia in that age group stood at 6.21 million. Due to the very small number of births during the post-Soviet crisis of the 1990s, that number is set to plummet – falling by half in the next decade – to 3.16 million by 2025 (according to UN Population Division 2015). The only way to prevent a major decline in population in the face of such a sharp fall in the young female population is through higher fertility, lower mortality, and higher immigration.

Yet all of these indicators are moving in the wrong direction. In November 2014, births were 5% lower than the previous November. Immigration has also been affected by the collapse of the ruble and the slowing economy, which make Russian earnings less attractive to foreign workers. Net immigration was 10% lower in 2014 than in 2013. And death rates – reflecting increases in heavy drinking and a fast-aging population – were up sharply in early 2015.

Russia can pursue its path to becoming a global power by military means. But that path is short-lived and self-defeating. The economic base for that path is already relatively small and weak, and fosters demographic and capital trends that will only further weaken that base in the future. The other path is to step back from military engagements, mend relationships with Europe, and invite capital in while providing conditions for new business to thrive free of corruption and government interference. It is only the latter path that can truly restore Russia to the status of a great power

In sum, Russia is again facing a perfect storm of demographically disastrous trends. If the government continues with its plans to loosen restrictions on alcohol sales and allows pro-natal welfare policies to lapse, Russia’s population could fall from today’s 143 million to 130 million, or even as low as 100 million by 2050. The only way to reverse this trend is with larger investments in childcare, health, and housing for families.

Russia could compensate for population decline with a growing and more technically advanced economy, but again the numbers are all heading in the wrong direction. Oil prices, which have driven Russia’s economic growth in the last decade, seem unlikely to ever rise strongly again – there is just too much supply and too little growth in demand for fossil fuels. China’s economy is slowing down, most of Europe and the US seem stuck at 2% or less economic growth, and all advanced nations are seeking to reduce their carbon footprint. Meanwhile, Iran’s oil output will soon become available on global markets, while new gas discoveries in the Mediterranean and the South China Sea will add to the vast expansion of supply already underway due to fracking in the US.

With fossil fuel prices stagnant, Russia’s main avenues for growth are in agriculture, industry, and technology. Improving output in these areas will require capital and creativity. Yet these are flowing out of Russia, not in. Capital flight was over $150 billion in 2014, and is likely to exceed $130 billion in 2015. Human capital is also leaving, with thousands of Russia’s scarce entrepreneurs moving abroad to pursue better opportunities.

The old new solution

There is a straightforward solution to Russia’s problems. It is not new, and has been advocated for nearly a decade by many of Russia’s own economic leaders, including Prime Minister Dmitry Medvedev and former finance ministers and other officials. It is to take advantage of Russia’s base of skilled workers and its talent in science and engineering, and to promote entrepreneurship by investing in new businesses and production processes with the goal of creating globally competitive enterprises.

Russia is again facing a perfect storm of demographically disastrous trends. If the government continues with its plans to loosen restrictions on alcohol sales and allows pro-natal welfare policies to lapse, Russia’s population could fall from today’s 143 million to 130 million, or even as low as 100 million by 2050. The only way to reverse this trend is with larger investments in childcare, health, and housing for families

Russia has tried to create a hothouse center of innovation in the Skolkovo complex outside of Moscow. Such an isolated effort is doomed to fail. What is needed is to turn every city and region in Russia into an innovation ecosystem, by freeing capital and entrepreneurs to seek their best returns. Yet such a course requires institutional changes, including security of private property and contracts enforced by impartial and professional courts; a government that withdraws from favoring particular firms and businessmen; a banking sector that is well capitalized and lends on the basis of business merit and objective risk assessment; and an education sector that emphasizes innovation and marketing and cooperation between engineering, design, and business talent.

For too many years, easy revenue gains from oil and gas exports gave the government streams of capital to finance investment, social welfare, and education without much concern for efficiency or quality. Russia became too dependent on fossil fuel production, which accounts for a quarter of total GDP, two-thirds of Russian trade, and half of government revenues. With revenue gains from energy drying up, capital needs to be brought in from international capital markets and invested efficiently to diversify the economy and create new sources of growth.

If Russia seeks to compete militarily with the EU, the US, and China, it can manage perhaps to be barely respectable at the price of putting a hugely disproportionate amount of its national income into military spending, while starving the investment, education, and social welfare sectors (as Russia is now doing), further eroding the foundations of Russia’s future economic growth. Greater security in the long run would come from more peaceful competition and cooperation rather than relying mainly on military strength.

Russia has been in this situation before. In the 1980s, following the strong economic growth of the 1960s and early 1970s, the Soviet economy began to stagnate and the increases in military spending to keep up with the United States took a heavier and heavier toll. Yet the Soviet leadership avoided real reform until it was too late, and eventually collapsed. If Russia continues to suffer major demographic and economic reversals, while trying to maintain great power status by spending ever more of its dwindling resources on the military, collapse looms once more.

But that is not the only possible outcome. Given its large population, if Russia could raise its per capita GDP to the level of France, its GDP would rise from $1.86 trillion to $6.1 trillion, a level that would vault Russia to the third largest economy in the world, and make it one of the premier global powers. Yet that would require political and economic institutions that promoted more open competition, curtailed corruption, and rewarded innovation and business talent rather than influence within the state.

It is not too late for Russia to choose. Russia can pursue its path to becoming a global power by military means. But that path is short-lived and self-defeating. The economic base for that path is already relatively small and weak, and fosters demographic and capital trends that will only further weaken that base in the future. The other path is to step back from military engagements, mend relationships with Europe, and invite capital in while providing conditions for new business to thrive free of corruption and government interference. It is only the latter path that can truly restore Russia to the status of a great power.