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If you want to understand the sometimes confounding moves played by Russian premier Vladimir Putin, then you could do worse than look at the accounts. On the face of it the country has seen 14 years of growth in the past 15, but that hides a persistent slowdown in the rate of growth. And although sanctions imposed over Ukraine have grabbed the headlines, the truth is that economic weakness in Russia is homegrown.

The country’s GDP has grown at an average of 4.6% annually since 1999. But growth is on the wane, however, and official data may soon show that the Russian economy is already in recession. It’s fairly easy to see where the mistakes were made.

During the boom years, exports of hydrocarbons and metals were used to finance a rapid expansion of state spending that benefited politically important sections of Russian society: the military, the defence industry, state employees, pensioners, parents, and workers in manufacturing firms all saw their incomes rise. This growth model helped the whole of Russian society benefit from the natural resource bonanza of the 2000s.

Unfortunately, instead of using the boom years to restructure the economy, policy makers in Russia have been asleep at the wheel. As growth in commodity prices slowed, most notably for oil, it has become increasingly difficult to ensure the growth rates that Russia has become accustomed to. Moreover, the boom years masked the failure of policy makers to undertake important structural reforms that would have made Russia a more competitive part of the global economy.

Happy days

Between 1999-2008 the Russian economy grew at average rate of more than 7%. This impressive performance was driven by various factors, including: rising oil prices and production, which led to a positive shift in Russia’s terms of trade; a weak ruble after the 1998 currency and debt crisis that enhanced the competitiveness of Russian industrial products on the domestic market; considerable spare capacity due to the under-utilisation of vast swathes of Russian industry during the 1990s; a growing labour force, even as the total population size shrank; sensible macroeconomic policies under the stewardship of Finance Minister, Alexei Kudrin; and the radical though incomplete structural reforms undertaken in the early 1990s that built a market economy in Russia, albeit an imperfect one.

These factors enabled Russians to enjoy a massive increase in living standards over the course of the 2000s. A stronger ruble made the cost of foreign imports decline, helping Russia become Europe’s fastest growing consumer market. All the while, the federal budget was in surplus despite the increase in spending. The pain of the decade-long recession in the 1990s began to subside.

From slowdown to stagnation?

Alas, this episode of economic tranquillity was rudely interrupted by the savage recession of 2008-09. Russia’s GDP contracted by nearly 8% in 2009, the most severe recession of any G20 country. Nevertheless, although post-crisis growth rates failed to reach pre-crisis highs, annual rates of around 4.5% in 2010 and 2011 were still considerably faster than Russia’s richer European neighbours, or other middle-income economies such as Brazil and Turkey. However, in 2013 GDP growth slowed to a pedestrian 1.3%, despite oil prices of well over $100 per barrel.

Accounting for the slowdown in growth since 2009 is not difficult. Quite simply, the factors that helped Russia grow so quickly between 1999 and 2008 were reversed: the volume of natural resources, as well as prices, plateaued; the ruble was now much stronger relative to other major currencies; spare capacity no longer existed in most sectors of the economy; the labour force began to shrink even as the size of the wider population began to grow again.

The tight fiscal policy associated with the boom years was gradually relaxed as state expenditure grew faster than tax receipts. However, as production couldn’t keep up with demand this caused only modest growth yet pushed up prices. And the programme of economic reforms fizzled out: Russia hasn’t seen major reform since the early 2000s. If anything, it has regressed in some areas. For example, the share of the state in total economic activity has risen over the past decade. If we add the fact that the EU, Russia’s largest trading partner, is stuck in an even deeper economic rut then we can see why Russia’s economic performance has worsened.

What is to be done?

None of this is news to Russia’s policy makers and there has been a vigorous public debate on potential ways to reignite growth. One notable contribution to the debate was the “Strategy-2020”, a liberal, market-oriented agenda for economic reform formulated in 2012 by a group of academics and state bureaucrats. This advocated lower spending on defence, public order and security to pay for a new, knowledge-based path of economic development through more investment in spending on education, health care, infrastructure, and research and development (R&D).

Proponents of liberal reform have also called for a reduction in state interference in the economy, support for a stronger legal system, and measures to reduce corruption and the abuse of private businesses by state officials.

But the liberal agenda was challenged by an alternative solution to Russia’s slowing economy, envisaging a greater role for the state. Statist policy proposals emphasise the importance of a rapid growth in defence spending, both on military forces and on weapons systems produced by the domestic defence industry. They also advocate the use of state financial resources to boost investment in Russia’s domestic manufacturing industry.

Standing at the crossroads

On the eve of the Ukraine crisis, the debate was evenly poised. Not for the first time in Russian history, policy makers found themselves at a crossroads. In one direction, liberals called for greater reform to help the private sector; in the other, statists pushed for greater defence spending, and an expansion of state-driven lending and spending on domestic industry. In practice, although the government was committed to increasing defence spending, many of the components of the liberal economic agenda remained in place, not least the commitment to fiscal discipline.

However, the Ukraine crisis and the subsequent imposition of Western economic sanctions may have altered the balance of power in favour of the statists. By affording them the opportunity to promote the virtues of economic self-sufficiency, statists are able to push an agenda that calls for a reassessment of Russia’s role in the global economy, especially in the so-called strategic sectors of the economy: energy, defence and finance.

At this stage, the course of action chosen by the Russian government in response to economic sanctions is of crucial importance, not just to the economy, but also to the wider political and social development of the country. If policy makers choose to abandon a model based on market-based integration with the global economy in favour of a state-driven, quasi-autarkic model of development, the consequences will be profound, not only for Russia, but also for its neighbours.