Petrostate: Putin, Power, and the New Russia

Preface to the Paperback Edition

Much has changed in the short time since Petrostate was first published in the spring of 2008. The price of petroleum, which peaked a bit later that summer at $147 a barrel, by winter plunged as low as $33. The drop in price and the resulting loss of revenue for Russia led my wife to comment that I should never have used “Petrostate” as the title of the book. With oil at $33 a barrel, “Impoverished State” would have been more descriptive. Besides, everyone was going to misread the title and wonder why an economist specializing on Russia and energy had written a book called “Prostate.” What did that have to do with Vladimir Putin? Did I know something about Putin’s health that his physicians had been hiding from the public?

She was right. Some readers did indeed misread the book’s title. Moreover, the collapse of petroleum prices, at least for a time, did crimp Putin’s swagger. The reduction in oil export revenues meant that the inflow of convertible currencies was no longer able to keep pace with the outflow expenditure of convertible currency spent on imports. As a result, a mere six months later, on March 31, 2009, Russia’s foreign currency reserves fell from nearly $600 billion in September 2008 to $384 billion (IMF update, April 23, 2009).

Of course the drop in petroleum prices was not limited to petroleum produced in Russia. It was part of a worldwide phenomenon precipitated by a slowdown in economic growth and, in many cases, even declines in GDP. Moreover, as petroleum prices fell in OPEC countries and Russia, where petroleum production can make up as much as 50 percent of the GDP, the drop in GDP was especially large. The result was not only a drop in export earnings but a reduction in government tax revenue and, equally important, in disposable income. In Russia, the consequent fall in consumer spending led to numerous factory closings, worker layoffs, and runs on banks.

The chain effect of the drop in petroleum prices hit Russia especially hard. Russian GDP in the first quarter of 2009 dropped 9.5 percent from a year earlier and fell even further in April 2009, declining by 10.5 percent compared to April 2008. This led to a 34 percent increase in unemployment over the preceding year. Simultaneously, prices rose 14 percent—meaning that in addition to its other problems, Russia found itself caught up in a bout of stagflation. If that were not enough to worry about, businesses fell behind in paying their wages, a periodic occurrence that the Russian economy has always had difficulty correcting.

The convergence of so many negative economic developments (something to make everyone worse off) triggered social unrest, even riots, especially when workers were laid off or were not paid in a timely way. One of the more dramatic examples took place in Pikalyovo, a small town south of St. Petersburg. In June 2009, 500 unpaid workers from the town’s three nonferrous metal factories blockaded the main highway, causing a 250-mile traffic jam. Fearing this unrest might spread, Putin sought to blame the wage arrears on the irresponsibility and greed of the factory owner, Oleg Deripaska. Identifying himself with the workers, Putin demanded that Deripaska pay the workers what they were owed. Ranked by Forbes Magazine in 2008 as Russia’s richest oligarch, with a net worth of $28 billion invested mainly in the Russian aluminum industry, Deripaska had been badly hurt by the recession. Revising its estimates in 2009, Forbes reported that Deripaska’s net worth had fallen to $3.5 billion, a loss of almost 90 percent. As painful as this must have been for Deripaska, by Putin’s reckoning Deripaska was not exactly a pauper either, although he was no longer Russia’s richest man. As Putin evidently saw it, with a little extra effort, and encouragement from Putin, Dereipaska could probably manage to scratch together enough to pay his workers their back wages. To increase the pressure on Deripaska, Putin arranged to confront him at one of the Pikalyovo factories, where by pure coincidence a TV camera crew just happened to be passing by. In a humiliating scene from the factory shown live on Russian TV and replayed around the world on YouTube, Putin berated Deripaska for his selfishness, conveying the message that it was the oligarchs like Deripaska, not Putin, who were responsible for Russia’s current economic decline. As a climax to their encounter, Putin then tossed Deripaska a pen and forced him to sign an order directing his staff to pay his workers their back wages. He signed.

Underneath the soap opera–like drama at the Pikalyovo factory, there was a poignant irony. After abandoning communism and becoming a market economy, Russia found that it was particularly ill prepared to weather an economic slowdown. Recessions had never been a problem in the days of the Soviet Union. Maintaining economic growth in the Soviet centrally planned economy era was in many ways easier to do than it was in a market economy. Soviet central planners simply ordered factory managers to produce a certain quantity of goods without worrying whether or not there were customers for those goods. By contrast, after the move to the market economy, the Russian government and its central bankers have had to struggle to juggle a variety of indirect economic variables such as interest rates, money supply, and government expenditures as well as tax cuts and increases, in the hope that consumers and businesses will take the bait and increase or decrease their spending in tandem with the government’s objectives.

Of course in actual practice, the USSR’s previous system of central planning turned out to be much more complicated and less achievable than official Soviet state reports would have the outside world believe. For example, even when Soviet factory managers produced what they were ordered to produce (which was all too often not the case), there was no certainty that Soviet consumers would buy those goods, even essentials. This planning shortcoming occurred largely because it is not easy to predict consumer demand, even for basic goods for which the demand is inelastic and unlikely to change. In addition, the quality and variety of goods put on the shelves by Soviet factories often left much to be desired. No matter how desperate they might have been, many Soviet consumers refused to buy the shoddy merchandise often produced by Soviet factories. Consequently, goods were left on the shelves. As for nonessential products, where demand is dependent on what the consumer might or might not crave at the moment, gauging the right amount to produce, but no less nor no more, turned out to be a particularly challenging and rarely achievable quest.

Theoretically at least, proponents of central planning argued that there would be no such problems. As unpredictable as consumers, both individuals and businesses, might be, the prevailing communist ideology insisted that once central plans were adopted and factory managers knew how much and when they were expected to produce and how many workers they needed to employ, central planning would work better than a market system in capitalist countries where factory managers have even more difficulty determining the right amount to produce and the right number to employ. Since the planning system was supposed to work so well, central planners saw no need to introduce the measures designed to cope with economic downturns that many governments in market systems in the West periodically have been forced to adopt. These Western measures included what economists came to refer to as “automatic stabilizers.” A good example is how Western governments deal with unemployment. In a time of prosperity, workers’ wages are taxed and the proceeds put aside in a rainy day fund to be tapped should that worker ever find himself or herself unemployed. Such mechanisms reduce consumption in prosperous times, but in a recession, when there is almost always a jump in unemployment, it makes possible higher expenditures on consumption than would otherwise have been the case without such stabilizers. In other words, such mechanisms help temper extremes and thus stabilize the economy, keeping it on a more or less even keel.

The Federal Deposit Insurance Corporation serves much the same calming function. Federally chartered commercial banks in the United States are required to pay into a fund at the FDIC that is used as the name suggests, as an insurance buffer for the banks. Should a US commercial bank ever run into difficulty and find itself unable to provide cash when one of its depositors seeks to make a withdrawal, the FDIC stands ready to draw on this insurance or rainy day fund in order to provide those depositors with up to $100,000 in cash. Because of such guarantees, most depositors in the United States feel reassured that they can gain access to their money whenever they need it. Such insurance makes it much less likely that depositors (at least those with deposits of less than $100,000) will panic and withdraw their money. In the past the lack of such insurance was the cause of most runs on US banks and the main reason for the near-collapse of the US banking system in the 1930s. It was in response to this crisis that in 1933 the US Congress created the FDIC. Few depositors today have as much as $100,000 in their bank accounts, but, just in case, in October 2008 the FDIC guarantee was increased to $250,000, and in May 2009 this higher coverage was extended to 2014.

Until recently, Russia lacked such protection. With central planning, there was no need for such mechanisms. Moreover, until the collapse of the Soviet Union almost twenty years ago, the state owned all the banks and factories. So if a bank or factory was undergoing financial difficulties, the Soviet state budget would simply subsidize its operations. It was only in January 2004 that Russia adopted FDIC-like bank insurance protection that later was increased to $26,800 for each deposit. Despite this guarantee however, in 2007 there were runs on Russian banks. Between 2007 and 2009, the state was called upon to assist with the closing of fifteen banks. Apparently the Russian public does not yet trust their FDIC look-alike to provide the protection they desire for their deposits. In addition, many Russian banks are poorly run and even more poorly regulated. Consequently, bank closings in Russia are due as much to mismanagement as to the economic recession.

As reflected by these bank closings, by the latter part of the first decade of the twenty-first century, the Russian economy was beset by a number of problems. This was reflected in the rise and fall of the RTS index of Russian stock prices (the Russian version of the Dow Jones Index). But the RTS could also be misleading. For example, in 2007, as a sign of investor confidence, the RTS rose above 1,500 and dipped below it on only a handful of occasions, and then only by a few points and only for a day or two. Conditions improved, apparently, even more in the first half of 2008. As world oil prices rose and the profits of Russian oil companies reached record highs, the RTS index on May 19, 2008, reflecting all of this, hit a high of 2,498, which in effect was a fivefold increase over the low of 500 recorded but a year earlier. Yet by the fall of 2008, as the price of a barrel of oil fell, the market index weakened again so that by October 28, 2008, the RTS had returned to 549. As the effects of the worldwide recession reached Russia, the RTS fell even more in the months that followed, and on January 23, 2009, it once again dropped below 500.

Admittedly, focusing on the price of oil or the increase or decrease of stock prices to measure Russia’s economic and political health can be misleading, especially if such measures are being used to gauge how Russia is regarded in the rest of Europe. Of course the higher the price of petroleum, the more euros the Europeans pay Russia to acquire their oil and gas. But as the Europeans in 2006 and 2009 discovered to their dismay, agreeing to pay a high price, particularly for Russian gas, is no guarantee that the flow of that gas will not be interrupted or that some intermediary consumer along the pipeline will not divert the flow of gas. The intermediaries that ship Russian gas are Ukraine and to a lesser extent Belarus, both of which periodically refuse to pay the higher prices for the gas they consume that are demanded by Gazprom, Russia’s main gas-producing company. When that happens, Gazprom almost invariably cuts off part of the flow intended for sale to Ukraine and Belarus even while demanding that both Ukraine and Belarus continue to send on the remaining gas to Russia’s other West European customers who are willing to pay Gazprom its higher price. However, in 2006 and again in 2009 neither Ukraine nor Belarus agreed to pay the higher price or send on all the gas intended for Western Europe This forced the West Europeans to draw down their natural gas reserves. These incidents demonstrated dramatically to the rest of the world how much Western Europe depends on Russian supplies and how vulnerable it is to Russian pressure.

Following from this, a major conclusion of this study is that because of its control over the bulk of natural gas deliveries to Germany and other countries of Central Europe, Russia is stronger relative to Europe than it was even during the Cold War. (When I made a similar assertion on a BBC broadcast in June 2009, I immediately received an e-mail from a Yevgeniy Tsarkov, saying “Sir, I think you are out of your mind and Russophobe.”) Granted, Russia could and can still inflict enormous damage with its nuclear weapons, but it has not used those weapons because it knows that the United States will retaliate with equal devastation. By contrast, there is no comparable threat today that foreign consumers of Russian natural gas can mobilize to retaliate when Gazprom decides to cut off its deliveries to Europe. Of course West European consumers can threaten to oust Russia from international organizations like the G-8. This may prevent the Russians from such mischief on a daily basis, but, as we saw in 2006 and 2009, it was not enough to dissuade the Russians from using their natural gas for such blackmail.

With the fall of energy prices in late 2008 and early 2009, Russia became less assertive, at least over economic issues. Putin, for example, no longer speaks about building up a reserve hoard of $1 trillion in foreign currencies and dollars. Similarly, while Medevedev occasionally may still muse as he did in St. Petersburg in 2008 and in London in 2009 about how the ruble was about to become a regional if not a world currency standard that would eventually even replace the dollar, that was more a reflection at the time of a weakened dollar than an assertion of a strengthened ruble. As for the ruble, the fact that during the 2008–09 economic contraction it lost one third of its value certainly undermined those like Medvedev, who predicted that the ruble would make a reliable standard of value. As for average Russians, given their past experience with the ruble, they are almost certain to be hesitant about tying their fate to what most Russians regard as an unreliable standard that every few years seems to lose one half and sometimes more of its value.

Nonetheless, whatever happens to the ruble, because Russia is so rich in natural resources, foreigners and Russians will almost certainly remain interested in investing in Russia, especially in mining and drilling. There will also even be some interest among Western manufacturers in opening up operations in Russia. If Russia promised to provide some tariff protection from foreign imports, that would probably attract even more investors. But encouraging more domestic production will not be easy nor assured. In part this is because fostering domestic manufacturing within Russia becomes all the more challenging when energy prices are high. The reason for this is that the higher energy prices go, the higher Russian export revenues are likely to be. To pay for their purchases of Russian oil, foreign buyers will need more rubles. This leads to a higher demand and thus a higher value for the ruble relative to other currencies. But this makes all Russian exports, not to mention the export of “expensive” Russian manufactured goods, less attractive compared to “cheaper” manufactured goods that can be imported from elsewhere, particularly Asia.

These are not easy problems to overcome. For that matter, Russia has never really been competitive in world markets. Certainly Russia has much to be proud of when it comes to advances in space and military technology. But almost all of these achievements are the result of a hothouse artificial environment where the Russian government has subsidized such developments through its military and space budgets. (The same can be said about the space and defense sectors in the United States.) Nevertheless, there is only so much that government underpricing and support can achieve at a time when an economic downturn has enveloped most of the countries of the world. As demand declines, energy prices fall. Even if the Russians offer to export their goods at a more competitive price, a recession, as in 2009, takes a heavy toll not only on the world’s buyers but on its sellers. As a result, even if Russian exporters lower their prices, potential foreign purchasers who might normally be interested in buying goods from Russia almost certainly will be forced to cut back on their consumption. Moreover, competing exporters will also cut their prices. That is why even in a recession, demand for Russian products including oil and gas is also likely to suffer.

What impact have these economic developments had on the Russian political scene? It was Vladimir Putin’s good fortune to be appointed prime minister in late 1999, near the end of Boris Yeltsin’s tenure as president at what turned out to be an economic low point. Beginning a few months later in 2000, however, the Russian economy began to grow an average of 7–8 percent a year until 2009, which just happened to coincide with the end of Putin’s tenure in office as president. As a result many Russian voters credit Russia’s decade-long economic prosperity to Putin’s actions as president. In reality, it is due as much as anything to the increase of world energy prices, which began in 1999 and continued until late 2008, just after Putin stepped aside as president and appointed Dmitri Medvedev as his successor. No wonder many Russians associate the sudden deterioration in Russia’s economic fortunes with Medvedev’s assumption of the presidency. In fact, Medvedev had no more to do with the drop in oil prices than Putin had do with their increase a decade earlier. If Medvedev is to be successful, he must win popular support. But unless the world recession comes to a quick end, he will have difficulty doing so as long as energy prices remain low and thus unable to boost Russia’s economic fortunes. This is a problem that Putin did not have to face. In a major way, then, the world price of energy has become a significant factor in determining the success or failure of Russia’s political leaders, an intriguing interplay of economics and politics.