Why has the Russian economy plunged SO SUDDENLY into the toilet?

But what's the story behind this?

Well, let's say that this is a big part of the explanation:

Based on newly available data, we argue that multifactor productivity increases over the period 1995-2008 generated only about a half of Russia’s GDP growth, a smaller increase than most previous estimates. Further, growth in multifactor productivity seems to have contributed to a smaller share of GDP growth in 2003-2008 than in the first seven years of our observation period. These results imply that increases in capital inputs, and consequently investments in fixed capital, are more important than previously thought for Russia’s economic growth.

Detailed analysis of industry-level data reveals two drivers of economic growth in the period: the extended oil and gas sector and high-skill-intensive services. Our analysis indicates that growth in the extended oil and gas sector reflected increased capital inputs, while growth in high-skill-intensive services seems to be part of catching up with more advanced markets. Neither sector is likely to spur growth in the coming decade.

To unwrap that for you. There's essentially two forms of economic growth. We are talking here about growth in GDP, for all its faults in not measuring distribution of incomes, wealth environmental degradation and all that. One is that we can produce more things by using more inputs. We can increase the educational level of the workforce, meaning that we've more skilled labour and less unskilled. We can burn more fuel and use less human muscle, we can do all sorts of things to increase resource use and thus increase production. That production is an increase in GDP. Hurrah!

The other form of growth is that “total factor productivity” (TFP). This is the advance of technology that allows us to do new things that add value and also use new methods to add value to things we already do. The important point here really being that we end up using fewer resources to add the same amount of value: thus freeing up resources to make yet more value with.

There are other ways that we can slice and dice growth, of course there are, but this is the important one for us here. That research paper is essentially telling us that Russia has been doing more of that resource led growth and less of the TFP led than we previously thought: and it's been getting worse more recently.

There's a very definite historical echo here, too. As Paul Krugman has said about Soviet Russia:

How, then, have today's advanced nations been able to achieve sustained growth in per capita income over the past 150 years? The answer is that technological advances have lead to a continual increase in total factor productivity – a continual rise in national income for each unit of input. In a famous estimate, MIT Professor Robert Solow concluded that technological progress has accounted for 80 percent of the long-term rise in US per capita income, with increased investment in capital explaining only the remaining 20 per cent.

When economists began to study the growth of the Soviet economy, they did so using the tools of growth accounting. Of course, Soviet data posed some problems. Not only was it hard to piece together usable estimates of output and input (Raymond Powell, a Yale professor, wrote that the job "in may ways resembled an archaeological dig"), but there were philosophical difficulties as well. In a socialist economy one could hardly measure capital input using market returns, so researchers were forced to impute returns based on those in market economies at similar levels of development. Still, when efforts began, researchers were pretty sure about what they would find.

Just as capitalist growth had been based on growth in both inputs and efficiency, with efficiency the main source of rising per capita income, they expected to find that rapid Soviet growth reflected both rapid input growth and rapid growth in efficiency.

But what they actually found was that Soviet growth was based on rapid growth inputs – end of story. The rate of efficiency growth was not only unspectacular, it was well below the rates achieved in Western economies. Indeed, by some estimates, it was virtually nonexistent.

It's not so much that the free market revolution in Russia hasn't done what it was said it would do. It's that to a certain extent, and less more recently, there hasn't actually been that free market revolution. Crony capitalism looks more like Soviet planning than it does that free market stuff.

Putin horsing around

And we've theory to guide us here too. As I've mentioned before on these pages the scholar on this sort of stuff is William Baumol. And his point is that sure, the Soviets, government, they're as good at inventing things as those free market thingamybubs. As Mariana Mazzucato keeps telling us. However, where the planning thing (and crony capitalism is planned, it has to be otherwise how will the cronies get the moolah?) fails is that it doesn't manage to promote that innovation: that working out of how to use the new inventions to do new stuff and to do old better. Which is, as above, that TFP stuff.

The end result of all of this is that Putin really has cocked up. Both in the minor manner of provoking sanctions and all that follows from them. But also in that major manner in that he's simply retrenched the bad things about the old Soviet manner of doing things in the economy in general. Way, way, too much of the growth that has been happening has been coming just from the extraction and use of more resources. And not enough of it from doing things smarter and more efficiently. So, of course, when the price of that major natural resource that has been driving the whole system falls then so does the edifice built upon it.

There's another interesting parallel here too. Way back, as that Krugman essay points out, people in the '50s and '60s did think that Soviet economics worked. Sure, brutal, not enough consumer goods, but that planned economy did actually create the omelette. Until, as above, people started to really look at it and see that the eggs were being cracked, and more of them over time, but that delicious comestible seemed still to be as distant as true communism.

If you're wondering why economists harp on about that efficiency, that TFP, so much the reason is one that Karl Marx not only understood but popularised. There's diminishing returns to quantity used in simply adding more resources. That last year of education doesn't raise worker skills as much as the first year does. That last $1m in capital has a very much lower effect than that first $1m. The millionth tonne of oil burned produces less than the first. If you only have resource consumption growth then you'll hit a limit and no more growth will happen (or it will slow to such a crawl as to be indistinguishable). That's why you need the total factor productivity growth, so as to be able to go ever onward and upwards.

Expect the market evaluations of the Russian economy to get worse, not better, over time. For, sure, there's this thing called the efficient markets hypothesis that says that markets already price everything in. But it's true only in a weak sense, that markets price what markets look for and know and know they know. As and when people start taking note of papers, then predictions for how well Russia can grow without oil are going to fall and fall again.

Just to show how extreme this could become it wouldn't surprise me at all to see China being regarded as a richer country than Russia in a decade's time (at the exchange rates of two months ago Russia was, GDP per capita, twice China's ... ish). I do a little bit of work in China and believe me, it's a viciously cut-throat free market economy even under that Communist Party control of politics - in a manner that Russia absolutely never has been.

If Baumol's right, and we all believe he is, then China will have that TFP growth that Russia hasn't - and that is, in the long term, the thing that really defines living standards.

As Krugman has said, productivity isn't everything but in the long run it's pretty much everything. ®