A sharp increase in military spending allowed Russia to create a temporary illusion of economic growth and prosperity — an illusion that is now beginning to fade. In the coming years, its economic establishment will face a dilemma. On the one hand, the endless expansion of defense spending is not financially sustainable. On the other, the structure of the economy has been thrown off balance by the disproportionate weight of state-driven military demand. Restoring that balance — in other words, raising the share of the civilian economy — would be a politically painful process.

If the fighting dies down, the already explosive question of whether to maintain current levels of military expenditure would become even more politically charged. So far, the war has served as a universal excuse for the underfunding of other sectors, as well as for various administrative failures. But if hostilities were to subside, issues related to civilian needs would return to the spotlight, while ignoring them would become far more difficult under peacetime conditions.

A wartime economic model

By the second half of 2022, it had become clear to the Russian leadership that the hoped-for quick victory over Ukraine was out of reach. Determined to maintain dominance over Kyiv, Russia chose to press ahead with a protracted war of attrition — a scenario for which Moscow was unprepared. Alongside other decisions triggered by this realization, such as the partial mobilization, the government also began shifting the economy onto a wartime footing in order to ensure the supply of weapons and ammunition to the front.

Broadly speaking, the evolution of Russia's war economy can be divided into three phases:

• Phase I (2022-23): recovery and crisis management;
• Phase II (2023-24): overheating and economic imbalance;
• Phase III (2024-25): deepening distortion and shrinking civilian economy.

The war economy began with huge injections of cash — equivalent to 1–2 percent of GDP — into the military-industrial complex, which had been chronically underfunded and underutilized for decades. When this money landed in the spring of 2023, weapons factories sprang into life. Machinery that had stood idle since the Soviet era was dusted off and put back into service to produce arms and ammunition.

The rapid increase in output drove up demand for labor. To attract new workers — and retain existing ones — the defense sector had to raise wages quickly. Until that point, Russia's defense industry had been a deeply unpopular employer, offering low wages (around €300 per month even for engineers) and no clear career prospects. The injection of government funding changed that picture dramatically. Wages have risen by an average of 30–50 percent each year — far outpacing inflation — and have given a boost to the economies of struggling provincial towns.

Alongside the defense industry, a second wave of cash from the war budget reached the population in the form of recruitment bonuses and salaries for contract soldiers. For people in Russia's provinces, the sums offered were — and still are — unprecedented in comparison with local pay levels, and this has enabled the state to meet its manpower targets. The authorities have probably judged, correctly, that offering high pay to attract volunteers is far cheaper than risking the social unrest that could result from another wave of mobilization. These developments are one of the key factors motivating at least part of Russian society to support the war in Ukraine — for some, the war has thus far brought a tangible improvement in their standard of living.

Government orders

The first phase of the war economy was broadly successful: waves of government funding reached the defense industry and soldiers' wages, feeding into consumer spending and, in turn, significantly boosting non-oil-and-gas budget revenues — value-added tax, excise duties and income tax. Alongside defense production, sectors such as retail and real estate also saw strong growth, as the extra military spending filtered through into consumer demand.

The second phase of the war economy was marked by the almost complete disappearance of unemployment and an acute labor shortage in many sectors — an estimated shortfall of 2-3 million workers. This has been compounded by the fact that the overall wage level is still too low to encourage substantial internal labor migration. As a result, in a country as vast as Russia, severe labor shortages exist alongside regions where unemployment remains significant, such as, notably, the North Caucasus.

By the spring of 2024, the war economy had reached its peak. Defense factories that before the war had operated at under capacity were now running at full tilt and workers with the necessary skills had already found employment. Consumers across Russia were spending enthusiastically and property prices were breaking records. But continued losses on the Ukrainian front meant more and more equipment and ammunition were needed. And to meet this demand, the state kept placing new orders, with massive sums of money attached.

An inflationary spiral

In a normal economy, such a surge in demand would be met by increased supply — through new production capacity and higher imports. But expanding capacity takes much longer than simply increasing the state budget. And the import of production equipment is hampered by sanctions. Although Russia is still able to obtain such equipment in significant quantities via various intermediaries and shadow channels, deliveries are slow and unpredictable and transaction costs are very high.

If the government continues to generate artificial demand through military procurement, but neither domestic producers nor importers can respond with additional supply, the result is a new supply–demand equilibrium — one set primarily by higher prices. Prices rise because demand can be created with the stroke of a pen, but increasing supply requires financial and physical investment and time. That is why inflation in Russia has surged sharply since last summer and shows no signs of easing. Officially, it is already over 10 percent per year. This inflationary wave marks the beginning of the third phase of the war economy.

The Bank of Russia is now in a particularly difficult position. Officially, it is still committed to keeping inflation below 4 percent — around one-third of the actual rate. But the central bank has no way to influence the real driver of inflation: military spending. Nonetheless, it must attempt to fight inflation, because that is the task it has assigned itself.

The bank has raised the key interest rate to 21 percent, pushing the civilian economy into clear decline. The impact on the defense industry has been smaller, because much of its funding comes directly from the state budget on preferential terms and is, therefore, not affected by the bank's interest rate. Still, the defense sector has not been entirely shielded from high interest rates. For example, defense plants still need to secure working capital largely on market terms. Some analysts argue that in the unique circumstances of Russia's current economy, high interest rates may have an effect opposite to that intended. They may fuel inflation rather than contain it, because they limit businesses' ability to invest in additional production capacity.

A withering civilian economy

Russia's economic outlook is bleak. Continuing the current policy trajectory is steadily strangling the civilian economy, which must make way for military demand amidst limited resources. Sectors that rely heavily on low-skilled labor — such as road transport, construction and agriculture — are in an especially difficult position. They cannot compete with wages in the defense industry, let alone the army. At the same time, Russia's labor pool is shrinking by 1,000 to 1,500 working-age people each day due to frontline casualties. Construction volumes have already fallen significantly, and if current trends persist, many other parts of the civilian economy are likely to follow suit within the year.

Reducing military spending to restore economic balance would, in turn, deal a major blow to the defense industry and its suppliers. It is important to recognize that many sectors that were focused on civilian production before the war are now partially reliant on subcontracts from the defense sector, including metallurgy, (civilian) engineering and the chemical industry. Yet due to years of underinvestment, their competitiveness in civilian markets has declined significantly. Pre-war export markets have been lost due to sanctions and competition from China is intensifying, not only in the remaining export markets but also within Russia's own domestic market.

Any reduction in military orders would come as a shock to these sectors and replacing lost revenue with civilian production would likely require years of difficult adjustment. The entire economy has been thrown off balance by the outsized share of state-driven military demand, and it cannot be stabilized without pain.

The logic of war

Lifting or significantly easing sanctions would help soften the impact of rebalancing the economy. It would breathe new life into several heavily impacted sectors — such as civil aviation and the timber industry — and reduce transaction costs and improve access to financing across the board. But even such developments would not change the overall picture. The war in Ukraine has severely damaged Russia's reputation, both as a trade partner and as an investment destination. Rebuilding that reputation would take years, even in the unlikely event that Russia abruptly decided to pursue a "rational" policy.

At the same time, there is no indication that economic factors alone could cause Russia's economy to collapse in the near term. The Russian economy today is fundamentally different from both the Soviet system and that of the 1990s. Structurally, it has more in common with Western economies — with the important exception of the state's dominant role in the energy sector, the defense industry and banking. As a result, forecasts for any potential economic crisis in Russia should take their cues from Western experience — such as the 2008-09 global financial crisis — rather than from memories of the last century.

Domestically, Russia's leadership also appears to have no clear idea of what ending the war would actually entail. The war has served as a catch-all justification for repression, shortages and failures of governance. If the war were to end, all of the uncomfortable problems and tensions swept under the carpet would come roaring out. One major open question is how contract soldiers currently deployed to the front could be reintegrated into civilian society — especially if their incomes were to fall sharply. For this reason, it cannot be discounted that for parts of the political apparatus, continuing the war in its current form remains the most convenient and least risky short-term option.

The article was written for the Lennart Meri Conference special issue of ICDS Diplomaatia magazine. Views expressed in ICDS publications are those of the author(s).

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