Planning for the post-Putin era 

How the Ukrainian crisis might look like in five years? We look at performance and identify most-probable growth trajectories for the EU, Russia and the Ukraine, analyze drivers, the internal logic of change and the influence of global trends when good or bad political decision-making by the involved parties disappears. 

Problem description

The current situation around Ukraine is a mess. The seizure of Crimea was the first time since World War II that a nation in Europe had engaged in territorial conquest. Ukraine’s democratic and market orientation is challenged by loss of territory and struggles to gain control over separatist area. Russia counteracts a perceived threat of Western influence, democracy, rule of law, and NATO enlargement. The possibility emerged of a permanent zone of conflict in eastern Ukraine (King). The West, acting in the best attention in offering support, is involved in a geopolitical struggle. It imposed limited sanctions on Russia with the fear that the new cold war could warm up considerably.

Despite the context of growing global confrontation between main global powers during the last years, the situation took all parties by surprise. The entire existing fabric of international relations is under scrutiny (Posner), not last because of the impact on confidence and valuations, and just general uncertainty. Differences in worldviews and economic trends have transformed into an open conflict, where the West and Russia are testing each other. The default lines serve the whole political spectrum: the values of an open society and traditional values in the interpretation of a petrol state; between demonization of Russia as a policy or an alibi for an absence of it (Kissinger); between Western universalism and national identity; between post-Cold War triumphalism and the lack of resources or mandate to police the World; between the Western support for democratic change in Ukraine and the lack of an EU membership perspective, to name a few.

It is an asymmetric situation. On the one hand, GDP of the US and EU is respectively 9 and 10 times bigger than of Russia. Russia’s total foreign debt is almost twice its international currency reserve, creating crucial vulnerabilities. Russia’s dependency on the export pipelines, demographic decline, widespread corruption, incompetent administrations, regional disparities, as well as coming obsolesce of its nuclear material dwarf the challenges faced by the US and Europe. There is no real military threat to NATO members. During a meeting of the International Monetary Fund in Washington the question was asked: “Do we really want to destroy Russia that fast.” (Aslund 2014).

On the other hand, one should be aware of the perils of Russia’s retaliation. The West needs Russia’s cooperation for strategic and geopolitical problem solving in Iran, Syria and Afghanistan, to ensure EU’s uninterrupted gas supply (Granville), from fighting terrorism to arms control to climate change. Russia has many levers to influence the future of Ukraine and is capable of exploiting Ukraine’s challenges and political fragmentation by different means and ways. Additionally, if Ukraine’s West integration is a policy goal, cooperation with Russia lowers the restructuring cost or might even not possible without it.

How to makes sense of the current situation? What are the long-term consequences that Ukraine became the de facto linchpin of Europe’s geopolitical equilibrium? In order to gain a more differentiated understanding, one might wish to look five years ahead where the influence of current good and bad political decision-making disappears while economic and political megatrends prevail.

EU

The worst may be over, but the EU is still in the midst of an outstanding historic experiment about a new balance of national states and supranational institutions. As often in major innovative undertakings, preliminary results are disappointing. The EU GDP is below its 2007 figure. Unemployment remains at a staggering 11.6 %. In Germany, the EU’s economic powerhouse, real wages are mostly stagnating during the last 15 years. Deflation in the Southern periphery worsens the structural adaptation process, the ongoing large-scale austerity challenges democracy and political stability. The Euro-zone member Greece has lost 25 per cent of its GDP without the perspective of recovering it in the near future, which is unprecedented for a developed Western country. The EU lacks shale gas and oil discoveries, which helped the US economy to achieve “escape velocity” from the Great recession. Comparisons are always risky, but the shadow of the global financial crisis from 2008 as well as the finding of the new institutional equilibrium shares patterns with the transformation process of Eastern Europe and former Soviet Union countries after the fall of the Berlin wall from a planned economy to a market-oriented economy that consumed growth for 10 years or more.

The ongoing internal restructuring process influences the possibilities to project power to EU’s neighbourhood.  EU is divided on long-term issues by competing readings of current events and trends. Lacking political will and economic resources, bureaucratic dilatoriness and subordination of the strategic element to domestic politics does not help to speak consistently with one voice. The EU enlargement process in the Balkans came to a still stand in 2013 and is under threat. The EU Mediterranean trade and cooperation agreements show disappointing results. To the East, the EU did not offer EU membership, a proven, but demanding instrument for enlarging the Western sphere of influence. The EU – Ukraine Association Agreement, signed on 27 June 2014, is a low-cost, low-impact replacement.

However, when all other options have been tried out, the learning curve of nations and elites will encounter a turning point for a sustainable political compromise that might include, for example, the use of Eurobonds as one of the many minefields in the current political negotiation process. If history is a guide, it is most probably that the EU will re-enter a growth trajectory in the next five years. The new equilibrium might not reflect the optimism of the Lisbon Agenda from the year 2000 to become the most competitive region through a knowledge-based economy. But it might be sufficient for a stronger commitment to common defence, energy policy and contingency planning. More resources and political attention will be available for large-scale initiatives in order to shape EU’s periphery.

Russia

Russia had the best era in its history full of drama and turmoil, a Golden age of prosperity and stability. Growth rates from 1998 – 2008 were 7 per cent. Measured in constant (2009) roubles, data indicate that the economy-wide average wage tripled from about 6,700 roubles per month in 2000 to over 19,000 in 2008 (Rosstat). Because of the appreciation of the rouble, real income per capita in current US dollars increased tenfold. GDP per capita narrowed to the upper half of the OECD. Total GDP set off from a dismal 271 billion USD in 1998 to 2 trillion USD in 2012 (IMF). The benefits of growth trickled down to all parts of Russian society. This performance shaped self-confidence of the population and legitimacy of the elites.

A more detailed narrative tells a controversial story about these impressive figures. Ian Morris calls it the “paradox of development, “ and Mark Elvin the “high-level equilibrium trap”: When a country thinks it is in a golden age, it stops focusing on progress.

Russia is still within a century-long wave-like development pattern of oscillation between external-induced shock therapy and inward turning, leaving a legacy of ambivalence towards modernity. The beginnings of the particular eras are personalized with their rulers: Peter and Catharina the Great, Alexander II of Russia and Lenin. The socialist revolution was nurtured from the gap between West’s advancement and Russia’s limited industrialization within a huge territory. A trade-off between the need of market and civil-society institutions versus economic growth allowed super power status, an arms race and an ideological confrontation with the rest of the world. After 70 years, the modernization impulse was exhausted and the Soviet Union has imploded beyond repair.

Yeltsin started in 1991 a new cycle with a trial-and-error phase of ambitious market-oriented and democratic reforms. The objective was to set up the missing institutions and capacities, necessary to modernize the country and compete in global markets. The societal cost of these demanding institutional innovations were high: loss of national identify, demographic collapse, hardships of economic restructuring and social misery. The Russian default of 1998 demonstrated the extent to which the entire social edifice was overstretched by the challenges of modernity.

Putin’s reign of 1999 started as a turning point towards consolidation within this cycle.  Unfortunately, relief came also by a parallel global commodity boom. Due to the outstanding cost-benefit profile, incentives favoured the integration of the inherited resource-intensive economy into world markets. As a pathway to a dual economy, any activity other than exporting commodities was not profitable or perceived as not profitable. Russia developed some high-value activities outside the country. London- named Londongrad by the oligarchs’ -became a centre for serving Russia’s needs in IPOs, business dispute settling and financial engineering with the value of transactions reaching 100 billion USD a year. It is estimated that the oil and gas rent reached about 30 per cent of Russia’s GDP. Many companies took debts abroad, larger than their market capitalization.

The governing elite, increasingly consisting of former KGB and military with their particular worldviews, exploited the results of the fortuitous set of circumstances and vindicated blind eyes to corruption and increasing dependency on hydrocarbon extractions. Russia’s economic modernization was limited to islands consisting of export pipelines, retail and consumption, and stayed ossified und inefficient, with disappointing investments in human capital and a deteriorating physical infrastructure.

With the fast-economy growing fast, incentives for following on Jelzin’s risky and demanding path of structural, institutional and social reforms were lost. After “low hanging fruit” of basic economic reform and prudent macroeconomic policies were picked up, the reform process slowed down in the face of popular indifference, bureaucratic inertia, and political resistance and manoeuvring. Missing institutional constrains similar to those in Australia or Norway, the Dutch disease and the resource curse worked their way. After 2000 structural reforms stopped by and large. While becoming richer, the country missed the chance to exploit windfalls to move up the global value chain.

Growth slowed down before the financial crisis of 2008 as an indication that Russia’s business model exhausted itself again. (When this happened in the 1970-ies, the Soviet Union started to export commodities, delaying change for many years.) The leadership did what it could to encourage change without addressing the underlying systemic problems of the post-Soviet state-let style of development. The list of failed initiatives to generate momentum from Russia’s newly-won soft and hard power is frustratingly long: the German-Russian partnership for modernization in 2008, the use of state-owned Gasprom as an instrument of foreign policy, the new-built town of Skolkovo as the Russian respond to the Silicon Valley, the Eurasian Union as a challenger to European Union for global influence (Beauchamp), the Collective Security Treaty Organization as a counterweight to NATO, an attempt to copy the US government that made huge investments in the development of nanotechnology in the 1990s (Block and Keller, 2011), a state program to enter the global aviation market, and other unsuccessful attempts to approach the technological frontier besides defence and aerospace. Billions were spent, but the declared results not achieved.

Sadly, as a downside of a “managed democracy”, Russia does not have an institutional landscape as in advanced Western democracies for a smooth replacement of the governing elite. The protests in December 2012 by urban middle-class dweller were brought under control, but proved the possibility of a regime change from the bottom. In order to strengthen legitimacy, Russia’s “securocratic” regime moved to the right and switched public attention beyond economic growth. In a kind of delayed reaction to the collapse of the Soviet Union in 1991 and skilfully exploiting the fragile national identity after the traumatic loss of superpower status, Putin promoted the vision of neo-Soviet authoritarian empire. From now on, the regime relied increasingly on nationalism, positioned Russia as a moral superior defender of conservative values and, recently, started a populist media campaign against Ukraine’s Euromaidan.

In the wake of Crimea’s annexation, President Putin gained approval ratings of up to 86 per cent (Bowen). At the same time, the economic results of Putin’s statecraft went into the negative: “Putin’s seizure of Crimea has weakened the Russian economy, led to China getting a bargain gas deal, revived NATO, spurred Europe to start ending its addiction to Russian gas and begun a debate across Europe about increasing defence spending”(Friedman).

Russia follows its own logic of historic development. As many times before, the country is on the eve of a new development cycle. The current national political equilibrium in support of Putin’s time in power is not stable at all. We are on the eve of the end of Putin’s era. A window of opportunities will open, where the cooperation with the West for identifying new opportunities will be appreciated. The success and deepness of these upcoming reforms will define Russia’s development trajectory for a decade and more. Latest in five years, Russia will be a very different country.

Ukraine

While Poland and Russia started the transition process with almost a similar GDP per capita as the Ukraine, they are now 2 and 3 times richer. Before the crisis, the outlook of leading experts was positive. “Ukraine is a competitive authoritarian regime, more pluralistic than those of Russia, Kazakhstan or Belarus” (Ishenko) and Ukraine is “an oligarchy about to break down into a democracy” (Aslund 2007:279). Why is the Ukraine now then near the bottom of transition country league tables, has the most energy inefficient economy, is riddled with unprecedented corruption and state failure?

A reason might be the consistently bad political decisions over the last two decades (Ash). For supply-siders, the underlying rational is the failure to push through reforms. Others maintain that Ukraine is located in the no-mans land between two economic regions and fails to capitalize on size. Lacking valuable natural resources, business opportunities and favourable bio-geography, Ukraine might just have bad luck. We investigate in more detail the influence of two factors, state building and the emergence of an adequate growth model, which might have contributed to the current state of affairs.

The challenge of state and nation building

The economist Alfred Marshall remarked in 1919: “The state is the most precious of human possessions and no care can be too great to be spent on enabling it to do its work in the best way.” As the rule of the thumb, it counts for 50 per cent of difference in GDP per head (Diamond). Ukraine has been independent for only 23 years with some historic roots before the 14th century. Furthermore, the Ukrainian territory is heterogeneous. The west of the Ukraine is largely Catholic, speaks Ukrainian, was part of the Habsburg monarchy and has had a century-long strong orientation towards the West. Economically it is dominated by agriculture with low productivity and high unemployment. The East is largely Russian Orthodox. As an industrial heartland of the former Soviet Union, it has outdated technology, depends on subsidizes, but still has above average value creation and export activities. Its foreign orientation is mainly towards Russia, following historic, cultural, mental and economic links.

Periodic turmoil and deep-seated fragmentation of the society might be an indicator that the elites are challenged by the Westphalian sovereignty, granted in 1991, and some elements of formal or juridical sovereignty are still significant (Jackson). Considering the conflict-ridden European history in the Middle Ages and the civil wars in the Balkan in the 1990-ies, Ukraine might be still perceived as a country on its way from a sum of regions to a nation. The implications are higher transaction costs and lower social capital. In a classic case of negative externalities, the localized costs of suboptimal behaviour – the ones one might expect to be internalized – fall well short of the overall national costs, contributing to elite capture and corruption.Consequently, spill over effects of tensions and loss of confidence contribute to lower outcomes, and higher risks of change for the years to come.

Indeed, we are beginning to understand nation building, including the identification of triggers that results in entering a sustainable modernization path. During the last decade, the international community has invested trillions of USD in Iraq and Afghanistan, that is comparable with the total of official development assistance since World War II and exceeds many time the GDP of the beneficiary countries. The focus was often on democratic skills and institution, civic participation, and good governance. The US alone invested US$ 5 billion (2,8 per cent of annual GDP) in Ukraine (Neuland). Of course, these are important wealth-enhancing arrangements, but their perception as a precondition for economic growth is a recent phenomenon. Historically, democratization often followed growth. In the US during its revolution, in Germany after World War II and in South Korea during the 1980-ies, the political consensus turned in favour of democratic and inclusive institutions because of economic incentives, not vice versa. Contrary to common economic textbooks, China’s successful reforms were the results of a bottom-up process of intensive institutional trial and error on local and regional levels (Rodrik 2007: 92). The Singaporean consensus, for example, promotes public housing, academic meritocracy, elite governance and primacy of growth as one of many alternatives to the Washington consensus that stills dominate international institutions. Little is understood about what is correlation and what is causation.

Identifying a sustainable growth trajectory

Every country has a growth model that embeds the national economy in competitive global markets and positions it in the global value creation pyramid. For more than 100 years the US is at the top as the “indispensable” start-up nation, creating an asymmetric equilibrium with the rest of the world (Acemoglu). With high costs, it defines by and large the global technological frontier and innovates value chains, corporate business models and institutions that diffuse to the rest of the world, either immediately, or throughout many decades. Germany found a lucrative global niche in the middle-technology segment by combining high-tech technologies with traditional metal. Competitive medium-sized companies, the Hidden Champions of the Mittelstand, lead the manufacture sector.  China captured on technological breakthroughs in transport and communication, a massive capital inflow of $ 1 trillion in foreign direct investment since 1992 and unimpeded access to Western consumer markets. Its labour-intensive and export-led model redefined global division of labour and made it the manufacturer of the world. On a lower scale, India became the office of the world. The new EU accession states prospered due to their integration into a single market as a provider of qualified, low-cost labour in exchange to subsidies, direct investment, know-how and a stable institutional landscape.

Identification of an appropriate growth model for the Ukraine faces a most complicated mix of challenges and opportunities. As a complexity analysis shows (Escobaria 2014), Ukraine exports machines and equipment to Russia and low-value agriculture products (soybeans, honey) and commodities (metal and steel) to the West. This is an unfavourable situation because – all other things being equal – the amount of structural change and investment is higher than in other countries.

Thus, an increase in Ukraine’s export of agricultural products requires investments investment and capacities for providing the regulatory, legal and other frameworks. On the one hand, Ukraine’s natural conditions are above average as the territory is mostly covered by fertile black dirt, has a favourable climate and demand occurs from the nearby world’s largest economic region. But in a classical hen and egg problem, the critical point is a long way away from providing the required state capacities, the necessary smart public investment in market creation and, eventually, a business environment that is enabling, stable, predictable, free of corruption and attractive for national and foreign capital.

There is no demand on Western markets for Ukraine’s machines and equipment. Foreign (Western) investment might be hampered by the close link of the sector with Russia’s defence industry.

Ukraine’s Eastern industrial heartland, particularly the Donbass basin with its old-fashioned energy-intensive coal and steel industry, needs investment, new management and, particularly, energy-saving technology. The experience of the US and EU in restructuring heavy industry and mining clusters does not give cause for optimism.

Wallonia, the first industrialized part of continental Europe, is underperforming and might be forced into independence by the richer parts of Belgium. Some towns in Germany’s Rhine basin are in worse shape than socialist-ridden Eastern Germany. The US rust belt is still the synonym for economic decline, population loss and decay. In all these cases, drivers of growth switched and costs of restructuring exceeded new value creation. Consequently and with mixed success, the focus moved on managing the transition to knowledge-intensive activities, outsourcing, downsizing, “factoryless” manufacturing and deindustrialization. As a result, not the West, but investment-led and environmental-intensive China counts today nearly for half the world’s steel and other low-value commodities.  For Ukraine, the search is out for an appropriate niche in the global market place that stops the relative fall in its economic dynamic.

The EU – Ukraine Association Agreement has offered a long-term development perspective, but is not a short-term game changer. Ukraine might be in a situation like Greece that lucks a sizable export potential and trade competitiveness. It is therefore no surprise that austerity and structural reforms add to a painfully slow process of harnessing the advantages from a single market. A similar example provides Mexico. It achieved on average growth rates of less than 2 per cent per capita after signing the North American Free Trade Agreement (NAFTA) in 1994, which is low by emerging-economy standards. Mario Draghi, the ECB’s president, raised the following concerns in regard to EU’s Southern periphery: “Each economy has to stand on its own feet. It has to be productive and competitive enough to benefit from the opportunities afforded by the Single Market” (Draghi). Eventually, the EU will find a mechanism for dealing with its periphery, an advantage that Ukraine does not have.

Summarizing the situation, Ukraine will need time to recover from the current shocks. It is faced with a dilemma of multiple crisis and the needs of demanding structural reforms. Significant risks remain for institutional overstretch and instability. Some indices of state failure do not disappear. The country has to balance the inherent trade-off between short-term costs and long-term benefits.

On a geopolitical and strategic level, the options of the West to frame these efforts might be reduced to two options. One policy is the focus on stability and macroeconomic stimulus (Gros, Summer, Gorodnichenko). The decline of GDP of more than 7 per cent for this year should be offset by financial and technical assistance of the broader international community. One might remember that the containment doctrine during Cold War included strategic support to frontline states like South Korea and Taiwan that triggered high growth rates. History does not repeat, political and technological circumstances are very different today. Ukraine competes with other geopolitical problems for resources and political attention, such as the aftermath of Arab spring, the emergence of the ISIS-state, a violent Bosnia, the Middle East conflict, and more. Nevertheless, the amount and conditions of investment test the political commitment of the West to support democratic change in Ukraine.

The other option, which is currently implemented, is support in exchange to a reform package with focus on structural reforms, fiscal stabilization and spending cuts. Ukraine will receive amounts up to $ 27 billion (15 per cent of annual GDP) over the next two years that covers reported financial needs of the government (Erlanger). The IMF program intends to float the Ukraine currency, remove energy subsidises, raise taxes and freeze minimum wages. At least in the short-term, this will contribute to a substantial economic contraction and political instability.

In our best guess, in five years a realistic scenario for Ukraine is a recovery from the current crisis, a durable cooperation with Russia and the emergence of the outlines fora sustainable growth model with a higher value proposition.

Recommendation and Conclusion

Based on these considerations we reach some conclusion:

1. De-escalate. Russia overplays its cards, but has the advantage of an asymmetric player. Low-scale confrontation prolongs Putin’s political life cycle; hard sanctions will hurt not only the Russian economy. The leitmotif should be the art of muddling through in order to achieve normalcy. Compromises are needed in the best traditions of realpolitik.
2. Prepare for a window of opportunity in Russia. The implosion of the Soviet Union took the West by surprise and there was no experience in of moving from a planned economy to a market economy. Today the situation differs. It would be a mistake to take current events by face value and assume historic linearity.
3. Stabilize the Ukrainian state. The political stalemate between the West and Russia is a contributing factor to the disorder in Ukraine. Russia cannot offer a long-term growth perspective; the West still copes with the aftermath of the global recession and looks inwards. Ukraine needs stability, time and resources for a trial-and-error process that encourages nation building and the identification of a suitable growth model.

Literature