I have increasingly become frustrated by the focus on “overheating” of the Russian economy championed by many Western military and geopolitical analysts.

The narrative more or less goes something like this: fiscal policy is very easy in Russia, so demand is high, and therefore there are now massive demand pressures, which cause ‘overheating’ and will lead to a collapse of the Russian economy soon. This is essentially a ‘boom-bust’ story.

The problem is that such a story aligns very badly with economic theory—or, for that matter, economic history. Economies don’t ‘collapse’ because of overheating.

Sudden economic collapses typically happen as a result of a major negative demand shock—typically monetary tightening, either caused by active monetary tightening by the central bank or caused by passive monetary tightening due to a financial crisis.

Russia might, of course, be hit by that, but that is not really the story being told by the military analysts who so very clearly have no economic education at all.

Furthermore, the focus on ‘overheating’ fails to address two much more important issues for the Russian economy: the structural decline in economic growth caused by Putin’s war on Ukraine, and the fact that the large Russian government budget deficit is clearly unsustainable and is de facto causing a major monetary expansion that is set to get even worse going forward.

To understand these issues, I have created a simple model for the Russian economy inspired by the seminal work of Sargent and Wallace on “Unpleasant Monetarist Arithmetic.” The model illustrates how fiscal and monetary factors have shaped Russia’s economic development since Putin started his war on Ukraine in February 2022, revealing that the apparent resilience of the economy is largely an illusion created by monetary manipulation.

Additionally, we will examine the evolving role of the Central Bank of Russia (CBR), which has transitioned from a conservative institution to one effectively subordinated to the Kremlin’s fiscal agenda. Contrary to the common conception, the Russian central bank is not an inflation fighter. It is effectively Putin’s lapdog.

The Model

Below are the equations in this simple model for the Russian economy. First, we focus on the supply side of the economy with a traditional Cobb-Douglas production function.

(1) y_t* = a_t + αk_t + (1 − α)l_t

Where y_t* is the growth rate of potential GDP in Russia, a_t is total factor productivity growth, k_t is the growth rate of capital and l_t is the growth rate of the labour supply.

Equation (2) determines the growth rate of the money supply m_t:

(2) m_t = m̄ + d_t

m̄ is the ‘structural’ growth rate of the money supply. Think of this as being determined by the financial system and the central bank, while dt is the government budget deficit, which we here assume de facto is fully financed by an increase in the money supply.

Equation (3) determines long-term inflation (π_tᶫ) as a pure monetary phenomenon:

(3) π_tᶫ = m_t − y_t*

If the money supply growth (m_t) persistently outpaces potential gdp growth (y_t*) then inflation will eventually increase.

However, in the short-run there are price rigidities and this is what is reflected in equation (4):

(4) π_t = π_t−1 + γ(π_tᶫ − π_t−1) + δŷ_t

Furthermore, we have a ‘Phillips curve’ effect on short-term inflation as a positive output gap (ŷ_t) also can push up inflation.

The fact that we have price rigidities also means that actual GDP growth can diverge from potential GDP in the short to medium term:

(5) y_t = y_t* + λ(π_tᶫ − π_t)

Hence, as long as long-term inflation is above short-term inflation then actual GDP growth will outpace potential GDP growth. Again, this is akin to the Expectations-Augmented Phillips Curve.

Equation (6) is (growth in) the output gap defined as the difference between actual gdp growth and potential gdp growth:

(6) ŷ_t = y_t − y_t*

Equation (7) is the natural real interest (r_t) which is determined by a ‘structural’ level of the interest rate (for example dependent on global interest rates) and a factor that dependent on the budget deficit so a higher budget deficit as share of GDP increases the natural real interest rate.

(7) r_t = r̄ + ηd_t

Equation 8 is the nominal interest rate (i_t):

(8) i_t = r_t + π_t

The nominal interest rate is simply determined by the sum of the natural real interest rate and actual inflation.

One could (easily) have argued that we should have used the long-term inflation instead to reflect inflation expectations, but we have assumed for simplicity that expectations are static in the model.

This is obviously not realistic, but by comparing the short-term and long-term impact of shocks to the model, we can analyze these expectational effects indirectly nonetheless.

The Russian Economy Post-2022: A Simulation

I have used the model above to simulate two simultaneous shocks to the Russian economy triggered by Putin’s invasion of Ukraine in February 2022.

First of all, we have assumed a decline in total factor productivity growth, the genuine driver of long-term economic development.

In our model, total factor productivity (TFP) growth drops dramatically from an initial 3% to just 1%, reflecting the profound economic disruption caused by international sanctions, technological isolation, and the massive economic restructuring forced by the conflict.

Simultaneously, the model incorporates a second critical shock: a severe contraction in labour market dynamics. While the initial baseline assumed stable labour supply growth, the simulation shows labour supply growth turning negative, dropping from 0% to -1%.

This shock represents the complex human capital challenges Russia faced: widespread emigration of skilled professionals, military mobilization, and the broader economic dislocation triggered by the invasion.

The fiscal dimension of these shocks is equally dramatic. The model assumes a rapid escalation of budget deficits, rising from 0% to 10% of GDP between 2021 and 2023. This represents the massive state expenditures required to sustain a war economy, fund military operations, and attempt to mitigate the economic consequences of international isolation.

Obviously, one can debate the magnitude of these shocks and their speed, but I have chosen them to more or less reflect the scale of the shocks we have actually seen in Russia since February 2022. The graph below shows our stylised fiscal shock where we assume that the budget deficit increases from zero in 2021 to 10% of GDP in 2023.

One can debate the actual numbers, but the latest data from the Russian Ministry of Finance do in fact show a budget deficit of this magnitude by the end of 2023. I have chosen to implement the shock a bit faster than it really was, but that will, on the other hand, make up for the fact that we have assumed static expectations rather than forward-looking expectations.

In the model, we have full monetary financing of this deficit, and consequently, we see money supply growth increase significantly in response to the sharp increase in the budget deficit, as the graph below shows – basically doubling money supply growth from just below 10% to close to 20%.

Again, one can discuss the actual mechanism by which this happens – whether it is through actual money printing or whether it is a result of the Russian central bank failing to offset the monetary and expectational impact of an increased budget deficit – but the fact remains that this development broadly speaking reflects the growth rate in Russian M2.

In the years leading up to the invasion of Ukraine, Russian M2 grew around 8-10% a year, and since early 2022, M2 growth has been consistently above 20% and often higher.

The sharp increase in money supply growth in the model is clearly inflationary.

First, of all through a direct monetary effect that increases long-term inflation (and in reality inflation expectations) and secondly, through a Phillips curve effect that also push inflation up in the short-term.

We see this in the graph below.

Initially – prior to the invasion – Russian inflation was below 5%.

However, as the shock hit, we see long-term inflation (the dotted line above) increase. However, initially actual inflation will remain below the long-term inflation, as we have assumed price rigidities in our model.

Such rigidities exist, for example, due to fixed prices in certain contracts, but they could also reflect the widespread price controls that have been introduced in Russia since February 2022.

However, eventually prices will adjust to the long-term monetary-induced inflationary pressures and, furthermore, the Phillips curve effects combined with the negative supply shock will also add to inflationary pressures in the medium term.

In the model, inflation hits 15% during 2023 and nearly 17% in 2024.

If we compare these numbers with actual inflation, as shown in the graph below, we see that the development has been somewhat more uneven in real life, where we initially in 2022 saw a very sharp spike in inflation to close to 20%, followed by a rather steep drop mostly reflecting a base effect, and then recently a new increase.

The latest official data shows Russian inflation at close to 9%.

One could clearly question the validity of the inflation data in Russia and I personally find it highly likely that they are manipulated, but even if we assume that the numbers are correct, I would argue that the model simulations get it pretty right.

Hence, if we instead of looking at a single year look at the average inflation from the beginning of 2022 to the end of 2024, then it is fair to say inflation has been around 10-12% as an average over the period and is clearly showing signs of increasing further.

And this is of course exactly what we are seeing in the simulation – inflation from 10-15% in the 2022-24 period and a clear upward trend. Consequently, if we instead had compared the actual and predicted price level in Russia, it would in fact be rather close by the end of 2024.

So not only does it look like the model is more or less correct in explaining the increase in Russian inflation (and in the price level) – it is also pointing towards a relatively steep further increase in Russian inflation over the coming year.

And the reason this might be kicking in with more effect now is that we are likely to begin to see the effect of the negative supply shock and because we are moving closer to the ‘long-run’.

We get an illustration of that by looking at the simulations for the development of potential and actual GDP growth, as the graph below shows.

We see two things here.

First of all, we see actual GDP growth (the solid blue line) increase slightly initially as fiscal and monetary policy is eased, but secondly, we also see a sharp decline in potential GDP growth (the dotted line).

The sharp slowdown in potential GDP growth is the direct impact of capital flight, sanctions and an erosion of the labour force as men are mobilized to go to the front and others – maybe close to 1 million Russians – have escaped from the horrors of Putin’s war.

This will soon become the real drag on the Russian economy, as we clearly see in the graph where we should already have seen actual GDP start to converge towards the much lower potential GDP growth.

However, in reality we haven’t seen that effect fully emerge yet, and that is also why actual inflation now is below (around 9%) what our model predicts (15-17%) – at least if we trust the Russian statistics (which we should not).

But what about actual GDP growth? We see that in the graph below.

First of all, we see that before the war, actual GDP growth was in fact somewhat below potential GDP (which we initially assumed to be around 3%).

Furthermore, we also see that actual GDP growth contracted significantly in the early phase of the war.

Our simulations – on purpose – have not taken the initial negative demand shock into account as we are more interested in analysing the longer-term impact of the negative supply shocks and the fiscal-monetary nexus.

However, we do see that over the past 15-18 months, Russian GDP growth has been around 4%, more or less as predicted by the model.

We also see that we seem to have begun a slowdown in Russian GDP – from around 4.5% to just above 3% by the end of 2024.

It is certainly no collapse, but keeping in mind just how expansionary fiscal and monetary policy is, then this is notable and in line with the predictions from the simulation.

It therefore also just seems a matter of time before the real world catches up (or rather down!) to the model predictions.

What will cause actual GDP growth to converge (down) towards the much lower potential GDP growth will be what we could call an inflationary-induced tightening of monetary policy – or what in textbooks is often called a real-balance effect or a Pigou effect.

This effect kicks in once inflation starts to adjust to the higher money supply growth. Remember, we have in the model assumed that there are price rigidities, and this is certainly realistic in an economy like the Russian with widespread price controls.

Effectively, this means that at some point inflation will start to outpace money supply growth, and at that time, we will effectively get monetary TIGHTENING. Not because NOMINAL money supply slows, but because REAL money supply growth slows once inflation picks up for real.

We see this in the graph below where the ‘monetary gap’ is the difference between nominal money supply growth and inflation.

In the model, this effect should have started to kick in a year ago, but in reality, this is likely somewhat delayed even though we are actually at the moment seeing this starting to unfold.

Consequently, this ‘passive’ or ‘automatic’ tightening of monetary conditions is very likely to start to depress demand in the Russian economy relatively soon, and as a consequence, we could see actual GDP growth start to slow rather substantially.

This would undoubtedly lead the ‘overheating’ crowd to yell ‘I told you so’, but the fact is that this is not a bust caused by overheating, but rather the good vertical Phillips curve combined with the Pigou effect kicking in and pushing actual GDP growth down towards potential GDP growth that in the meantime has slowed substantially compared to before the war.

There is, however, also another scenario: a scenario where inflation is ‘contained’ by even more widespread and draconian price and wage controls in Russia, and given the regime’s more and more totalitarian and Soviet-style policies, this should not be a surprise.

However, in this scenario, we get the ‘bust’ in another form. What we should then expect to happen is that we don’t see open inflation, but rather ‘closed’ inflation, which means that goods simply disappear from the shelves in the supermarkets.

In this scenario, GDP growth contracts not because of lower demand, but because producers simply stop producing as it will no longer be profitable due to price controls. But that is not the scenario we simulate in the model. The model nonetheless educates us as to why such a scenario could become reality.

So now we have looked at inflation and real GDP growth, and we have shown that sooner or later, inflation will rise sharply if large budget deficits are funded by printing money. What we have in fact assumed is that the Russian central bank is not really independent and that it is the needs of Putin’s war machine that determine the growth rate of the money supply.

Elvira Nabiullina Is Just Another Servant of Putin

The Russian central bank governor Elvira Nabiullina has for years been seen in the financial markets as a guardian of price stability in Russia, and she is often described as ‘conservative’ or ‘ultra-orthodox’ in her monetary policy views and even as a ‘reformer’.

Frankly speaking, I used to use those terms about her, and the fact that she has hiked the CBR’s key policy rates repeatedly over the past year has led many observers to conclude that she is still a world-class central banker trying hard to secure price stability in Russia.

Even among the biggest critics of the Russian regime, it is hard to find anybody willing to be critical about Nabiullina’s conduct of monetary policy.

But this, in my view, is wrong, and it stems from a well-known fallacy in monetary analysis – the fallacy of concluding that ‘high’ and ‘increasing’ NOMINAL interest rates indicate a tight monetary policy, but as Milton Friedman taught us long ago – interest rates are HIGH when monetary policy has been EASY.

And this is in fact exactly what our simulations show us.

The graph below shows the development in nominal and real interest rates in the simulation.

It is important to notice that in the model, the central bank does not in fact CONTROL interest rates – at least not directly and certainly not in the way that many people (and even economists) believe central banks SET interest rates.

In the model, the natural real interest rate is determined by fiscal policy. If the government runs a large deficit, then the real interest rate will increase. And if we add inflation (or inflation expectations) to the real interest rates…

What we see in the simulation is that this ‘market’ determined nominal interest rate increases from around 7% before the ‘shocks’ to just above 21% in 2023 and further towards more than 25%.

This, however, is not ‘monetary tightening’ – it just reflects a large increase in the budget deficit that first of all increases natural real interest and secondly higher inflation due to higher money supply growth – also caused by the large budget deficit.

But let’s compare this with what Nabiullina has actually done with the key policy rate. The graph below shows this.

What do we see?

We start out around 7% and we are now at 21%. Nabiullina delivered the latest rate hike back in October.

If we compare this to our simulation – this is more or less the same, or rather we should have been at 25% rather than 21%. Looking at real interest rates, the difference is a bit smaller.

But what is the real story here?

The story is that Russian monetary policy in no way can be described as ‘TIGHT’ and there is nothing ‘prudent’ or ‘ultra-orthodox’ about how Nabiullina has conducted monetary policy, particularly over the past 12-18 months. She is barely keeping up with the increasing natural real interest rate and inflation expectations.

And there is another story here – is she getting ‘soft’? Or has Putin now fully taken over also in terms of monetary policy?

Back in 2022, she did in fact tighten monetary policy as we see in the graph above – the key policy rate was increased sharply and much more so than our simulations indicated it should. This is an indication that at that time Nabiullina actually had some monetary independence.

On the other hand, the rate ‘hikes’ over the past 12-18 months do not really show that – it simply shows that the CBR is ‘shadowing’ the market interest rates.

In fact, it might even be worse. Last week the CBR unexpectedly kept its key policy rate unchanged at 21% (a hike had been expected) and at the press conference following the rate decision the governor said:

“The decision to leave the rate at 21% was motivated by the fact that the data over the past six weeks, which describe both actual lending activity and the intention to grow loan portfolios further, demonstrate quite convincingly that it’s very possible that the required tightness in monetary conditions needed to slow inflation has already been achieved.”

And she might in fact be right – it is the Pigou effect that we mentioned above that might be starting to kick in. However, the monetary “tightening” is NOT a result of direct actions of the central banks as the rate hikes over the past year have simply been a ‘shadowing’ of market interest rates.

Nabiullina continued:

“The labour market – really, its condition – is a very important factor now in assessing the possibilities of expanding production, and companies still continue to cite it as the main constraint… But we do see the first signs of a decline in demand for labour. This process will be uneven across the economy, flowing from one industry to another, from one enterprise to another. This process will have a significant impact on our assessment and decision-making, including monetary policy.”

Again, she might indeed be right – I do also, based on my simulation, expect things to start to cool down quite a bit in the Russian economy, but I also expect inflation to continue to rise further.

In fact, what our simulations are indicating is that the Russian economy is increasingly heading for a stagflationary scenario – likely with inflation above 15% and basically no economic growth.

But I will happily acknowledge that Nabiullina is not to blame for this. It is 100% a result of Putin’s war on Ukraine – the massive budget deficit and major negative supply shocks it has created.

On the other hand, we can no longer consider governor Nabiullina ‘ultra-orthodox’, ‘prudent’ and ‘hawkish’ or any other words used to describe inflation-fighting central banks. This is simply a servant.

Economic Gravity – Not Overheating – Is Putin’s Primary Economic Headache

The fundamental misunderstanding of Russia’s economic trajectory stems from a failure to distinguish between monetary dynamics and structural economic deterioration.

Our model clearly demonstrates that what many Western (military) analysts interpret as “overheating” is actually the early manifestation of a complex monetary-fiscal nexus, one that will inevitably lead to stagflation rather than a simple boom-bust cycle.

Economic gravity sooner or later always sets in, and Russia’s case will be no exception. The laws of economics cannot be indefinitely suspended through monetary manipulation or statistical sleight of hand.

The apparent resilience of the Russian economy is largely illusory, sustained by massive monetary expansion and increasingly compromised institutional independence at the CBR.

What we’re witnessing is not the prelude to a classical overheating scenario (if such a thing ever existed), but rather the erosion of Russia’s productive capacity masked by aggressive monetary accommodation of fiscal deficits.

The simulation results point to an uncomfortable truth: Russia is not heading for a sudden collapse, but rather a grinding deterioration characterised by rising inflation and declining potential output.

This “slow burn” scenario is actually more pernicious than a quick boom-bust cycle, as it represents a structural decline in Russia’s economic capacity that will persist long after the immediate effects of the war have faded.

The transformation of the CBR from an independent inflation-fighting institution to an enabler of war financing represents more than just a policy shift – it signals the complete subordination of monetary policy to Putin’s military ambitions. Hence, Nabiullina’s position has evolved from independent monetary policy maker to facilitator of war financing.

Nabiullina’s recent policy decisions should be viewed not as prudent central banking but as evidence of this fundamental institutional change.

Looking ahead, the choice facing Russia’s economic leadership is increasingly stark: either allow inflation to accelerate while maintaining the fiction of price stability through selective data reporting, or impose increasingly draconian price controls that will inevitably lead to Soviet-style shortages.

Neither path offers a sustainable solution to the fundamental problems our model has identified. The real tragedy is that this outcome was entirely predictable from the moment Putin chose war over economic stability.

Try the RUST Model Simulation yourself

The model simulations above were based on modelling I did with the help of ChatGPT and particularly Claude 3.5 Sonnet.

I call this framework the RUST model — Russia’s Unpleasant Structural and Transitional economic model.

The acronym reflects both the theoretical foundation in “Unpleasant Monetarist Arithmetic” and the slow economic decay (“rusting”) of Russia’s economy under the weight of fiscal irresponsibility, war-induced supply shocks, and institutional degradation.

This also means that you can play with the model and its parameters.

You can do that by clicking on this link.

Let me know if you find it useful.

If you want to know more about my work on AI and data, then have a look at the website of PAICE — the AI and data consultancy I have co-founded.

Note: Cartoon created with fal.ai/FLUX