Warfare without the state - New Keynesian shock therapy for Ukraine's home front

16.11.2022
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Adam Tooze
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As the war in Ukraine rages on, the question on the battlefield is whether Russia resorts to nuclear escalation. In Washington the political consensus is crumbling. After the midterms will a re-energized Republican party pull back from support of Ukraine? Meanwhile, Ukraine celebrates its military triumphs but is increasingly concerned about its mounting economic and social difficulties. In Washington during the IMF and World Bank meetings earlier this month, all three questions - nuclear risk, GOP risk, and economic and financial risk - converged. 

It is clear that Ukraine, unlike Russia, faces an urgent economic and social crisis. The World Bank and IMF at their latest meeting confirmed dark predictions that Ukraine’s GDP will likely shrink by 35% this year. More than ten million people are displaced and need relief. As one report notes: “According to estimates by the National Bank of Ukraine (NBU), more than a million workers have been dismissed from previous employment and more than half of firms have cut nominal wages (in many sectors by 50%) since the war started. Many firms report operating under reduced hours.” 

Furthermore, it is increasingly clear that the policies with which Kyiv has successfully met the early stages of the war are not sustainable. Inflation is surging towards 30 percent and more. The national currency, the hryvnia, has fallen in value by roughly 70 percent. Meanwhile, Ukraine’s foreign exchange reserves are being burned up in the effort to slow the depreciation of the currency. 

There is gamesmanship on all sides. In negotiating for concessions from creditors Kyiv has no incentive to paint its situation in rosy colors. But there is little doubt that the situation is truly serious. By the winter Ukraine’s parlous economic and financial situation may well begin to undermine its ability to continue the war. 

There is an obvious solution in the form of foreign aid. But will that be forthcoming? If not, what does realism dictate? And specifically what is the role of Western commentators and experts in such as situation? I am prompted to ask these questions both by reflecting on my own engagement with the issue and by a close reading of a report issue by CEPR on September 14th co-authored by an all-star group of American and European economists.

 

 

The report is clearly motivated by real concern for Ukraine’s situation. But I fear that its proposals threaten to undermine what it seeks to defend. When democracy is under attack we need to tread carefully on political economy. The CEPR authors do the opposite. Contrary to what you might expect, namely that war would lead to a search for solidaristic social and economic measures to shore up the Ukrainian home front, the CEPR team demand radical deregulation. In this respect they outdo the imagination of even a radical observer such as Slavoj Žižek who in a recent piece in project syndicate fondly imagined that the war had led to a temporary retreat of neoliberal designs on Ukraine. History, it seems, is more radical than that. Licensed by formulaic assumptions about endemic corruption and inefficiency on the part of the Ukrainian state, the CEPR authors propose to sever any association between war-making and the state as anything more than a residual safety net. The 21st century has thus given birth to a new strange new vision of warfare without the state. This is all the more striking for the fact that it emerges unbidden out of a far more familiar set of questions. 

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The most urgent issue at hand is, after all, how to pay for Ukraine’s war. Ukraine’s tax base is weak. Military spending is surging and cutting non-military spending is easier said than done.

 

 

Foreign funding covers only a fraction of the resulting deficit. Local investors are not keen to buy Ukrainian local-currency bonds, on account of inflation. So borrowing from the central bank, the NBU, i.e. printing money has become the last resort of (inflationary) war finance. 

 

 

No central bank wants to preside over rampant inflation. Since the summer, the NBU had been urging the Zelenskiy government to raise the interest rates on the debt that it issues to make the loans more popular. The government has demurred. 

Back in September, I argued in Chartbook #149 that the social and economic pressure on Ukraine would likely exacerbate divisions within the elite and notably those between the government and the central bank. At the time - those were the days of Ukraine’s spectacular military advances on the Northern front - I felt some nervousness about even bringing up the issue. But then, on October 6, under somewhat mysterious circumstances, Ukraine’s central bank governor Kyrylo Shevchenko resigned and disappeared from the scene, to reemerge on facebook somewhere outside the country. He claimed medical grounds, but it also emerged that he is facing a corruption investigation. 

Some very well-informed observers note that this may be all there is to it, a corruption case - see for instance the commentary by @DaveDalton42 who is a great follow on Ukraine’s political economy. But one does have to wonder why a corruption investigation, of which there are presumably many ongoing at any one time, should have been allowed to unseat such a critical official just ahead of the IMF meetings. Strikingly, Anders Aslund, who can hardly be accused of lacking sympathy for Kyiv, interpreted Shevchenko’s departure in political terms.

 

 

Likewise, the well-connected Bloomberg team of Volodymyr VerbyanyJorge Valero, and Daryna Krasnolutska did not shrink from a political reading of the reshuffle at the NBU. Tensions between the government and the central bank go back to June and the new boss at the bank, Andriy Pyshnyi is well connected in Zelenskiy’s circles. 

With Zelenskiy’s government continuing to put pressure on the central bank to stretch its capacity to finance the war-battered budget, it’s not clear how Pyshnyi, a 47-year-old ally of the president’s chief of staff Andriy Yermak, will react. “This is the main problem and threat,”said Dmytro Boyarchuk, executive director of the economic-research company Case Ukraine in Kyiv. After serving on Oschadbank’s board in the early 2000s, Pyshnyi began his political career when President Viktor Yushchenko appointed him deputy head of the National Security and Defense Council. He and his allies later joined forces with the political party that became the driving force of the so-called “Revolution of Dignity” that ousted pro-Russian President Viktor Yanukovych in 2014. He resumed his banking career soon after, serving as Oschadbank’s chief executive officer until 2020. While Pyshnyi is a political and business veteran, he doesn’t have universal support among economists, some of whom said a candidate with more of a technical background would be a better fit. “The main monetary body should be governed by an economist, who understands macroeconomic processes, not by a business person like banker,” Boyarchuk said. 

Given the instability of Ukraine’s economic policy team and the apparent resolution in favor of Zelenskiy loyalists, who immediately announced that they were holding interest rates at their current levels, the question now becomes whether Kyiv can establish what Elina Ribakova of the IIF (the chief lobby group of international finance) describes as a “credible macroeconomic framework”. 

 

President of Ukraine Volodymyr Zelenskyy. Photo: Office of the President of Ukraine

 

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If you were looking for such a framework one of the places you might be tempted to go would be the September 14 report published by the CEPR team. They formulate Kyiv’s dilemma in dramatic terms. 

For over 160 days, Ukraine has been resisting Russian aggression. A prolonged war is increasingly likely, a prospect that calls for a recalibration of the country’s macroeconomic strategy. Specifically, the current policy mix, which relies on running down foreign reserves and other temporary measures, is progressively untenable. Unless altered, this course will result in a major economic crisis that will cripple Ukraine’s ability to sustain its war effort over an extended period.

They then go on to argue: 

The government can hope for foreign aid in necessary amounts, but this may be wishful thinking: the moral support for Ukraine is only partly translating into a strong financial lifeline. The recommendations in this report will help Ukraine adjust to this reality. 

So, with Ukraine’s survival and Europe’s future at stake, what does “realism” dictate?

The report is divided into four parts. The first three components, as they pertain to macroeconomic stabilization and the question of how to pay for the war are, in fact, easy to agree with. The Ukrainian state clearly needs to strengthen its revenue base. It needs to ensure a modicum of price stability. It should let the exchange rate depreciate whilst preventing mass capital flight by means of tough capital controls. 

To their credit the CEPR team note the need for progressive taxes to finance the war.

Ukraine has a flat personal income tax with a rate set at 18%. The existing military levy (introduced in 2015) is also a flat 1.5% of income. If the government cannot make these taxes progressive, it can introduce a progressive ‘war surcharge’ (for example, the surcharge would apply only to income or capital above a certain threshold) that may be easier to accept politically and could be rolled back after the war. Higher taxes on luxury items can also help to make taxation more progressive.

Beyond tax revenues the team aims for an ambitious agenda of domestic resource mobilization. 

The aim should be to increase the collection of tax revenues and for remaining shortfalls to be financed primarily through non-monetary means: preferably through external aid, but if not, through domestic debt issuance, with much less reliance on seigniorage (printing money). 

 

Damaged equipment at the high-voltage substation of the Ukrenergo operator after a missile attack, November 10, 2022. Photo: GENYA SAVILOV / AFP via Getty Images

 

How exactly domestic savers are to be persuaded to subscribe to war loans at a time of rapidly rising inflation, remains unclear. Handwaving towards the example of the US in World War II is largely beside the point. Most likely, Kyiv will have to rely on forced savings.

Sensibly enough they argue for a “durable nominal anchor” i.e. price stability. 

The aim should be for relatively low inflation. In a time of national mobilisation, the main responsibility for attaining price stability falls on the fiscal authority, which can strongly influence inflation through the tools it chooses to raise resources from the domestic private sector. The government should aim to enhance national savings rather than rely on monetary financing from the central bank. In coordination with fiscal authorities, the central bank should implement a flexible framework to support macroeconomic stability. A managed float of the exchange rate is consistent with this goal. 

Third, external imbalances should be addressed through a combination of strict capital outflow controls, restrictions on imports, and some flexibility in the exchange rate to avoid jeopardising internal macroeconomic stability in the face of huge fiscal needs. A comprehensive standstill on external debt payments is essential. 

All of these are sensible, stability-orientated policies that seem well-designed to secure a platform from which to sustain the war effort. All the more jarring is the fourth section of the CEPR report in which the team depart from the task of macroeconomic stabilization to discuss the adjustment of Ukraine’s economy to the shock of the invasion. In this section, all notes of sensible caution are abandoned in favor of a breezy radicalism and a fatalistic view towards the Ukrainian state itself. 

… although wartime governments usually take over the allocation of resources, Ukrainian circumstances call for more market-based allocation mechanisms to ensure cost-effective solutions that do not overburden the state capacity, exacerbate existing problems (such as corruption), or encourage (untaxed) black market activities. To this end, the aim should be to pursue extensive radical deregulation of economic activity, avoid price controls, and facilitate a productive reallocation of resources Ukraine’s very survival – and Europe’s future – is at stake. Extraordinary challenges must be matched by extraordinary policies and extraordinary support from Ukraine’s international partners.

Faced with the shock of Russian invasion rather than seeking to strengthen the Ukrainian state, the authors call for it to stand back. 

 

A base with destroyed Russian military equipment in Izyum, Kharkiv Region, liberated from Russian occupiers, October 31, 2022. Photo: Vyacheslav Madiyevskyy / Ukrinform/Future Publishing via Getty Images

 

Historically, wartime governments have relied on a mix of central planning and market-based allocations. In many cases, governments had to play a critical role in the economy to mobilise resources to produce weapons and munitions, given market incompleteness and imperfections (and lack of confidence in the market mechanism during WWII, which occurred in the aftermath of the Great Depression). But allocating resources through rationing and executive direction requires institutional capacity. Ukraine currently lacks such capacity to micromanage flows of goods and services to meet the needs of the defence and civilian sectors. Hence, the capacity of the government to direct the economy should be used sparingly … market-based mechanisms can be helpful in reinvigorating the economy, thus providing a larger tax base. To this end, the government should minimise regulation and other red tape that can constrain or slow down the reallocation of labour, capital, and materials in the economy. On balance, market-based allocations are preferred.

This puts a rather different complexion on their fiscal policy advice. When it comes to non-military government spending the report takes a stern view. 

The need to provide safety nets is urgent and clear: the UN estimates that approximately 12 million Ukrainians need humanitarian assistance. Still, the government can be more efficient in its provisions. For example, it recently decided to fix prices for utilities and other public services. Apart from undermining the financial health of state-owned enterprises and private firms that provide these services and goods and creating a need to recapitalise these providers, this blanket approach is costly because it effectively subsidises households and businesses that can afford higher prices, and because it creates disincentives for saving energy and other critical resources. Current financial assistance to refugees and internally displaced people roughly corresponds to providing basic income. While this approach was adequate in the early chaotic days of the war, the cost of basic income is high. There is no differentiation between vulnerable and relatively well-off refugees … Furthermore, this type of assistance does not create an adequate incentive for refugees to look for jobs, while getting displaced workers back into the labour force should be a priority for the government. To this end, the government can tie continued assistance to job search and employment in public works.

As far as possible the report argues the basic functions of Ukrainian government should be outsourced.

Doctors Without Borders can provide basic medical services, while the UN and Red Cross can provide (and pay for) medical supplies. Spending on cultural programmes (such as protecting museums and galleries) can be covered by international organisations and NGOs.

 

A Pole is loading a bus at a distribution center. Photo: Sebastian Gollnow / picture alliance via Getty Images

 

And given the exodus of a large part of the population, reserved categories of civilian spending cannot be sacrosanct:

Although military spending is the highest priority and hence must be protected from budget cuts, the government may need to re-examine other currently protected items of spending categories. Furthermore, spending should not be tied to pre-war guidelines or objectives (e.g. X% of GDP should be allocated to Y). For example, given that many children and young adults have left the country, the number, locations, and budgets of schools and universities can be recalibrated, freeing up resources for other uses.

On price controls the CEPR teams argues against responding to the social crisis by limiting price movements. It offers a familiar series of arguments about inefficiency and market distortions etc., but then adds this high-tech zinger

… price controls are often justified by the need to ensure solidarity and equal access to goods. However, governments during WWII and other wars lacked the technology to target aid to those most in need. The current level of digitalisation provides alternatives to price controls, such as targeted transfer payments, that can protect vulnerable groups of the population at a lower cost in terms of economic efficiency.

The CEPR team thus seems to imagine a Ukrainian society and economy adjusting to the shock of the war, assisted by high tech and NGOs, but with the Ukrainian state itself pruned back as far as possible. And this vision becomes explicit when it comes to the question of deregulation. 

As a result of the Russian invasion, some sectors and locations in Ukraine have little to no economic activity currently. The released resources must be employed elsewhere, and government policies should facilitate this large-scale reallocation of resources. The government has encouraged businesses to move to Western Ukraine, where security risks are lower, but this policy has had only modest effects (fewer than 1,000 firms have moved). This problem can be addressed by a radical liberalisation of markets to accelerate the flow of the workforce and capital towards sectors/regions where the economy can operate robustly. For example, the government dramatically loosened labour market regulations (e.g. firms can fire workers relatively easily and unilaterally suspend elements of labour contracts; workers who would like to quit do not need to give advance notice to their employers). This approach should be applied to other areas. Land regulation, access to electricity, and other infrastructure should be streamlined to allow easier reallocation for firms. … Perhaps, the government can appoint a high-level official (e.g. ‘deregulation chief’) to coordinate and push for deregulation.

In conclusion the team ends by arguing 

The marathon of this war requires prudence and caution in public finances, a durable nominal anchor, a resilient financial system, a careful management of external balances, and flexibility and efficiency in the allocation of scarce resources. Various branches of the government must coordinate their efforts to this end.

The CEPR reports thus ends with a jarring and, it seems, largely unselfconcious juxtaposition: On the one hand, when it comes to macroeconomics, what is called for is prudence, caution, durability, resilience. On the other hand, when it comes to the fate of the Ukrainian economy, the CEPR team envision a radical liquefaction of labour market regulation, the land market etc. 

 

Ukrainian military on Khreschatyk Street on the eve of Independence Day, Kyiv, August 22, 2022. Photo: Julia Kochetova / Bloomberg via Getty Images

 

Ukraine has turned out to be a very competent military actor but the experts continue to doubt its capacities as a social or economic actor. So best to strip to strip those regulations down to the bone. The CEPR’s proposals would seem to amount to a vision of warfare without the state. 

You might say that this is the apotheosis of the “MIT synthesis” as classically proposed in Paul Samuelson’s textbook, in which macroeconomic stabilization is combined with an uninhibited embrace of conventional, markets-first microeconomics. 

But since several of the CEPR authors are associated with “new Keynesianism” in the US and since they invoke WWII and New Deal experience as a guide, let it be said that their position is the antithesis of Keynes’s own position. He argued for active macroeconomic management precisely because he considered an assault on the collective structures of society as ruinously dangerous. 

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One might criticize the recommendations as a remarkable example of the maxim that one should never let a crisis go to waste. They are a typical, top-down technocratic proposals for radical social upheaval justified by the claim that the end justifies the means. One might describe them as an attack on the social fabric of Ukraine under the mantle of martial law and limited freedom of the press. You might think of them as an anti-politics. Except that they are not. In fact, as the reference to the evisceration of Ukraine’s labour law suggests, the CEPR team are explicitly taking sides with the highly politically contentious deregulatory agenda of the Zelenskiy government and its supporters in parliament and in Ukrainian business. 

The labour market measures which the CEPR team cite as a model for their deregulatory drive were first touted in 2020 but stopped in their tracks by domestic opposition and the COVID crisis. They were reintroduced in 2021, in part with inspiration from a consultancy funded by the British embassy, which, in the mounting tension with Russia, spied an opportunity to bounce the measures through. They were finally signed into law in August 2022 over protests from European labour movement. The one international agency which has not had its grandstand moment in Kyiv this summer is the International Labor Organization (ILO). 

The legislation that was signed into law by Zelenskiy at the end of August effectively removes 70-80 per cent of the country’s workforce—employees of small- and medium-sized enterprises—from the protection of national labour law. As Thomas Rowley and Serhiy Guz report in Social Europe

According to an ILO technical note, the legislation ‘appears to exclude a significant share of the Ukrainian workforce from … the general labour law through the establishment of a parallel and less protective regime’. It will institute the possibility of ‘termination at will’ of employment and ‘unilateral change by the employer of essential terms and conditions’ of work.

Under pressure from opponents of the reform, the law that Zelenskiy signed into effect obtains only for the duration of the war. But it will create facts on the ground. And it is clear that the struggle is already beginning in Ukraine about the terms of postwar reconstruction. Ukrainian labour lawyer and activist George Sandul described the final goal of the draft reconstruction plans as a ‘Mad Max-style dystopia’ where ‘everybody will negotiate on their own without any rules’. 

Melodrama aside, the advocates of the new laws speak frankly about their agenda. 

In an interview published on the Ukrainian parliament’s website on 28 July, Halyna Tretiakova, head of the parliamentary committee on social policy, claimed the ILO was a barrier to Ukrainians striking individual employment agreements and protecting their employment rights through more flexible means. ‘People don’t want to negotiate their employment through collective agreements, but through civil law, royalties, author rights,’ Tretiakova said. ‘But the International Labor Organization, created in 1919, in the epoch of industrialisation, says no … [The ILO says] a person is economically dependent on their employer and should therefore come under Ukraine’s labour code, developed in 1971.’ Tretiakova told openDemocracy that ‘international agreements’ such as the ILO conventions were ‘part of our legislation’ but that claims at the European Court of Human Rights against Ukraine for breaches of social and employment rights were ‘snowballing’. She said: ‘We have to re-examine the obligations of the state, and they have to match the capacity of the state at this specific historical moment. To ensure the number of claims don’t rise, we have to “reset” the labour code and [Ukraine’s] social model, which was not done during the country’s transition from socialism to a market economy. Whether this will require Ukraine leaving some forms of international agreements is a question for the executive branch, which will have to clearly define what we have funds for—and what we don’t.’ Critics have claimed that deputies in the Ukrainian parliament have used Russia’s invasion, which has displaced millions inside and outside the country, as a ‘window of opportunity’ to pass potentially controversial reforms. Before the war, Ukrainian trade unions organised protests against attempts by the ruling Servant of the People party to cut back on workplace and trade union rights. The draft reconstruction plan names ‘low loyalty of workers to the reforms’ and the ‘active position of resistance taken by trade unions’ as ‘key constraints’ on economic development.

 

Meeting of the Verkhovna Rada of Ukraine, February 23, 2022, Kyiv. Photo: Pavlo_Bagmut / Ukrinform / Future Publishing via Getty Images

 

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Any program of economic policy involves a politics. Arguing for international assistance for Ukraine in its struggle with Russia is itself a political choice. Macreconomic stabilization is anything but innocent. But, in a Keynesian spirit, I would argue that there is a difference between setting the broad parameters of macroeconomic policy, especially if it is done in the progressive spirit implied by the first three points of the CEPR program, and the kind of no-holds-barred deregulatory agenda that they tout in their program for Ukraine’s social and economic future. Furthermore, we should also insist that there is no necessary relationship between the two. As the Ukrainian advocates of deregulation are clearly aware, the deregulatory agenda involves a radical reconstruction of the post-Soviet order in their country. And they may, of course, have a point. But to conduct this kind of reconstruction under wartime conditions when the scope for public debate, strikes and opposition is limited, short-circuits democracy. Since defending democracy is part of Ukraine’s appeal this is bitterly ironic. It is also a gamble. It risks driving wedges into the national solidarity that is, if history is any guide, necessary to sustain the war. Of course, it may be the case that in the 21st-century and particularly in the post-Soviet space, the logic of politics and war is different. In any case, as a highly divisive policy it is fundamentally at odds with the image of patriotic national mobilization that Zelenskiy’s team have been so effective at communicating and which has been so appealing to much of the rest of the world. It is remarkable that such a high-profile group of international experts as the CEPR authors should choose to add their weight to such a program in the name of economic necessity.

Author: Adam Tooze

First published on AT

Translation: Maryana Matveichuk

Editing: Oleksandr Kravchuk

Cover: Kateryna Gritseva

 

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