Category: Economics: Ch 23

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AI: benefits but catastrophic risk



Artificial intelligence (AI) has become a key technology in the 21st Century. Businesses use AI systems to analyse data, automate routine tasks, improve customer service, write software, create content and even assist with decision-making. As AI improves and becomes even more capable, governments, economists, businesses and society are debating its effects on productivity, employment and economic growth – and also its potentially extreme dangers.

Some commentators compare AI to earlier technological revolutions such as the steam engine, electricity and the Internet. They argue that AI will continue to increase productivity, create new industries and improve living standards. Others worry that AI may eliminate a large numbers of jobs, increase inequality, concentrate economic power in a few firms and, in the most extreme scenarios, pose a threat to humanity itself.

These debates raise important questions including how society should evaluate the potential risks of a technology whose benefits may be enormous but whose long-term consequences remain uncertain.

AI and the labour market

Historically, technological change has had both positive and negative effects on employment. Automation reduced the demand for many agricultural workers, while creating jobs in manufacturing. Computers automated clerical tasks but generated entirely new industries in software, telecommunications and digital services.

AI appears likely to follow a similar pattern. According to the World Economic Forum, advances in AI, robotics and information-processing technologies are expected to transform labour markets significantly during the second half of the 2020s, creating demand for new skills while reducing demand for others. The fastest-growing skills are expected to include AI and big data, technological literacy and cybersecurity.

The potential benefits

AI may benefit labour markets in several ways:

  • Higher productivity: Workers can complete tasks more quickly with AI assistance.
  • New occupations: Demand has emerged for AI engineers, prompt specialists, data scientists and AI governance professionals.
  • Better decision-making: Firms can use AI to improve forecasting, inventory management and customer service.
  • Complementing human skills: AI may perform repetitive tasks, allowing employees to focus on creativity, problem-solving and interpersonal activities.
  • Economic growth: Higher productivity can increase profits, wages and living standards over time.

Many economists argue that AI will not simply replace workers but will change the tasks they perform. Research from the OECD suggests that even highly AI-exposed occupations continue to require management, communication, collaboration and social skills that technologies struggle to replicate.

The potential costs

At the same time, AI may create significant labour-market challenges. Many white-collar occupations previously considered relatively safe from automation are becoming vulnerable. Generative AI systems can draft reports, analyse legal documents, write computer code and create marketing content. This means that some professional and administrative roles may face considerable disruption.

The World Economic Forum reports that business leaders have differing expectations about the effects of AI. In a 2026 survey (see link below), around 54 per cent expected AI to displace existing jobs, while only 24 per cent expected it to create new jobs within their organisations. Economists have identified several potential problems:

  • Structural unemployment: workers in industries that are in decline may struggle to find employment requiring their existing skills.
  • Increased income inequality: there may be a growing income disparity between highly skilled and less-skilled workers.
  • Growing market power: the largest technology firms that own the most advanced AI systems may see their market power grow further creating dominance in certain areas.
  • Regional inequalities: AI-related investment may become concentrated in particular cities and countries, exacerbating regional inequalities within and between countries.
  • Pressure on governments: to address issues of structural unemployment and increasing inequality, governments may be forced to expand retraining and social-support programmes.

AI and catastrophic risk

Most economic discussion around AI focuses on employment and productivity. However, some researchers argue that the most significant risks from AI may be much broader.

Economists distinguish between ordinary risks and catastrophic risks. Catastrophic risks involve events with a very low probability of occurring but potentially enormous consequences. Examples include nuclear accidents, pandemics and certain climate-related disasters.

AI raises similar concerns. Advanced AI systems could potentially be used to conduct cyberattacks, spread misinformation, disrupt critical infrastructure or support the development of dangerous technologies. Some researchers have even suggested that highly advanced AI systems could pose an existential risk to humanity if they become sufficiently powerful and are not properly controlled.

This became a widely discussed topic in the media in September 2026 following the resignation of an employee, Jacob Coxon, from AI firm, Anthropic. He said that people working on AI were ‘genuinely frightened’ about how quickly AI was advancing and what it might mean for the future of humanity. He said:

I believe that if we don’t slow down at the current rate of progress, there is a strong chance that we could all die in the immediate future.

Other researchers have raised similar concerns and there have since been calls from some of the biggest AI companies for regulation of AI to prevent this.

The policy debate and CBA

All of this creates a challenge for cost-benefit analysis. Suppose AI generates trillions of pounds of economic benefits. But, if there is also a very small probability of catastrophic harm, how should policymakers weigh up the two?

Traditional cost-benefit analysis values risk by multiplying the size of a potential outcome by its probability. However, this approach becomes problematic when both the probability and the consequences are highly uncertain. The risks may be extremely difficult to estimate, while the potential costs could be vast and affect future generations. For this reason, governments and firms increasingly use scenario analysis, stress testing and AI safety assessments to evaluate potential risks. These approaches attempt to prepare for extreme outcomes rather than relying solely on probability calculations.

Supporters of AI argue that technological progress has historically improved living standards and that restricting AI too heavily could reduce innovation and economic growth. Critics argue that uncertainty about potentially catastrophic outcomes justifies a more cautious approach.

The debate therefore extends beyond labour economics to the wider issue of managing catastrophic risk. As with nuclear power or climate change, policymakers must decide how much risk society is willing to accept in exchange for potentially large economic benefits.

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Questions

  1. How might AI increase productivity while also causing unemployment in some sectors? Which sectors are likely to be affected the most?
  2. Why is it difficult to estimate the costs and benefits of advanced AI?
  3. Assume that a disaster is estimated to cost society £1000 billion (£1 000 000 000 000). The chances of the disaster occurring are said to be minute, however. Estimates vary from a probability of one in a million to one in a billion. What estimate of this cost would you include in a cost–benefit analysis?
  4. Why are many low-income countries apparently prepared to accept riskier projects than are high-income ones?
  5. Discuss whether the greatest economic challenge posed by AI is (a) job displacement; (b) increased inequality; (c) market concentration and the power of large technology firms; or (d) catastrophic long-term risks.
  6. Read the article by Bill Gates, The turbulent AI era is here. The choices we make now are critical. According to him, what steps should the world take to ensure that ‘AI will be a force for good and leave everyone better off’?
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Manchesterism: will greater devolution boost economic growth and help tackle inequality?


Andy Burnham is set to become UK Prime Minister on 20 July if no-one else stands to replace Keir Starmer. In a speech on 29 June, he outlined his economic vision. Central to this is devolution, where a greater number of economic decisions would be taken locally rather than by central government. This approach has been dubbed ‘Manchesterism’, in reference to his time as Mayor of Greater Manchester from 2017 to earlier this year. Under his mayoralty, Greater Manchester (GM) achieved faster economic growth than other regions or cities in the UK. From 2017 to 2023, GM’s gross value added grew by an average of 6.6% per annum and the city of Manchester’s by 8.4% – the highest of any city in the UK. The UK average was 4.9% and London’s was 4.6%.

The UK, especially England, is one of the least devolved of the OECD countries. One aspect of this is taxation. The chart shows local taxes and, in the case of federal countries, state/regional/provincial taxes too. (Click here for a PowerPoint.)

Only 4.9% of UK tax revenue is in the form of local taxes (council tax and 50% of business rates) and the amount that can be raised in council tax is capped by the central government. The remainder of UK tax revenue goes to central government in the form of income taxes, social security taxes (national insurance), VAT, excise duties, etc. This compares with an average of 7.1% local taxes and 24.5% local plus regional taxes across the 17 OECD countries shown in the chart.

Andy Burnham plans to shift some of the spending and tax-raising powers from Whitehall to metro mayors and local councils. The aim is to stimulate productivity and economic growth at a regional and local level by tailoring support and incentives to local needs and strengths. Local leaders will be best positioned to understand these needs and strengths and will be able to customise spending and support appropriately.

Examples of the types of greater autonomy over decision making would include:

  • Control over adult education budgets to allow them to be tailored to provide training and apprenticeships to meet the skills requirements of existing and emerging industries in the area;
  • Forming partnerships with local universities to support research and development that complements regional economic growth;
  • Providing greater funding for and control over local transport infrastructure, including roads, buses, trams, trains, etc., with local consultation to make them fit for the local population and businesses;
  • Tailoring business incentives to local needs and to the needs of the businesses themselves so as to attract an increase in investment;
  • Greatly expanding council house building, which has virtually dried up in recent years, with mayors and/or local authorities empowered to develop local housing strategies, including affordable housing programmes, and to direct housing investment funding to particular housing developments in areas of greatest need.

Andy Burnham has pledged to stick to the government’s two existing fiscal rules:
a) The Stability Rule (Fiscal Mandate): the current (day-to-day) budget must be in balance or surplus. In other words the provision of salaries, public services, state pensions, welfare, etc. must be covered by government revenues (largely taxation). The government should borrow only to fund long-term investment.
b) The Debt Rule (Stock Mandate): each year, public-sector net financial liabilities (PSNFL) must be forecast by the OBR to be falling as a share of GDP compared to the previous year in three years’ time. This acts as a break on the amount of borrowing for long-term investment.

It is likely, therefore, that there will be little extra government money for investment. Rather, the policy involves a redistribution of public-sector investment from central government to mayoral/local authorities.

In theory, such a policy of devolution need not see a redistribution from richer to poorer regions, but that might be part of the policy when the details are published. The UK has a bigger gap in productivity (GDP per worker) between its capital city and other large cities than in do other countries. Birmingham, Sheffield, Leeds, Newcastle, etc., as well as Cardiff, Glasgow, Edinburgh and Belfast, lag further behind London in output per head and economic growth than do other European countries lag behind their capital city. Thus the gap between Paris and Lyon, Toulouse and Marseille is narrower; as is that between Belin and Munich, Hamburg and Frankfurt. It is a similar picture in Spain and Italy. In the USA, some cities, such as San Francisco, outperform Washington DC and New York. A redistribution of government funding from London to the regions could see their incomes rise faster without having too much impact on London, which would still continue to attract large amounts of private investment.

Overall, there would be little increase in government funding. ‘Manchesterism’ is not, therefore, a demand-side policy. It is a supply-side policy – directing funds to areas where, combined with local incentives and local knowledge, the funding could yield greater returns and thereby increase potential GDP.

But this is not to say that there is no effect on aggregate demand. The hope is that devolution along the lines outlined by Andy Burnham will attract increased private investment, thereby increasing actual GDP as well as further increasing potential GDP.

We wait to see the details over the coming weeks.

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Questions

  1. Use an aggregate demand and supply diagram (simple or dynamic) to illustrate the effects on real GDP of a successful devolution strategy.
  2. Find out the details of the last Conservative government’s ‘levelling up’ policy. Was it similar in aims to that of ‘Manchesterism’?
  3. How could a policy of devolution as outlined by Andy Burnham affect income distribution within regions?
  4. Find out about the approach to regional policy in the EU. Is it similar to that being advocated by Andy Burnham?
  5. What is meant by ‘regional multipliers’? Why might they differ from the national multiplier?
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Supply shocks – long-term gain from the short-term pain?

The world has suffered from a number of adverse supply shocks in recent years. First there was the credit supply shock of 2007–9 that led to a default on mortgages, a collapse in confidence in the banking system, the drying up of the inter-bank market, the freezing of lending and a global economic contraction. Then there was the COVID-19 pandemic. This shock to the the global economy led to a a fall in output and breaks in supply chains. As recovery took place, supply-side difficulties led to a surge in inflation.

Then there was the Russian invasion of Ukraine. This shock to energy and grain supplies led to rises in fuel and food prices: a cost-push inflationary shock. More recently, the closing of the Strait of Hormuz has cut off an important supply route and again sent fuel and other other prices rising.

These supply-side shocks create a dilemma for central banks. They push up inflation, but push output and employment down – a situation of ‘stagflation’.

This can be illustrated with a simple aggregate demand and supply diagram. The shock shifts the aggregate supply curve upwards to the left, illustrated by the move from SRAS1 to SRAS2. The price level rises to P2 and GDP falls to Y2.

But central bank policy is designed to affect aggregate demand, not aggregate supply. If it raises interest rates, aggregate demand will shift to the left. The price level will fall (or at least the rate of inflation will fall), but output will fall further. If it cuts interest rates, aggregate demand will shift to the right. This will help to curtail, or even reverse, the fall in GDP, but will lead to even higher prices.

For countries where their central bank has a simple inflation mandate (e.g. keeping inflation close to 2%), sticking to this target in the short term would result in higher interest rates, lower economic growth and higher unemployment – and possibly even a recession. In such cases, central banks tend to project forward beyond the short-term shock and set interest rates to target inflation in a few months’ time. Indeed, many central banks do explicitly target inflation in the medium term (1 or 2 years) rather than the short term.

Central banks, such as the US Federal Reserve Bank, which have a dual mandate of targeting inflation but also maximising employment, the trade-off between these two objectives can be stark. Getting the inflation down requires a higher rate of interest; maximising employment in the face of an adverse supply shock requires a lower rate of interest.

The short-term economic costs, let alone the human costs if the shock involves a war, can be great. People may suffer extreme hardship. The cost to the US Treasury of the first six weeks of the Iran war were estimated by the Pentagon to be some $29bn1 – which translates into higher taxes for US residents, lower government spending on non-war related items, higher government borrowing or some combination of the three. Other estimates put the cost to the US taxpayer as much higher – up to $1 trillion over the longer term.2 Then there are the costs to consumers of higher fuel and other prices, estimated at around $410 per month.3

The costs to Iranian citizens will be much higher in terms of war damage and loss of livelihood, let alone the suffering and loss of life. Then there are the costs to the rest of the world from higher prices of fuel, fertilisers and various industrial materials that are normally shipped through the Strait of Hormuz.

Long-term economic gain?

Supply shocks often expose economic vulnerabilities that can later be addressed, making supply chains more diverse and more resilient. They can give a boost to alternative technologies, such as a switch from fossil-fuels to green energy.

After the 2007–9 financial crisis, banking systems were made more robust under the Basel III system. Capital and liquidity requirements were increased and bank leverage was decreased. Many countries, such as the UK, introduced ‘ringfencing’ to separate retail banking from the riskier investment banking. This increased confidence in the banking system.

The COVID-19 pandemic gave a boost to working remotely and the establishment of more flexible work patterns. What was a necessity during lockdowns, was seen as an effective model by many companies. Fully remote or hybrid working became commonplace for many jobs that were previously done in the office. Time has allowed employers to find the best balance of in-office and remote working, with the optimum balance often varying by type of job being performed.

The rising price of oil and gas following the Russian invasion of Ukraine in February 2022, saw many countries that had been reliant on imports from Russia, accelerating their efforts to switch to renewable energy. Supply chains were re-examined and there was a move towards ‘re-shoring’, ‘near-shoring’, or ‘friend-shoring’: that is, obtaining supplies from countries that are nearer and/or more reliable as trading partners.

This approach was further boosted by the extensive tariffs imposed by the Trump second administration. One of the responses to the higher tariffs was to seek markets, both for exports and imports, away from the USA. To the extent that there is ‘re-shoring’ (substituting exports and imports for production and consumption within the country), then this amounts to deglobalisation. If this represents a move from low-cost to high-cost production and is contrary to the law of comparative advantage, then there will be a net economic loss. If, however, the reduction in risk of disruption and the boost to domestic industries allows a reduction in costs, there could be a net gain.

The most recent example of the Iran war has led many countries to reconsider sources of supply and to make their supply chains more robust and less risky. Gulf countries are considering expanding their pipeline network to avoid the Strait of Hormuz. For other countries, it is providing a further boost to green energy. Increased investment in the renewable sector will help to bring down costs and make countries less vulnerable to future conflicts involving oil-producing countries or sea passages.

To summarise: if initially adverse supply-side shocks cause a diversification and strengthening of supply chains, a diversification of energy sources, accelerated technological innovation and the adoption of new more efficient techniques, the long-term supply-side effects could be positive. Pain today for gain tomorrow?

But the short run comes before the long run and today’s costs are real and mounting. A shock may stimulate a positive response, but the current shock is persisting, and forecasts are getting more dire by the day. And even when the Iran war is over, there may be more shocks around the corner – ‘unknown unknowns’. As Keynes said: ‘In the long run we’re all dead’.

References

  1. Pentagon’s estimate for Iran war grows to $29B

    2. Politico, Mark Sweney (12/5/26)

  2. World Politics The Iran war could cost the American taxpayer $1 trillion, says Harvard academic

    3. CNBC, Joseph Wilkins (14/4/26)

  3. The Economic Costs of the Iran War

    4. American Enterprise Institute, Roger Pielke Jr. (2/4/26)

Articles

Questions

  1. What policies have central banks pursued during the Iran war?
  2. Paint an optimistic scenario for the global economy five years hence.
  3. Paint a pessimistic scenario for the global economy five years hence.
  4. Compare the sources of supply of oil and gas for Europe directly prior to the Iran war with those directly prior to the Russian invasion of Ukraine.
  5. Compare the relative merits of globalisation and deglobalisation. Does this depend on the nature of globalisation and deglobalisation?
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Youth unemployment and the post-pandemic peak

Unemployment in the UK reached its highest level in nearly five years at the close of 2025, according to new data from the Office for National Statistics. Figures show the unemployment rate rising to 5.2% in the three months to December, up slightly from 5.1% in the preceding quarter.

This marks the highest unemployment level since the pandemic, coinciding with a slowdown in wage growth and increasing speculation that interest rates may soon be lowered.

Youth unemployment

However, young people are taking the heaviest hit, with unemployment climbing to 16.1% among those aged 16 to 24. (Click here for a PowerPoint of the chart.) This is the highest level in more than a decade, including the spike seen during the pandemic. Economists largely attribute this trend to rising payroll costs, which they say are discouraging employers from offering entry level roles. Long-term youth unemployment is also worsening, with recent data showing that a growing share of unemployed young people have been out of work for over 12 months, highlighting deeper and more persistent barriers to re entry.

At the same time, although wages for those in work continue to grow faster than prices, the pace of wage growth is steadily slowing, adding further pressure on young people already facing the most challenging labour market conditions in years. According to ONS data, the annual growth in average weekly wages, excluding bonuses, slowed to 4.2% in the last three months of 2025. Private-sector wage growth eased to 3.4%, bringing it closer to the 3.25% rate that the Bank of England believes is consistent with its 2% inflation target.

The impact on interest rates

The Bank of England is watching the slowdown in the UK jobs market closely as it gauges when next to lower its interest rates. In February 2026, the Monetary Policy Committee voted to hold the base rate (Bank Rate) at 3.75%. However, the committee voted with a majority of 5-4, with four members voting to reduce the rate to 3.5%.

The Bank of England uses interest rates as a policy tool to control inflation, the rate at which general prices rise in the economy. The current rate of inflation of 3.4% is above the Bank of England’s target of 2%.

In addition to the split vote, some economists believe that the easing in pay growth makes it likely that Bank Rate will be cut at the next meeting on 19th March. Paul Dales, chief UK economist at Capital Economics, said the fall in wage growth ‘supports the idea that the Bank of England has at least a couple more interest rate cuts in its locker’. A decrease in interest rates will be welcomed by investors.

What is behind the increase in youth unemployment?

Young people always tend to be the most impacted by a downturn in hiring. But economists warned that the rise in youth unemployment was a sign that employers are being more cautious about hiring younger workers. Openings for low-skilled entry-level roles and for new graduates have dropped steeply. Many businesses have slowed hiring due to an increase in costs because of measures in Chancellor Rachel Reeves’s last two Budgets. Businesses claim that the combination of increases in employer National Insurance contributions and a rise in the minimum wage mean they are facing higher payroll costs.

Peter Dixon at the National Institute for Economic and Social Research said, ‘there are indications that younger workers in particular are being priced out of the market’, supporting the explanation that raising the minimum wage might also be disincentivising the hiring of young people.

The ONS reported that the retail and wholesale sector saw the biggest fall in the number of workers on company payrolls, with 65,000 jobs lost in the sector since January last year. Meanwhile, health and social work saw the biggest rise in payrolled workers of any sector, adding 39,000 jobs in the year to January. Financial analyst at AJ Bell, Danni Hewson, suggested that those leaving the retail sector were now entering healthcare, with both sectors employing large numbers of women. However, she also warned that a recent surge in investment in artificial intelligence could hit young people the hardest as it could result ‘in a scarcity of entry level posts’ (see the blog Will AI make the world less equal?.

Job vacancies

Job vacancy data across the UK indicates a significant cooling in labour demand. According to the latest ONS figures, vacancies fell from 736,000 in the three months to December to 726,000 in January, signalling continued weakening in hiring activity. According to the job search site, Adzuna, the number of vacant positions has dropped to its lowest level in five years, with job listings sliding 3% in January to 695,000, marking the first time vacancies have dipped below 700,000 since early 2021. Notably, graduate opportunities have fallen below 10,000 for the first time since Adzuna started tracking in 2016, underscoring the deepening challenges for new entrants to the workforce.

This downward trend in job openings extends patterns seen throughout late 2025, with vacancies down 16% from the previous January and nearly 20% lower than six months earlier. This coincides with a rise in unemployment to 5.2%, slower wage growth, and a growing concern that young people are disproportionately affected as hiring slows. As opportunities shrink, competition has intensified: there are now 2.4 jobseekers per vacancy, up from 2.27 in December, with the most sought-after roles including warehouse staff, healthcare support workers, lorry drivers, labourers and kitchen assistants.

How can the situation be improved?

Pat McFadden, Secretary for Work and Pensions, has commissioned the former Health Secretary Alan Milburn to lead a review into the causes of rising youth inactivity. There will be a particular focus on mental health issues that are pushing young people out of education and employment. This initiative responds to the growing number of young people not in education, employment, or training (NEETs), many of whom are now classified as inactive rather than unemployed. Some receive health-related benefits and are therefore not required to look for work, while others fall outside the benefits system entirely, making them harder to identify and support.

However, Pat McFadden said there was ‘more to do to get people into jobs’, and that tackling youth unemployment is a key government priority. He added that Labour was working to make it easier for young people to find and secure an apprenticeship, supported by a wider package of reforms. The reforms announced by McFadden include creating 50,000 additional apprenticeships. The government will also expand support for 350,000 people to move into work or training in sectors such as care and construction, with the risk of losing benefits if they refuse. They also include the provision of 55,000 state-funded, six-month work placements for the long-term unemployed.

While these measures are widely seen as necessary, campaign groups argue the government should go further by extending its ‘Youth Guarantee’ to cover all young people up to age 24, rather than ending at 22.

However, as Alice Martin, head of research at Lancaster University’s Work Foundation, notes, initiatives designed to help people return to the labour market have limited impact ‘if the jobs aren’t out there.’ Even graduates are finding that opportunities are scarce, and for those leaving education with few qualifications, the situation is even more challenging. Sectors such as retail, once a reliable source of first jobs, have been in long-term structural decline, a trend that is now accelerating and further narrowing the pathways available to young people entering the workforce.

The situation has prompted government discussions about postponing the planned rise in the minimum wage for 18- to 20-year-olds to address employers’ concerns and encourage more youth employment. However, on Wednesday, Keir Starmer stressed that Labour remains committed to its manifesto pledge to align the pay of younger workers with that of older employees. The Prime Minister confirmed that the promise to ‘remove the discriminatory age bands’ in the minimum wage system still stands, and that the increase scheduled for April will proceed as planned.

Starmer said ‘We’ve made commitments to young people in our manifesto, and we will keep to those commitments, including the commitment that we would make sure that the living wage and minimum wage will go up this April, which we can absolutely confirm to you will happen.’

Unemployment outlook

Multiple economic forecasts predict that unemployment will to continue to rise in 2026. The most frequently cited projection places the 2026 unemployment rate around 5.2%–5.5%. However, some economists expect businesses to regain confidence and begin hiring again later in the year, supporting a gradual stabilisation in job markets.

Yet risks remain significant: if that recovery fails to materialise, unemployment could edge toward 6% by the end of the year, with forecasts from JP Morgan suggesting unemployment may reach 2 million in the first half as firms delay recruitment following the recent rise in the employers’ National Insurance rate. This environment is proving especially challenging for young people, with early career opportunities among the first to disappear and delayed entry into work potentially limiting long-term earnings and progression.

As hiring becomes more cautious and entry-level roles tighten, the path into the labour market risks becoming narrower, underscoring the need for policies and conditions that support both employer confidence and opportunities for new entrants.

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Questions

  1. Explain why youth unemployment has risen more sharply than overall unemployment at the end of 2025.
  2. What are the costs to the individual of being unemployed?
  3. What are the wider non-monetary costs to society?
  4. Explain the main financial costs to the wider economy of a rising unemployment rate.
  5. Assess the likely impact of slowing wage growth on the Bank of England’s decision about whether or not to cut interest rates in early 2026.
  6. Discuss how falling job vacancies, particularly graduate and entry‑level opportunities, might affect long‑term labour market outcomes for young people.
  7. Evaluate the effectiveness of government policies such as expanding apprenticeships, increasing work placements, and reviewing youth inactivity in reducing youth unemployment.
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The Russian economy after four years of war

At the fourth anniversary of Russia’s invasion of Ukraine, we look at the effect of the war on the Russian economy. Two years ago, in the blog The Russian economy after two years of war, we argued that the Russian economy had seemingly weathered the war successfully.

Unlike Ukraine, very little of its infrastructure had been destroyed; it had started the war with a current account balance of payments surplus, a budget surplus and a low general government debt-to-GDP ratio; it had achieved a lot of success in diverting its exports, including oil, away from countries imposing sanctions to countries such as China and India; it was the same with imports, with China especially becoming a major suppliers of machinery, components and vehicles; it has a strong central bank, which engenders a high level of confidence in managing inflation; the military expenditure provided a Keynesian boost to the economy, with production and employment rising.

The situation today

But two years further on, the Russian economy is looking a lot weaker and on the verge of recession. GDP growth fell to 0.6 per cent in 2025 and is forecast to be no more than 1 per cent for the next two years. (Click here for a PowerPoint of the chart.) And despite growth still being positive (just), this is largely because of the growth in military expenditure. Retail and wholesale trade fell by 1.1% in 2025, reflecting supply chain problems and high inflation dampening consumer demand.

With labour being diverted into the armaments and allied industries or into the armed forces, this has led to labour shortages. This has been compounded by the emigration of up to 1 million people by 2025 – often young, educated and skilled professionals.

Official CPI inflation averaged 8.7 per cent in 2025, although the prices of food and other consumer essentials rose by more, especially in recent months. At the beginning of 2026, supermarket prices rose by 2.3% in just one month, made worse by a rise in VAT from 20% to 22%. The central bank has responded to the high inflation with high interest rates, which averaged 19.2% in 2025, giving a real rate of 10.5%. With such a high real rate, the response of households has been to save. This has masked the constraints on production, or imports, of consumer goods. Savings have also been boosted by large payments to soldiers and bereaved families, with the money saved by the recipients being used in part to fund future such payments. So far there has been trust in the banking system, but if that trust waned and people starting making large withdrawals of savings, it could be seriously destabilising.

Whilst the high real interest rates have helped to mask shortages of consumer goods, they have had a seriously dampening effect on investment by domestic companies. Gross capital formation fell by 3% in 2025, not helped by an increase in the corporation tax from 20% to 25%. At the same time, foreign direct investment remains subdued due to high perceived risks. The lack of investment, plus the labour shortages, will have profound effects on the supply side of the economy, with potential output in the non-military sector likely to decline over the medium term.

The balance of payments and government finances are turning less favourable. The balance of trade surplus has declined from US$173bn in 2021 to US$67bn in 2025. This could decline further, or even become a deficit, if oil prices continue to be weak, if Western sanctions are tightened (such as stopping the flow of Russian oil exports in the ‘shadow’ fleet of tankers) or if major importing countries stop buying Russian oil. Indian refiners have announced that they are not taking Russian crude in March/April as India seeks to finalise a trade deal with the USA.

The budget balance has moved from a small surplus of 0.8% of GDP in 2021 to a deficit of 2.9% in 2025. Although the government debt-to-GDP ratio remains low by international standards at 23.1% of GDP in 2025, this was up from 16.5% in 2021 and is set to rise further as budget deficits deepen. Nevertheless, as long as the saving rate remains high, the debt can be serviced by domestic bond purchase.

Russia’s economy is definitely weakening and labour shortages and low investment will create major problems for the future. But whether this deterioration will be enough to change Russia’s stance on the war in Ukraine remains to be seen.

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Questions

  1. What constraints are there currently on the supply side of the Russian economy?
  2. Some economists have argued that the economic effects of a stalemate in the Ukraine war would suit the Russian leadership more than peace or victory. Why might this be so?
  3. Under what circumstances might a deep recession in Russia be more likely than stagnation?
  4. In what ways does Russia’s current financial system resemble a pyramid scheme?
  5. What cannot a Keynesian boost contunue to support the Russian economy indefinitely?