Wartime Economy in Ukraine Has Not Been Created Yet. Is It For The Best?

The provocation in the headline is justified. First of all, because the phrase “wartime economy” has become a kind of common place for simplified discussions about what the Ukrainian economy should look like during the war.

Indeed, what should it look like?

The answer to this question should be sought in the analysis of the three-sector Fisher-Clark economic model. According to this theory, a modern economy consists of three main sectors. The first, primary, sector is comprised of mining and agriculture. The second sector is manufacturing. The third consists of the services sector, science, education and medicine.

In the most developed creative economies, the fourth (highly developed financial, information, corporate and legal segments, etc.) and fifth (that same services sector, but based on more qualified personnel with the inclusion of elements of artificial intelligence and digital economy technologies) sectors are currently being formed.

Before the war, Ukraine had a classic three-sector economy of the post-industrial type.

In his book The Conditions of Economic Progress, Colin Clark came to the following conclusions. As per capita income grows, the relative demand (as a share of total expenditure) for primary sector products, primarily agricultural products, begins to decline.

As for industrial products, the relationship is not so linear but parabolic: the higher the per capita income, the higher the demand for industrial goods, but then it starts to decline.

As for services, the relationship is again linear, but while it is inverse with agricultural products, it is direct in the case of services: the higher the per capita income, the higher the demand for services, and it is nothing but growing.

Thus, the key task of any government in a post-industrial economy is to try to link the strategy of increasing consumer spending with a change in the economic structure – in other words, to start the engine of the third, fourth and fifth sectors of the economy on the basis of the first and second.

It resembles the upper stages in a space rocket: the higher it goes, the more such stages come into operation and then fall off until the spacecraft itself is in outer space.

However, on the eve of the war, Ukrainian governments directed all incentives in the form of subsidies towards bolstering the agricultural (first) sector of the economy. Hence, deindustrialization (shrinkage of the second sector) and sluggish development of the service sector (third sector).

In such an economic paradigm, any stimulation of effective demand only provoked an increase in the volume of imported goods, and agricultural products found markets abroad, as the domestic market was not sufficiently large. This only increased the country's dependence on external price environment and its vulnerability to global crises and war.

Post-industrial system

Every economy goes through several stages in its development, dominated by the primary sector (pre-industrial type), the secondary sector (industrial type) and the tertiary sector (post-industrial type).

In his book The Great Hope of the 20th Century, Jean Fourastié expressed this transition depending on the structure of employment of full-time workers.

In the pre-industrial type of economy, only 10% of workers are employed in the tertiary sector, in the industrial type, 20% of workers are employed in the tertiary sector, and finally, in the post-industrial type, more than 70% are employed in the services sector.

If we divide Ukraine's GDP into three sectors, we are in the post-industrial phase, as the third sector accounts for the largest share of GDP — 63.4%.

Analyzing the level of employment in the Ukrainian economy before the war (as of 2021), we can see the following: 63.5% of the population worked in the tertiary sector (trade and services), 19.2% in the secondary sector (industry and construction) and 17.2% in the primary sector (agriculture).

This is basically a standard post-industrial economic structure, but with some atrophy and simultaneous overdevelopment of certain sectors. For example, the tertiary sector is underdeveloped for the post-industrial format — its share should be 70%, but in fact it is 63.5%. The secondary sector of the economy — industry — is significantly compressed: its share should be 25%, whereas in fact it is 19.2%. And the primary sector (agriculture) is hypertrophied at 17.2%, while it should be no more than 5%.

In other words, a certain sectoral “cannibalism” has taken place: human and investment resources migrated to the agricultural sector, where high incomes could be obtained, and this happened precisely at the expense of the resources of the other two sectors of the economy.

What happened to the economies of different countries during World War II? At that time, almost all the participating countries were in the industrial phase of development, i.e. they had powerful industrial nuclei that generated most of the GDP and provided the major share of employment.

Let's take the United States as an example. This country was in the industrial phase of development. That is, the tertiary sector of the economy accounted for about 30% and the remaining 70% were industry, natural resource extraction and agriculture. But industry, the industrial core, comes first. In such a model, it doesn't matter what kind of products are produced, civilian or military. When a war breaks out, you simply shift industrial production from peaceful to military: most of the GDP and employment was generated in the industrial core and continued to be generated there. But there were all the ingredients for this: human resources, industrial capacities, experience in organizing production processes and the relevant competencies of the population and political elites.

Instead, the post-industrial economy lacks such options: most of the population is employed in the services sector, where the bulk of GDP is generated and the largest amounts of taxes are paid. To put this format of the economy on a war footing means to destroy it. That is, simultaneously destroy the tertiary sector and fail to build the secondary sector (industry). For this purpose, there are neither personnel nor ready-made industrial capacities, nor the competencies of political and business elites in organizing production processes that dominate other activities.

So what is to be done?

For obvious reasons, Russia faced a similar dilemma at the beginning of the war. But the then Russian Minister of Economy Belousov (now Minister of Defense) said that a wartime economy requires a wartime society. And in a postmodern and consumer society format, such social transformations would be destructive to the political stability of the state. After all, the wartime format of society means forced labor “for rations” and a huge coercive apparatus.

That is why Russia has a conditionally two-circuit, binary model of the economy: on the one hand, a civilian economic system that provides employment, generates GDP and taxes and, on the other hand, the military-industrial complex sector, which is financed from the revenues of the civilian economy. In particular, there is a huge flow of oil and gas revenues (which before the war were transferred to Western assets in the form of capital outflows abroad) into the military-industrial complex.

Thus, the key task is to ensure a correlation between civilian economic revenues and investments in the military-industrial complex (to create a capital flow, as in a communicating vessels). In these conditions, the more profit the civilian sector generates, the more investment goes into the military sector (not only in the military-industrial complex, but also for the maintenance of the army and contractual payments).

Ukraine's problem is that we have not yet formed this flow of civilian economic surplus to the defense sector. Almost all raw material revenues are “leaking” abroad through various schemes. According to the National Bank of Ukraine, as of 2023 alone, grain traders failed to return foreign exchange earnings to Ukraine in the amount of more than $8 billion. Moreover, starting from July 12, 2024, Ukraine extended settlement deadlines for exports of certain types of agricultural products from 90 to 120 days.

At the same time, the amount of returned foreign exchange earnings to Russia in 2023 averaged more than 90% of the total.

Thus, instead of mantras about the “wartime economy,” the Ukrainian government should work towards building an effective civilian sector, whose profits should be used for the defense sector and invested in the development of the second economic circuit — defense industry enterprises. To this end, a new fiscal mechanism should be used to transform part of the country's raw material revenues into a package of investments in the defense sector and defense industry.