Hamish McRae: Flushed with power, Russia has yet to learn how to handle its new strength

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Quite suddenly Russia has become an awkward neighbour again. The Cold War may be long past, but Russian dominance of world gas reserves, coupled with its proximity to gas-hungry Western Europe, has led to a shift of power back towards the East. There may be no threat of military invasion, just a squeeze on energy supplies, and hints that Gazprom could buy a gas retailer such as Centrica, maybe we should be thankful for that. But over the past few months the UK, along with the other EU nations, is becoming aware of just how difficult this relationship is going to be.

Step back a century. In the early years of the 20th century Russia was the fastest-growing European nation. We relied on it for our raw materials, just as we do now, though then the principal import was timber, which played a larger part in our economy than it does now. The Russian dash for growth was financed largely by European money; the string of tsarist bonds issued in London and Paris was soon to become worthless. France lost about half of its external assets when the Communists took over.

So, in one sense, Russia is back to a similar relationship with Western Europe to the one it had 100 years ago: the provider of raw materials to the more sophisticated West but also a consumer of luxury goods and other products. In another, though, the balance is slightly different, for Russia does not need Western funds - at least not at present energy prices, for it can afford to buy what it wants. But it does still need Western technology.

By that I don't just mean BMWs, flats in Kensington and other goodies favoured by the Russian elite. More important is the need for Western energy technology if Russia is to exploit its oil and gas reserves in a sustainable way. Russian oil production has yet to reach the levels of the early 1990s, following a decade of underinvestment in the chaos that followed the collapse of the Soviet Union.

Further, Russia needs to develop other sources of foreign earnings alongside energy. At present price levels, oil and gas account for about 30 per cent of the Russian economy and 70 per cent of its export earnings; they also provide about half the tax revenues. But they employ only about 3 per cent of the workforce. It is dangerous to have such an unbalanced economy for social and economic reasons. Russia is unbalanced in terms of industrial structure as well as wealth.

The trouble is, it doesn't really recognise this. So its uses its economic power in a crude way. There are specific high-profile issues, such as cutting gas supplies to Ukraine last winter. But there is also a more general malaise in that business people and officials dealing with Russia report that it is very difficult to negotiate with. BP has had a string of difficulties in its ventures there, and a former EU commissioner told me that negotiating with Russia was the most unpleasant experience he'd had in his career. The most difficult thing, I understand, is the unpredictability and stupidity: negotiators actually act against their own self-interest just to throw their weight around.

I don't see this changing. Of course, it is ridiculous to generalise but the experience in recent dealings is something we should be aware of, particularly when Russian interests seek to buy British corporations. We are going to see a lot more of that in the years to come.

There is a wider point here. The durability or otherwise of the Russian boom will help shape the EU's relations with the country. So how long will the Russian growth run last?

The best starting point here is the Goldman Sachs' Brics study, the model it constructed of prospective growth in Brazil, Russia, India and China.

You can see in the left-hand graph above the comparison with the other European countries, with Russia projected to become larger than any of the Western European economies. It will pass Germany and the UK in about 20 years' time. This will happen despite Russia's falling population and even faster fall in the size of its working age population (see centre graph). This is mainly the result of very low birth rates in Russia since the break-up of the Soviet Union (right-hand graph).

Now these are just projections: they are not what will happen, rather what is likely to happen in the absence of some other set of grand economic circumstances. Nevertheless, they deserve to be taken seriously. So for now, let's assume that Russia does indeed catch up in this way. What might that mean?

The first point to be made is that in human terms a richer Russia is much preferable to a poor one. We should wish that the Russian people are able over the next generation to move towards the sort of lifestyles that we enjoy in the West.

We should also recognise that Russia would be moving back some way towards its natural economic size. Figures for the size of Soviet Union economy were very suspect because it was a command economy: it produced goods people were forced to buy but that would not have been saleable in the marketplace.

But there is no doubt that the Russian economy contracted sharply in the early and middle 1990s, so some recovery of ground is normal and natural.

The third point is more debatable but it seems to me to be reasonable to expect prosperity to push Russia towards Western values as well as lifestyles. The issue is whether Russia is difficult now because it has felt humiliated and accordingly needs to assert itself or whether it is difficult because it is difficult. My own guess, for what it is worth, is that the scars of that searing experience of the loss both of empire and ideology are already healing at a popular level. Still it will take another generation at least before Russia is a "normal" nation.

So how should we deal with it? Common sense suggests a two-pronged approach. One would be to engage Russia as much as possible, drawing it into economic partnership where we can - and doing that despite the practical difficulties on the way. The other would be to be very careful with something so important as energy security. We need to have diversified supplies, rather than all our eggs in one (pretty ragged) basket.

Think rate rises and they may not happen

The Federal Reserve has nearly finished its increases in interest rates, the European Central Bank and the Bank of Japan are getting going, and as for the Bank of England - there is a sharpening debate as to whether the next rate move will be up or down. There are three simple stories and a complex one.

The US story is the simplest. After three years of zero or negative real interest rates (ie the Fed's key rate was lower than the rate of inflation), the Fed had to get rates back to normal. It seems that the accepted normal rate is currently 5 per cent, a nice round number that ought to be credible to the markets. Alan Greenspan's policy is being concluded by his successor Ben Bernanke, with one more increase due next month.

The question was whether this would be enough to cap the consumer boom without tipping the economy over the top. The answer seems to be yes, for though the economy grew swiftly in the first three months (at nearly 5 per cent annual rate), some easing is expected. Barring accidents, rates should come down by autumn.

The European Central Bank remains concerned about eurozone inflation, which has persisted at or above the ceiling of 2 per cent. But it has felt incapable of more than a token increase because domestic demand has been so weak. But now things have picked up as consumers in France and businesses in Germany report a better mood. Expect another increase soon.

In Japan, the economy is growing again, so the authorities can abandon their zero interest rate policy. Expect them to start increasing rates later this year.

Things are not so straightforward here. There is debate as to whether the economy will pick up later this year, in which case there will be no need to cut rates further. Indeed, the market is predicting an increase this year.

But unemployment has been creeping up and the housing market seems less buoyant now. Hardly anyone expects a change in rates this week but the week after will see the next Inflation Report, in which the Bank will have to clarify its views.

So up, down or sideways? Remember, fear of an interest rate increase can be as effective as an increase itself. If people expect rates to go up, maybe they won't have to.