Fears of the Incredibly Shrinking Defense Budget May Be Overblown

By Sandra I. Erwin
Here’s a defense budget nugget that should scare the bejeebers out of Pentagon contractors: If there is a 2 percent annual decrease to the defense budget’s top line for the next decade, without other changes, the acquisition budget will fall to zero.

As everyone awaits the recommendations of the debt-reduction “Super Committee,” no sector of the government contracting community is as anxious about the future as Pentagon suppliers.

The extent of the cuts to defense is still unknown. This irritates industry leaders because they see their biggest customer paralyzed by indecision, and putting off the investment planning decisions by which contractors live and die. In this defense downturn, the “bottom is not defined,” said Sean O’Keefe, CEO of EADS North America.

Compounding industry’s fears are the cataclysmic forecasts about the Pentagon’s procurement budget. The aforementioned scenario that has acquisition funds evaporating over the next decade is extreme, but not inconceivable, given the current trends. A 2 percent cut from the top line may not sound like much, and would not significantly affect the Pentagon’s operations. But it is the consensus view among budget experts that the bigger menace to procurement spending comes from within the Pentagon’s budget. Investment accounts — procurement, research and development — are being eaten alive by the budget “hogs” — personnel, operations and maintenance.

If funding for the Pentagon begins to decline in the next several years, that pressure will fall disproportionately on the acquisition budget, noted a study by the Institute for Defense Analyses. The usual noise that often is made about the importance of preserving the defense industrial base tends to fall on deaf ears if the political winds blow in favor of spending cuts. “In the past, such arguments have not been entirely successful; the biggest defense cuts have been in acquisition,” the report said.

Budget watchers will point out that this trend is nothing to panic about. This is what happens every time there is a defense downturn, and the industry should weather the storm just fine, as it has in the past. Investments inevitably take a hit because they are the most discretionary portion of the defense budget.

But even if the industrial base manages to adapt to smaller budgets, an environment of shrinking resources only means that dark days are ahead, analysts warn. Alpha Capital, a firm that advises industry investors, calculated that, based on current defense spending of about $700 billion a year, a 2 percent growth in personnel, operations and maintenance costs would result in investment spending falling below 30 percent of the defense base budget by fiscal year 2015, and the trend would continue further downward. Investment accounts have never fallen below 30 percent of total spending since 1950, according to Alpha Capital.

A shrinking procurement budget combined with rising weapons inflation — the total cost of the Pentagon’s portfolio of major weapon systems has grown by $135 billion, or 9 percent, over the past two years — only adds to the gloom and doom.

Some experts see this confluence of financial woes and shifts in spending priorities — more money for people and administrative overhead, less for weapons — leading toward the slow death of the military-industrial complex.

Retired Air Force Maj. Gen. Charlie Dunlap Jr. lamented the “declining fortunes” of the MIC. “Sophisticated weaponry does not appear to be a Pentagon priority, not withstanding the influential status supposedly enjoyed by arms makers,” Dunlap wrote in the latest issue of the journal of the American Academy of Arts & Sciences. Two decades’ worth of pay raises and costly new benefits for military personnel are all but guaranteeing there will be no money for advanced weaponry, Dunlap predicts. But he sees the dismal U.S. economy by far as the most destructive force that is “emasculating America’s military-industrial complex.”

It may be too soon to prognosticate Armageddon, however.

Industry consultant Loren Thompson of the Lexington Institute is betting that the political system has no stomach for draconian cuts to weapon systems. The credit-rating agencies and media pundits today may be caterwauling about the government borrowing $4 billion a day, but once the hysteria wanes, Congress and the White House may conclude that borrowing money — at today’s historic low rates — may be easier than making painful cuts, Thompson argued. The deficit reductions that the Super Committee is deliberating may in fact fade into oblivion just like the Simpson-Bowles debt-cutting plan. Once lawmakers, including the tea party budget hawks, see the political price they will pay for weapons cuts, they will likely back off, suggested Thompson.

The low cost of borrowing money might give weapons programs a lifeline for a few more years, but the best hope for the defense industry is that the U.S. economy recovers from the current doldrums. Even moderate growth would ease deficit fears and almost guarantee that defense spending would be spared from cuts, Thompson said.  

“Nobody should be trading defense stocks today based on current negative scenarios,” he said. There are still “too many uncertainties on how the deficit agreement will be implemented,” he said. “Once the political pressure is off, I can easily imagine this being repealed or restructured.”

And here’s another reason why a defense industry apocalypse is not here yet: Everyone in Washington is always in favor of savings in the abstract but when they see the particulars, they tend to get cold feet.

Topics: Defense Department, DOD Budget

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