In Today’s Fiscal Debate, Doubt About The Future Is the Elephant in the Room

The prevailing incertitude in the defense industry about what to expect in the coming downturn speaks to the larger financial and regulatory problems facing the nation’s economy at large.

The latest spate of gloomy economic news has produced the usual orgy of analysis, hand wringing and finger pointing. The focus has been on the puny job growth number for May — 58,000 jobs added — and the anemic 1.8 percent first-quarter GDP number. In The Wall Street Journal, Martin Feldstein pointed out that two-thirds of that growth went into inventories rather than sales. That means that real sales growth is only 0.6 percent annually or 0.15 percent quarterly — essentially no growth at all. This unhappy news is further underscored by an increase in unemployment to 9.1 percent, a drop in manufacturing, weak sales reports and lowered consumer confidence.

The situation was not helped when the chairman of the Federal Reserve admitted that monetary policy has its limitations, and held out no hope of a third round of “quantitative easing.”

Some analysts have pointed out the large financial reserves of businesses, estimated at $2 trillion, and wonder why corporations aren’t hiring and expanding.  

Much of the media’s analysis has been pretty much on target. But many pundits have continued to ignore the elephant in the room. Why isn’t the private sector showing signs that it is preparing for an economic upturn? More specifically, why aren’t small businesses, which create seven of every 10 jobs, hiring?  The entrepreneurs who create and innovate seem nowhere to be found.

The basic problem is that a business today looks at an uncertain future, especially when it comes to taxes and regulations. No business or individual today knows what the corporate and personal tax will be come 2013. Added to that is the apprehension surrounding the implementation of the latest healthcare legislation. The Wall Street Journal cited a recent survey by McKinsey & Co. in which 505 employers said they are likely to pursue alternatives to their current health insurance plan once the Patient Protection & Affordable Care Act takes effect in 2014. About 78 million people would be affected. This contradicts the president’s assurance that “if you like your healthcare, you can keep it.”

This only adds to the sense of uncertainty about the future.

Another regulatory overhang concerns the implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act. This massive legislation is not only little understood, but the final regulatory lay-down is mostly unknown. And the credit market has not yet fully recovered. The New York Times reported that businesses, lacking access to bank-provided credit, are turning to hedge funds for loans with up to 12 percent interest rates. Given the Federal Reserve rates are close to zero, this is a remarkable trend.

Other areas of concern are legion. Nobody seems to know when the Federal Reserve will start raising interest rates. It is not clear who will buy U.S. debt now that quantitative easing has ended. Further, when will the U.S. Congress pass a budget? Will inflation begin to rise again?

Most significantly for the defense industry is what areas of U.S. federal spending will have to give way in order to free funds to pay for increased interest on the U.S. debt. As debt continues to pile up, inevitably interest rates will rise. Current estimates show that interest on the debt will exceed the entire defense budget in 2020. And finally, how will the United States address the coming insolvency of Medicare and Social Security? Anyone who doesn’t believe this is a serious crisis should check out the latest trustee’s report.

Defense suppliers — and particularly the small businesses that make up the bulk of the defense-contracting sector — face additional uncertainties. A big question is how the administration will spread the $400 billion in defense cuts — $33 billion per year for 12 years beginning in 2013 — proposed by the president. Then there is the law passed during the Bush administration that would withhold 3 percent of owed revenues to any company providing products or services to any level of government (federal, state, local) against future tax obligations. In this environment, surviving would be a challenge for any business, and more so for small firms that experience chronic cash flow problems. This will put a number of companies out of business. And many of these are critical sub-tier suppliers to Defense Department prime contractors.

Reflecting the difficulties of executing these new withholding rules, the IRS has slipped the implementation to January 2013. The Congress had previously delayed the tax law from January 2011 to January 2012, but it still can’t seem to find a way to repeal what is a certain job killer in the defense industry and a loss of critical capability.

While it is a fact that sales are slow and confidence is down, the more significant question now is what is driving all this pessimism. What we know for sure is that business can’t function and consumers won’t spend without a predictable future. A more optimistic climate will not materialize until we have a rational and definitive public policy blueprint that addresses our crushing debt, crippled entitlement programs, long-range defense budgets and all those other nagging problems that are dragging the nation down.

Topics: Defense Department, DOD Budget