By Ben Strubel of Strubel Investment Management, LLC
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The Federal Government is broke. They depend on borrowing from China and other investors to pay their bills. At least that is what we are constantly told. Both parties are proposing massive Federal budget cuts. So why would we be dumb enough to buy a defense contractor, let alone the defense contractor responsible for biggest contract the DoD has undertaken, the JSF program, that has been plagued by cost overruns.
Looking beneath the headlines, many of these risks aren’t what they first appear to be. Let’s take a look at each issue individually.
Federal Government Spending
Despite what the media and Congress might have you believe the Federal government is not broke and it most certainly does not borrow money from anyone let alone China. The US Federal government (I’m combining the Federal Government, Federal Reserve, and Treasury Dept. for ease of explanation purposes) is monetarily sovereign, that is it operates a non convertible, floating exchange rate, sole issuer currency system. The one and only entity that can issue dollars is the US Federal government. Comparisons of the Federal government to states, businesses, or households, or non-monetarily sovereign currency using nations such as Greece or Italy are flawed.
The Federal government spends money by simply marking accounts in computers up or down. It then issues T-securities to “mop up” the excess reserves in the banking system that any spending in excess of tax receipts created. Taxes do not fund the Federal government’s spending. The budget deficit is simply the amount by which the government has provided net assets to the private sector in excess of tax receipts. The national debt is therefore nothing more than an accounting identity equal to the net private sector savings. It is not some mythical burden our children need to payoff.
Federal government spending is then only constrained by two things. The first is inflation, which with unemployment over 9% is not a threat. The second is the political will to spend, which right now is the biggest sticking point. The DoD has already published its plans for reducing expenditures which, to the extent they affect defense contractors, have already been priced in to the stock. Additionally, Washington seems to have no appetite for further DoD budget reductions. Both the President and Congress have been zeroing in on Medicare, Medicaid, and Social Security for cost savings.
I realize the information about how the monetary system works is new to most people. For more information on how the Federal government spends and how the monetary system works I recommend the following links.
Articles by Warren Mosler (more in depth)
Articles by John T. Harvey on Forbes (generally shorter and easier to read)
We Spend as Much on Defense as the Next X Number of Countries Combined
In 2010 U.S. military expenditures (including the wars in Iraq and Afghanistan) were approximately $687B. Critics frequently then show how this figure is larger than the next X number of countries combined. Well, of course it is. The US military affectively subsidizes security for the Western world.
From the 2010 Quadrennial Defense Review:
“Since the United States assumed the role of a leading security provider after the end of World
War II, DoD has worked actively to build the defense capacity of allied and partner states. Doing
so has also given the U.S. Armed Forces opportunities to train with and learn from their
counterparts. These efforts further the U.S. objective of securing a peaceful and cooperative
international order. Security cooperation activities include bilateral and multilateral training and
exercises, foreign military sales (FMS) and financing (FMF), officer exchange programs,
educational opportunities at professional military schools, technical exchanges, and efforts to
assist foreign security forces in building competency and capacity. In today’s complex and
interdependent security environment, these dimensions of the U.S. defense strategy have never been more important. U.S. forces, therefore, will continue to treat the building of partners’ security capacity as an increasingly important mission.” [emphasis mine]
In plain English, “basically everyone we work with is incompetent but us.”
Additionally NATO action in Libya shows just how dependent NATO nations are on US support. It was only the US that had the capability to neutralize Libya’s integrated air defense network (assuming it was functional). The NATO coalition was also dependent on US intelligence gathering and targeting specialists, and as the war dragged on eventually dependent on US munitions stocks. (Source: Departing Secretary of Defense Gates’ comments: http://articles.latimes.com/2011/jun/10/world/la-fgw-gates-brussels-20110611)
Finally while US military expenditures are high in absolute dollars they are at low levels when put in a proper context at only 4.7% of GDP. At the height of the Vietnam War military spending reached 8% of GDP. Backing out the wars and other overseas operations the base DoD Budget was $527.9B or 3.6% of GDP.
Military Budget Overview
It is well known that the DoD is reducing its budget. What isn’t as well known is what portions of the budget are being reduced and how the cost savings are being deployed. In short the DoD is reducing manpower and restructuring to save money to invest in new weapons systems and capabilities.
The DoD base budget is broken down in to multiple categories. The categories most important to defense contractors make up what is called the Investment Account which includes Procurement and Research, Design, Testing, and Evaluation (RDT&E).
The DoD budget request for fiscal 2012 is $553B.
The proposed budget for FY2013 through FY2016 shows slowing top line growth.
(Source: DoD FY2012 Budget Request Overview http://comptroller.defense.gov/defbudget/fy2012/FY2012_Budget_Request_Overview_Book.pdf)
In order to meet these proposed budgets the DoD has undertaken a $178B cost savings program composed of $78B in reductions from the DoD and $100B of reduction from the services (Army, Navy, and Air force). The $100B the services save will be reinvested.
The DoD’s $78B in savings comes primarily from:
- DoD staff efficiencies: $54B
- Restructuring and re-pricing the JSF program: $4B
- Adjustments in economics assumptions: $14B
- Reducing ground forces in 2015-2016: $6B
The $100B reduction for the services is shown on the following table.
As we can see the items receiving the smallest budget cuts are the weapons system programs. So what is the DoD going to do with the $100B in projected savings?
$28B will be spent on “must pay” bills such as staff expenses, training, and maintenance. $70B will be invested across the three major services mainly in acquiring new weapons systems or modernizing existing weapons systems.
- Army: Modernize the M1 Abrams family of tanks, Bradley fighting vehicles, and Strykers; and expand ISR capabilities.
- Navy: Refurbish Marine equipment. Purchase more F-18 and pay for a service life extension program. Finally procure six additional ships. One LCS, one DDG-51, and four support ships.
- Air force: F-15 modernization program, more UAVs, and start the next generation bomber development program.
Additionally, defense contractors haven taken to using the tactic of scattering the work of large profitable contracts over politically important Congressional districts. No Senator or Representative wants to be the man or woman who cast a vote that cost people in their district jobs. Once programs are deeply