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Aerospace and Defense Channel

Defense Spending and the Looming Fiscal Cliff - A Three-way Heavyweight Fight Between Taxes, Entitlements and Defense

Can we make the right choices to fund our military in the midst of the fiscal challenges our nation faces?

December 11, 2012
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The Fiscal Endgame  
Are we approaching a national disaster for our future Military Budgets, or is there a chance that an acceptable compromise is still possible to “avoid the unavoidable” – the mindless cuts of across the board sequestration? With all the arguments and positioning being played out in the media, and all sides weighing in with their views and predictions-- is there any real hope for a solution? Have we all forgotten that this is about something very serious—about our National Security Strategy and defending our Nation?  It’s about protecting our people from those who would do us harm. While people on all sides of the debate are busy wrapping themselves up in knots with heightened rhetoric about Defense policy, protecting their programs, and all of this is ongoing against a backdrop of deep spending cuts.  Our enemies are not standing still. There are real threats and security concerns which need to be faced now by our military forces.  This includes Ballistic Missiles from North Korea, Iran's Nuclear Program, Hezbollah rockets from Gaza fired into Israel, and the instability concerns of the fledgling government in Egypt. The civil war and chaos in Syria is alarming to the U.S. population. And with the new concerns about Assad potentially using chemical weapons against his own citizens, the stakes are dramatically raised and that issue threatens the security of the entire Middle East.

The U.S. clearly needs to be engaged on the world stage as a leader among nations, not seen as someone who can't seem to get their act together when confronted with economic concerns. Can we break out of our “dug in” defense budget positions and the “analysis paralysis” that accompanies it—and do the right thing? Or will the self inflicted wounds of sequestration and political bickering slow us down and possibly impede us? I have written extensively in this column about all the details surrounding this debate for many months, and have done several “deep dive analysis” pieces on what's really behind the headlines, on the so called “game within the game”. What can we do? Now, the clock is starting to run out, it's late in the game, and we are in the red zone—and we are poised to act. We are in the endgame. 

In this article we will do a quick refresh on the latest issues influencing matters, and try to frame the endgame debate which will occur over the next few weeks.  Hopefully, we can offer some insight for the leadership of companies in the microwave industry and help them plot their own course in the turbulent defense marketplace. We will identify the most recent factors that have surfaced that effect the debate and help all understand the situation we are facing.  We are all key stakeholders in this matter and are part of the Defense Industrial base. Indeed, our financial future is inexorably tied to these budgetary matters and how they are decided. It is time for America—our elected leadership, our Military and our citizens-- to stand tall, or stand down on the future of Defense Spending.

Defense Spending Cuts—The Funding Engine for Social Programs or Defense Priorities
The threat of the “fiscal cliff” presents a unique opportunity to tackle a large number of vexing problems in possibly some new and innovative ways. By preventing these blind sequestration cuts, our country's leadership—the President, House, Senate and Pentagon—can begin to address our conundrum of the national debt, rising annual spending, annual budget deficits, our economic woes and our national security funding in a truly game changing way. Our military and foreign policy leaders have been very outspoken about America's economic strength as the underpinning of our National Security Strategy. Joint Chiefs Chairman General Martin Dempsey has recently said, “It makes no sense at all for us to have an extraordinarily capable military instrument of power if we are economically disadvantaged around the world. The fight that matters most is the one in the global economy and for the “dominant narrative,” not the one on the battlefield.”  Wow. If our elected officials are looking for a smart and balanced solution by the end of this month, most believe they need to look at the entire framework of our economy.  It has been said the enduring peace, economic prosperity, and national security is far more than tanks on the ground, ships at sea, or planes in the air. So the debate is being framed—a balanced U.S. budget that makes smart, targeted reductions that could strengthen both our economic foundation and increase our global position in the world. Yes, less money for Defense in total, but enough money for the Defense that we need. What this means is that the DoD will be prioritizing our defense investments in capabilities and programs that support our defined military objectives. These were called out in the recent DoD Defense Strategy (the so called pivot to the Pacific Theater) and the DoD S&T Investment Priorities.

The sobering reality is that, unlike the past where funds were easily obtained for most good ideas, it will not be the same going forward. The U.S. Military cannot be all things, to all people, on all matters. We can't cover all our perceived weaknesses, and address every peace and security challenges in a globalizing world.  There is not enough money to do that. It is believed that we must create a sustainable economy, with low unemployment, for all of our citizens, who are part of an increasingly globalized networked world. However, there will be some real disconnects when Defense budgets are slashed for “non essential programs.” One person's non essential program is another person's essential program. Constituencies develop around such things, and hence the contentiousness of the debate on cuts will increase. And the rancor that will surround the proposed Defense cuts will be deep. There is a feeling in the U.S. that we have done a lot of nation-building abroad, and most Americans believe it’s time we did some here at home. So the pressure to redirect Defense funds for social programs is great. Some believe the "fiscal cliff" is an opportunity finally to rethink and reset our Cold War approach to foreign policy and national security. Others think it is a battle to hold on to what we have and don’t give an inch.

Aerospace Industry Associations Views
The leading defense and aerospace industries trade group is predicting growth in 2013 despite the threat of across-the-board cuts to the Pentagon’s budget. The Aerospace Industries Association’s (AIA) prediction of $6 billion in additional sales in 2013 doesn’t take into account the $55 billion in defense cuts set to take place next year if Congress doesn’t act. “There’s good news for 2013 — yes, that may surprise you,” AIA CEO Marion Blakey said in a recent speech to industry officials. “Yes, I’m sure some of you are wondering, 'Did she factor in sequestration?'” Blakey said. “No, folks, I didn’t. I’m an optimist, and we have to prevail.”  With only a few weeks to go before the across-the-board cuts take effect, the defense industry’s fate remains very much up in the air. For more than a year, AIA has lobbied the Congress to stop the sequestration cuts. AIA has published studies showing more than 2 million jobs could be eliminated, with great harm to our National Security interests if this happens. In addition, there is great fear of the U.S. losing its technological advantage with these cuts. Democrats and Republicans on Capitol Hill generally agree that crippling defense cuts should not be enacted but the two sides have been unable to reach a deal to prevent them because of disagreements over taxes and entitlements. Blakey has been quoted as kidding Washington lawmakers for putting sequestration on the table in the first place, asking what message it sent to the world about the U.S. commitment to national security. “The fact that the world’s arsenal of democracy has been relegated to the status of a political bargaining chip is difficult to fathom,” Blakey said. Even if sequestration is avoided, the Pentagon is likely to be asked to accept some spending cuts as part of a deal. Defense was not mentioned in Speaker of the House John Bayner/Republicans’ fiscal-cliff recent offer to the White House. But there was $300 billion in additional discretionary cuts included, without explaining how much might come out of the Pentagon. Even lawmakers who are the biggest defenders of a robust military have acknowledged more cuts could be on the way. Sen. Lindsey Graham (R-SC) who said before the election he would not go beyond the $487 billion already cut from the Pentagon softened his position, saying “Potentially yes, but not a trillion dollars.”

DoD Prepares for Sequestration
The White House last week has finally ordered officials at the Pentagon to begin planning for the budget cuts from sequestration. I guess they just woke up from a long winters nap. Officials from the Office of Management and Budget directed DoD leadership to start assembling a framework to deal with the $500 billion in automatic defense cuts that will begin next year, and extend for the next 10 years, unless Congress passes legislation to stop them. The DoD admits it is flying by the seat of their pants in uncharted airspace on a lot of this, as they really don't have a lot of specifics on which to base their plans. DoD has not identified any specifics on programs or personnel actions. The planning effort that is being undertaken represents a major break from the Pentagon's policy to not take any action in response to the sequestration threat. In September, DoD officials constantly were saying that they had not taken sequestration into account when planning for the department's upcoming budget proposal for fiscal year 2014 and President Obama has said that the cuts, which were set in motion by the debt-ceiling deal last year, should not happen. When asked in September whether department officials had considered drafting two budgets, one reflecting normal Pentagon expenditures and another reflecting the fiscal impact of sequestration, the answer from DoD was an emphatic no.  But with less than a month to go before the massive budget cuts go into effect, the White House's decision to order DoD to begin the planning process does not bode well for efforts on Capitol Hill to come up with a plan to somehow avoid sequestration.

The defense industry has lobbied tirelessly this year to prevent sequestration from taking effect, but is running out of time to prevent the first installment of the cuts, around $55 billion at the Pentagon, from being triggered on Jan. 3, 2013.  Most industry people believe that we likely will not get a grand bargain in the next few weeks, and (frustratingly so) there really wasn’t a good reason that  the White House and Congress could  come together and draft the plans and framework to stop sequestration.  There is a widely held belief in Industry that Congress needs to act to meet their obligations to the American people, to restore fiscal order to the country and global financial markets, and alleviate the uncertainty in the defense sector about military spending, cuts and contracts.

Senate/House Pass Defense Authorization Bills
The Senate last week passed the $631 billion defense authorization bill, moving it one big step closer to getting signed into law. It even was passed unanimously, 98-0; so much for partisan bickering on the Authorized spending levels. Senate Armed Services Committee Chairman Carl Levin (D-MI) was quoted as saying it was only the second time in 51 years that the Defense bill received a unanimous Senate vote, a sign that the bill did not have any overarching divisive policy issues that would move lawmakers to vote against the bill. The $631 billion bill was approved with $230 million less than President Obama’s budget request, and the Senate’s bill is about $3 billion under the House version. So there is still a lot of money in the Pentagon’s Budget for FY 2013. If sequestration were to happen its effect on the DoD Top Line would be around 9%, or $50 billion, with overall spending just under $600 billion. That still is a lot of money to be spent on National Defense.

Industry Leaders Speak Out
Leading defense-industry executives are bearing down on Republicans to accept tax increases as part of a “fiscal cliff” deal to prevent sequestration, as it is clear that Democrats will not agree to any deal to avoid the “fiscal cliff”. David Langstaff, the CEO of The Analytic Sciences Corp. (TASC), recently said "the resistance that some Republicans are showing to tax increases is “just nonsense.” They have to be on the table,"   Defense company executives have expressed frustration at being pushed aside in the deficit talks between President Obama and congressional leaders, where attention has centered on the fate of the Bush-era tax rates that are set to expire in January.

Taking a hard line on revenue could help the defense companies get off the sidelines as they try to steer the debate back to the $500 billion cut slated to hit the Pentagon from sequestration. Defense company leaders have been reported to have met regularly and frequently with Republican lawmakers about the fiscal cliff and urged them to accept tax increases. A lot of people in the defense business community are taking a pragmatic approach, in their efforts to forge a deal.  The willingness on the part of defense-sector leaders to back tax increases in order to avert sequestration should provide centrist lawmakers enough political space to get a deal done. Critics of military spending say the embrace of higher revenues highlights the defense sector’s weak bargaining position in the fiscal-cliff talks. The whole fiscal cliff has been characterized as a three-way heavyweight fight between taxes, entitlements and defense. And it is widely believed that the Pentagon is actually the lighter of those three heavyweights. The electoral implications are more significant for the tax-hike crowd than cuts to Pentagon spending. There are some divisions within the defense industry about whether tax rate increases in a debt deal would be acceptable. Some smaller defense firms oppose increasing the individual rates, and say industry giants Lockheed Martin and Pratt & Whitney don’t speak for them when they call for higher revenue in a deficit deal. Business leaders believe that the negotiations over sequestration should include comprehensive tax reform for corporations and individuals.  But as the clock continues to run out on a possible sequestration deal, defense-sector leaders have begun to manage expectations about what Congress can actually get accomplished before January. 

Defense Critics Weigh In on the Debate
As the defense industry wages an uphill fight to protect defense spending in the fiscal cliff talks, critics of Pentagon spending see more cuts on the horizon. Advocates on the left side of the political spectrum who want a leaner defense budget have sounded a renewed sense of optimism that more cuts were coming, whether sequestration happened or not. Northrop Grumman CEO Wes Bush has been quoted as saying that the defense industry is “not a jobs program, it’s about defending our Nation.” DoD Contractors have engaged in a very public, very expensive campaign to convince voters that the sequestration defense cuts would lead to more than 1 million in job losses. It has been said that the Defense industry was playing more like defense than offense in the fiscal cliff talks, and that it had acknowledged cuts were coming. Now executives are trying to keep that number they quote as small as possible. Defense industry and defense-minded lawmakers are very concerned that they are being crowded out of the fiscal cliff debate, because it’s mostly focused on tax rates and entitlements, despite there being $500 billion in Pentagon dollars at stake through sequestration. While the defense spending critics acknowledged that the mechanism of sequester was not good policy, they endorsed the level of cuts to the Defense Department, and suggested there would be future “bites at the apple” after the sequester fight. The industry, however, is making a push for a fiscal cliff deal that does away with the sequestration cuts. 

Threats to U.S. National Security
There are real concerns around the world that threaten our National Security interests, and we need to have in place a strong military presence and credible deterrent to potential adversaries. To have an uncertain future for Defense programs and future budget spending only emboldens our adversaries. For example we need to counter the aspirations of an increasing belligerent North Korea. The United States has recently warned North Korea not to carry out its new plan to launch a space satellite sometime in December. It is believed by U.S. DoD leadership that a North Korean satellite launch would be a highly provocative act that threatens peace and security in the region. A North Korean launch using ballistic missile technology is in direct violation of UN Security Council Resolutions (UNSCRs) 1718 and 1874.  North Korea has announced that it will be launching a peaceful satellite into orbit.   North Korea tried and failed to launch its first satellite in April, causing major embarrassment to supreme leader Kim Jung Un before an audience of international media observers. The new launch is seen partly as an attempt to disrupt upcoming South Korean presidential elections. The United States already has imposed strict sanctions over its nuclear weapons program. North Korea withdrew from the Nonproliferation Treaty in 2003. The satellite launch is seen by the United States as part of an attempt to develop long-range weapons capable of striking Japan and America.  Similar situation exists in Iran over their Nuclear Weapons programs, and the growing proliferation of advanced technology in the hands of terrorists.

Tax Fight Freezes Defense Out of the Debate
The defense industry has $500 billion in pending Pentagon cuts at stake in the fiscal cliff talks, yet it finds itself largely sidelined in the heated debate.  Defense firms desperately want to prevent those cuts, which could cost them contracts and jobs. But in a debate focused on taxes and entitlements, the Industry Execs are finding themselves on the outside looking in, with great anxiety. They perceive that in the final hours here that it has come to the point where it’s out of their hands. It is widely believed that most elected leaders in the House and Senate, on both sides, don’t want this to happen, and the president clearly doesn’t want it. But this is really a debate over taxes and spending, and Industry leaders say they are willing to do their part, and have called for lawmakers to do the same by accepting all options for reducing the deficit, including new tax revenues.

Some defense analysts see the industry’s fiscal-cliff hand weakened dramatically by measures taken before the election, when several defense firms threatened to send mass layoff notices to their employees over the threat of the across-the-board cuts. Industry studies forecast losses of more than 1 million jobs if sequestration took effect, and Republicans made those issues a key part of their campaigns in military-heavy states like Virginia.  The defense industry wants to have a special status in budget deliberations because of its role in protecting the nation, but there is the perception that the public doesn’t appear worried by military threats right now, and so ends up sounding like any other interest group in the fiscal-cliff debate. Industry officials and defense-minded lawmakers have been successful in convincing rank-and-file lawmakers that cuts to the Pentagon will not solve the deficit issues. There is a widespread belief and understanding that going into those fiscal cliff negotiations there are not a lot of savings left that are easily derived from the Pentagon.  Industry officials emphasize that defense spending is trending downward with the end of the two wars and last year’s Budget Control Act that implemented a 10-year cut of $487 billion to Pentagon spending.

Still, several defense analysts say that if a “grand bargain” is reached, there could easily be further cuts to defense spending in the range of $200 billion to $300 billion over 10 years. Senate Armed Services Committee Chairman Carl Levin (D-MI) suggested earlier this year that an additional $100 billion cut to the Pentagon was achievable. It’s still possible defense hawks in the House will have a key role in the fiscal-cliff endgame. They might have to convince other conservatives in the House to accept higher taxes in exchange for doing away with defense cuts. For now, defense officials say the biggest thing they are pushing for in the lame duck, even if they face new cuts, is an end to the uncertainty that’s surrounded the Pentagon budget for more than a year. Generally, all believe everything the defense industry touches will be affected, and it would happen just a few weeks from now, and they do not know whether it will happen. The crazy timing and series of events puts in play a tremendous amount of uncertainty for industry, as companies may have to plan for the fact your future sales might be cut 10 percent across all your programs. Not a good thing.

The Endgame Has Arrived
So, where are we at with about three weeks to go? We are precariously poised on the edge of the Fiscal Cliff, waiting for Congress and the President to stop playing “a silly game of chicken”. We really need them to act like adults and become the leaders they are supposed to be—and get something done. It is clear that Defense spending has to be reduced as an integral part of any Fiscal Cliff Deal between the Congress and the President going forward.  We must put our financial house in order, as a weak economy is also a real threat to our National Security and our ability to project military power around the world.

OK, so what do I think will happen to the Fiscal Cliff debate?  Most people, including myself, believe a deal albeit imperfect will be struck in December on the permanent nature of the so called Bush middle class tax cuts. There will likely follow some revenue enhancements from elimination of certain loopholes and deductions on the wealthiest 2 percent of Taxpayers, along with the end of their Bush Tax cuts. In addition, some entitlement cuts will be made, not effecting benefits but hitting administrative costs.  Social Security will be OK.  And through some miracle, sequestration will be avoided.  Yes, Defense may be allocated some of the discretionary cuts (I would suggest some $25 billion out of a $615 billion budget) so it’s not the end of the world.  But it is nowhere near the Draconian measures that would have been mandated by sequestration and the Budget Control Act (BCA). With all that said, take a deep breath. It’s only the beginning of the endgame on how future Federal spending will be reduced over the next ten years.  So, what does it mean for Defense spending?  I think the DoD has done a really good job under SECDEF Gates and now SECDEF Panetta for the past two years, to put the Defense Department on a good track of establishing priorities, clarity of roles and missions, and investing in the force we need to fight the future conflicts. Yes, there will be heated debates as this refocusing of our Defense Spending gets accomplished.  As it all gets vetted, it will be clear that advanced sensors, weapons and electronics will be real winners. So we are on the right side of history on this one.  Heck, I'd rather be a supplier of Defense Electronics and Microwave parts in this endgame, than a provider of fuel, uniforms or provisioning supplies. Our Microwave industry is positioned very well to survive, and indeed thrive in this new budget environment.  It is our time.  Now, if we can just back away from that Fiscal Cliff!!

Recent Articles by Jim Fallon, President and CEO, Fallon and Associates Consulting LLC

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