Peak Defense

A convergence of indicators suggests the recently passed Defense Appropriations Act will mark a peak for US defense spending. Even the Administration’s own outyear defense-spending projections grow at an annual rate of only 2 percent, which is just enough to keep pace with the White House’s expectations of inflation and below those of the Congressional Budget Office. Still other indicators suggest inflation will erode the purchasing power of future defense appropriations more deeply. To coin a phrase from the oil patch, I think we are approaching “peak defense”, an outlook of flat-to-declining US defense budgets across the next decade. How we prevent this trend of defense spending from imposing a commensurate diminution on US defense capabilities is now the compelling work that lies before defense planners, military professionals, and Congress.

At the end of last month, President Trump signed into law the Defense Appropriations Act for the fiscal year that began on 1 October. The Act is remarkable for two reasons. For the first time in more than a decade, the Congress passed a full-year appropriation for defense ahead of the start of the fiscal year, an achievement made easier by passage in February of the Bipartisan Budget Act, which relieved appropriators of the caps on discretionary spending which had stymied timely resolution of federal spending bills since 2011. The 2019 defense budget is also really big: $686 billion for DoD, a figure more than 20 percent above the 2015 trough of the current defense-spending cycle and also higher on a constant-dollar basis than even the heights of defense spending in the Cold War.

Regardless, fiscal realities, from which Congress and the Administration have taken a holiday over the past two years, will begin next year to pinch defense spending. The New York Times recent front-page story, “As Debt Rises, the Government Will Soon Spend More on Interest Than on the Military”, provides an overview of the fiscal outlook based on new estimates of the Congressional Budget Office indicating that by 2020 the cost of paying interest on the national debt will have roughly doubled from when President Trump took office and will exceed the level of discretionary defense spending within five years. Recall too that next year’s debate over the 2020 defense budget will not enjoy relief from the Budget Control Act caps on defense discretionary spending, which for 2020 are set at least $100 billion below what is likely to be the Administration’s base-budget request.

These indicators converge about a month ahead of congressional elections which, it is widely believed, will result in a Democrat-controlled House of Representatives and even the possibility of a change in control of the Senate. While the once tidy correlation of Democratic politics with resistance to higher defense spending is an anachronism, Democratic control of Congress would add political power to the economic pressures on defense spending in the next decade. Asked in September about the level of defense spending in the appropriations bill Congress was about to pass, Representative Adam Smith, the ranking member of the House Armed Service Committee, was unequivocal: “I think the number’s too high, and it’s certainly not going to be there in the future.”

Regardless of which party prevails in November, there is almost certain to be an economic reaction to the loose-money 115th Congress. Earlier this month, the yield on the benchmark ten-year Treasury note jumped 20 basis points above 3 percent following a speech by the Chairman of the Federal Reserve in which he said that tightening of monetary policy had “a long way” to go before the inflationary urges given fuel by the 2017 tax cuts and expansionary 2018 – 2019 expenditures had been neutralized. The 10-year Treasury Note is referred to as a benchmark because it serves as a common measure of baseline risk for investing in everything from private homes to corporate expansions. In a country where an entire generation of homeowners has never paid more than 6 percent per annum for a mortgage, or of business executives whose cost-of-capital hurdle rate has never exceeded 10 percent, the political effects of rising interest rates on federal spending may be swift and sharp.

Depending on the full magnitude of the discrepancy between flat-to-declining budgets and the growth on which Secretary Mattis’s defense strategy is staked, fiscal tightening will require at least a restructuring of the defense program which includes an unprecedented reform of how much “bang” the Pentagon gets for its “buck”. Failing that, it will require resetting the defense strategy altogether.