Defense Spending and the Economy | Mercatus

By Veronique de Rugy

In the fall of 2011, the Aerospace Industries Association (AIA) commissioned a report looking at the impact that a $45 billion reduction in defense procurement spending in FY 2013 (brought on by the implementation of both the BCA caps and sequestration) would have on the economy and jobs. According to the study, performed by Stephen Fuller of the Center for Regional Analysis at George Mason University, the cuts would result in economy-wide sales losses of $164 billion in FY 2013, a $86 billion reduction in GDP, and a loss of over a million jobs. The study also predicts $59.4 billion in wage and salary reductions, and about $27 billion in lost sales by subcontractors and other suppliers, all in the short term.

I don’t think we can overstate the impact this economic doomsaying, exemplified by Fuller’s projections, had on Washington and the defense industry when it was released. Every major defense contractor spent months on the Hill testifying before Congress about the devastating effects that these cuts would have on their bottom line, forcing them to fire people, hurting the economy and damaging a regional industrial base. The findings of the study were even echoed in a series of ads on the campaign trail when presidential candidate Mitt Romney launched a series of TV ads explaining how he will protect and create jobs by preventing the implementation of defense spending cuts. One of the ads argued, “Here in Virginia, we’re not better off under President Obama. His defense cuts threaten over 130,000 jobs — lowering home values, putting families at risk.” Ads running in other states also tallied the expected job losses from the cuts.

However, this week brings some evidence that, like much of the other threats about impact of the sequestration, this senario was overblown. In particular, defense contractors’ bottom line seems to be doing just fine. On Monday, Politico reported that:

Top DoD contractors are scheduled to announce their earnings for the second quarter of the year — and their conference calls with investors could make for awkward listening. Lockheed Martin and United Technologies are set to hold their calls tomorrow. General Dynamics, Northrop Grumman and Boeing are set to hold their calls on Wednesday. And Raytheon is set to hold its call on Thursday.

For the most part, contractors are preparing to release good second-quarter results, industry sources tell Morning D. And this’ll put them in the odd situation of being on the defensive about their good news: They’ll have to explain to investors why sequestration isn’t having a major impact on their sales, especially since several contractors said last year there would be disastrous consequences if the automatic cuts weren’t averted. We expect to hear CEOs describe sequestration as a slow-moving problem, one that’ll have a bigger impact next fiscal year.

This piece from CNBC also seems to signal that things aren’t looking too grim for Pentagon contractors, in part due to huge cash reserves and massive order backlogs:

Defense stocks are on the offensive.

Investors seem to be betting that the U.S. defense industry has so far waged a successful campaign against looming budget cuts to secure a profitable peacetime footing after a decade of war.

But it remains to be seen whether these companies can offset tens of billions in shrinking orders for swords with new, long-term contracts for plowshares.

For the moment, investors seem to be overlooking expected cuts in military spending. As defense contractors continue to churn out solid earnings and dividends, their stocks are reaching new highs. Teledyne Technologies, Boeing,Northrop Grumman and United Technologies have hit record highs. Lockheed Martin, General Dynamics and Rockwell Collins are within 10 percent off their all-time peaks.

Analysts say several powerful forces are at work offsetting the heavy headwinds of military spending cuts.

Finally, yesterday the Washington Post had a story about how “big defense contractors are weathering the federal budget sequester far more easily than they projected, in part because they have gradually eliminated jobs over the past few years in anticipation of spending cuts.” Case in point: the nice bump in Lockheed Martin’s profits this year despite the fact that the firm the firm “had predicted that sequestration would wipe out $825 million in revenue this year.”

Bethesda-based Lockheed Mar­tin, the world’s largest defense contractor, reported Tuesday that its profit rose 10 percent, to $859 million, during the second quarter even as revenue dipped slightly. Northrop Grumman and General Dynamics, two other large contractors, are scheduled to report results Wednesday.

“Lockheed’s setting the tone,” said William Loomis, a defense industry analyst for the financial services firm Stifel Nicolaus.

Contractors seem pleasantly surprised that the automatic spending cuts are not hurting nearly as much as the industry’s lobbying arm warned they would in the months leading up to the sequester that took effect in March. […]

“We’re seeing less impact . . . than we had expected to see through the first half of the year,” Bruce Tanner, Lockheed’s chief financial officer, said in a conference call with reporters Tuesday. “It’s somewhat hard for us to imagine that the full [anticipated] impact will be realized.”

This, of course, isn’t to say that sequestration won’t have any impact on the long run on contractors’ profits, but does reveal that the impact of sequestration was overhyped. It is worth noting that Fuller himself has admitted that his projections may have also been overblown: Back in March, he told a reporter from Washington Business Journal that ”those that might’ve argued that the federal government might be able to absorb these cuts without derailing the economy might be more right than they were given credit for.” ​It is also important to note that, even if contractors’ profits were going down, it hardly means our country’s security was in jeopardy — the real reason to sustain defense spending. Even though national defense is a core mission of the federal government, not every defense dollar increases our security.

Besides, there is a strong case to be made that reductions in defense spending may actually improve economic growth. In a recent paper that assesses the economic effects of defense spending and defense cuts in particular, Harvard economist Robert Barro and I found that:

While the impact of across-the-board federal defense spending cuts on national security may be up for debate, claims of these cuts’ dire impact on the economy and jobs are grossly overblown . . .

[A] dollar increase in federal defense spending results in a less-than-a-dollar increase in GDP when the spending increase is deficit-financed…

[O]ver five years each $1 in federal defense-spending cuts will increase private spending by roughly $1.30

The government doesn’t have money of its own; in order to spend, it first has to extract resources from the private sector, in the form of taxes or borrowing. In fact, there is strong evidence that the net effect of government spending is negative over the medium to long term. This is true for defense spending, too, even if it’s necessary to some extent to defend the nation. When it comes to the impact of such spending on the economy, we shouldn’t overlook the fact that any gain in GDP will be short-lived. A similar dynamic is true with spending cuts: They may result in brief declines in GDP at first, but the adverse effects will be small and short-lived. What’s more, in the long run, the benefits of cutting spending are clear. Our paper concludes:

There may be grounds for objecting to defense cuts based on reasoned arguments that these spending reductions would impair national security. But Keynesian arguments that a smaller defense budget will retard economic growth are not convincing.

Our piece is here.

Defense Spending and the Economy | Mercatus.