The Mother of All Drawdowns

Ten years after the Sept. 11, 2001, terrorist attacks, the Pentagon confronts a new enemy that will require it to embrace an unfamiliar strategy: spending less money.

Forget Islamic radicals or even an ascendant China; the “biggest threat to our national security is our debt,” says Admiral Mike Mullen, chairman of the Joint Chiefs of Staff. Indeed, the Congressional Budget Office expects that by 2021 the U.S. will be spending almost as much on interest payments each year as on national security.

Buckling beneath $14.3 trillion in IOUs, the U.S. now is pivoting from the whatever-it-takes philosophy employed against Osama bin Laden to a whatever-we-can-afford defense posture. The shift will be a wrenching one, for both the national security establishment and its arms suppliers, which have grown accustomed to operating as if money really were no object. “Industry performs well in ‘up’ budgets. It tends to flounder in ‘down’ budgets,” says Michael Bayer, a defense consultant and former chairman of the Defense Business Board, a Pentagon advisory panel.

Over the past decade, defense spending ballooned with scant controversy against a backdrop of credit-fueled economic growth. It is now set to plunge as much as $1 trillion over the next decade, at a time when fears of irreversible economic decline shadow American confidence. “In the absence of some major new threat, we can expect a continuing decline in defense spending in the coming decade,” says Loren Thompson, chief operating officer of Lexington Institute, an Arlington (Va.) research organization.

Since the attacks on New York and Washington, the annual defense budget, including the wars in Afghanistan and Iraq, has increased almost 70 percent in real terms, to more than $700 billion. Political scrutiny of the military’s shopping lists has been so lax that Mullen admitted earlier this year: “We’ve lost our ability to prioritize, to make hard decisions.”

The brass better recover that ability fast. This summer’s protracted wrangling over the debt ceiling proved that the days of the blank check are over. Defense accounts for nearly 60¢ of every dollar of Uncle Sam’s discretionary spending, meaning that along with entitlement programs it represents one of the big pots of money debt hawks are circling.

In January, then-Defense Secretary Robert Gates tried to preempt pressure for cuts with a $178 billion “efficiency initiative.” Three months later, President Barack Obama unveiled a proposal for a 12-year flattening of the defense spending curve and, as if to underline the point, named a former budget czar, Leon Panetta, to replace the retiring Gates.

The eventual debt ceiling deal that the President signed into law on Aug. 2 included $917 billion in spending cuts over the next 10 years; $350 billion of that will come from defense. If members of a congressional supercommittee can’t agree on further reductions by Thanksgiving, an additional $500 billion will be stripped from the Pentagon in the years through 2021. “The saliency of defense has declined politically. People are no longer scared to death of terrorists,” says Gordon Adams, who directed national security budgeting for the Office of Management and Budget during the Clinton Administration. “They’re worried about jobs, the economy.”

It’s not just tighter purse strings that will complicate life for the defense establishment. Despite the free-spending era now ending, the Pentagon needs to replace gear worn out after a decade of combat, including Army Humvees and such Air Force planes as the Eisenhower-era B-52 bomber and KC-135 tanker. Almost three-quarters of the decade’s increase in spending was chewed up by the wars in Iraq and Afghanistan and pay raises for uniformed personnel, according to the nonpartisan Center for Strategic & Budgetary Assessments (CSBA) in Washington. Only 16 percent went for equipment modernization.

The uniformed services’ wish list includes a new strike fighter and bomber for the Air Force, nuclear-missile-firing submarines for the Navy, and combat vehicles for the Army and Marine Corps.

That’s the sexy stuff. Future budgets will also be swollen by tough-to-cut personnel costs, including troop pay and allowances and veterans’ benefits. Of each Pentagon dollar, roughly 25¢ goes for such expenses, according to data from the Defense Dept. comptroller. An additional 43¢ funds operations and maintenance; 20¢ buys new weapons; and about 12¢ goes to research and development.

Compensation changes are likely. Annual pay and benefit increases have driven per-person costs up 46 percent since 2001, says CSBA. In July 2010 the Defense Business Board called it “unsustainable” to continue providing 40 years of pension and health-care benefits for service members retiring after 20 years in uniform. “Military ‘entitlements,’ which have expanded rapidly, have become part of the nation’s mandatory spending problems,” the panel concluded.

Like the rest of the country, the U.S. military has a problem with out-of-control health-care costs. The Pentagon has requested $52.5 billion in the next fiscal year for its Tricare health insurance program, which cost $19 billion in 2001. Military retirees are eligible for Tricare for life. Even after taking post-retirement jobs in the private sector, an increasing number of ex-military personnel opt to stick with the taxpayer-paid insurance. “When the budget declines, that’s going to cause a train wreck,” says Todd Harrison, an analyst at CSBA.

The $350 billion in cuts through 2021 sounds like a lot of money—and anywhere other than the Pentagon it would be—but the debt ceiling compromise preserves more than 95 percent of the original spending blueprint. Most analysts expect the reductions to be more severe. The co-chairmen of last year’s Presidential commission on fiscal reform, former Senator Alan Simpson (R-Wyo.) and former White House Chief of Staff Erskine Bowles, for example, recommended cutting defense spending by $1.2 trillion over the next decade. “When push comes to shove, the cuts will get worse,” says Robert Spingarn, an analyst with Credit Suisse Group. “I think $1 trillion is possible.”

Ironically, the budget pressure may only intensify as the economy heals. The government today borrows at extremely low rates, just 0.4 percent for two-year bonds. Once stronger economic growth drives borrowing costs toward their long-run average of around 3.8 percent, the Treasury Dept.’s interest tab will soar and the need to reduce other spending, including at the Pentagon, will become overwhelming. “Industry will find itself under its most intense pressure as the economy begins to recover,” says Bayer. “This is a situation they’ve never had to face before.”

There is room to cut military budgets. Annual U.S. defense spending has been rising each year since 1998 and, adjusted for inflation, is about $100 billion higher than the Reagan-era peak. With 5 percent of the world’s population and 24 percent of global gross domestic product, the U.S. accounts for 42 percent of worldwide military spending, according to the Council on Foreign Relations.

There’s certainly precedent for deep cuts: President Eisenhower slashed defense spending by 27 percent in the eight years following the end of the Korean War—a similar-size cut today would translate into 10-year savings of more than $2 trillion.

For the defense establishment, the winding down of the wars in Iraq and Afghanistan means military planners now must identify the next generation of potential security threats. Some worry that a rising China may become more aggressive. Others cast Iran, North Korea, and even Russia as potential menaces. Emerging dangers such as cyberattacks also draw new attention. Yet to date, nothing approaches the existential challenge once posed by the former Soviet Union or bin Laden’s messianic threat. “These missions are not force-intensive,” says Adams, the former OMB official, who is now a fellow at the Stimson Center in Washington.

Once defense drawdowns begin, they tend to be protracted affairs. The end of the Cold War saw Pentagon budgets fall for 13 years straight until 1998. In May, Gates launched a “comprehensive review” aimed at ensuring that any defense cuts make sense from a security standpoint and not be “simply a math and accounting exercise.” Gates, whose career in the national security bureaucracy dates to 1966, worries that the U.S. will repeat the mistakes of previous demobilizations and end up with the “hollow” force of the late 1970s.

To avoid that fate, the Pentagon must confront some long-deferred questions. Does the U.S., two decades after the collapse of the Soviet Union, still need 79,000 troops in Europe—and an additional 44,000 in East Asia? Could the three-pronged nuclear retaliatory force known as the triad get by with two legs? And perhaps most important, is it realistic for the military to prepare to fight two wars simultaneously on opposite sides of the globe?

While the questions are well-known, some industry executives fret that a war-time Pentagon has been slow to provide answers. “I’ve just never seen such a lack of theorizing and strategizing. We’re left with a big drawdown, a complex drawdown, and no real clear signals,” says Mark Albrecht, chairman of U.S. Space, a privately held space services company.

Investors are alert to the collision between the new austerity and the defense industry’s culture of plenty. The Bloomberg Americas Aerospace/Defense index of defense and aerospace stocks has risen 3.65 percent over the past year, lagging the Standard & Poor’s 500-stock index’s 9.85 percent gain. Shares of Lockheed Martin, the nation’s largest weapons maker, have lost 10 percent over the past six months as the seriousness of the public debt crisis became more apparent. “We know we have to be more responsive and more agile, and we’re working to do that,” Robert Stevens, Lockheed’s chief executive officer, told analysts on July 26.

Indeed, the Pentagon is trying to cut costs by staging competitions for more new contracts and by seeking to shift more of the risk of building new weapons to its contractors. Rather than traditional cost-plus contracts, which pay companies a negotiated fee above their expenses, DoD acquisition chiefs are increasing their use of fixed-price deals. “The price competition will be more intense than ever. Contractors will have to learn to survive on lower margins,” says David Berteau, a senior adviser at the Center for Strategic & International Studies in Washington.

Gates began positioning the Defense Dept. two years ago for the end of what he called “the no-questions-asked funding” era. He jettisoned the military’s poorest-performing acquisition programs, including the Army’s Future Combat Systems, a $200 billion effort led by Boeing and Science Applications International.

Like its industry peers, Lockheed—whose $382 billion F-35 fighter jet and its escalating costs present a tempting target for the green eyeshade corps—already has begun reshaping its business and workforce. In June the company announced 2,700 job cuts in addition to the voluntary departure of an additional 350 executives. The layoffs and other moves, including a salary freeze for senior executives, are expected to save $500 million over the next five years, according to Stevens.

Other defense contractors are spinning off nonessential units. Witness Northrop Grumman’s March sale of its shipbuilding business. And they are looking overseas for sales to replace business lost here at home. In June, Boeing, which had $32 billion in defense revenue last year, said it plans to increase international orders to 25 percent of its defense business by 2015, up from 17 percent today.

In recent analyst calls, several defense industry CEOs said they understood the unforgiving new era that is dawning. But while the heads of such companies as Lockheed, Northrop Grumman, Boeing, and Raytheon acknowledged public funds would be harder to tap, they all suggested their products would be the ones the Pentagon would continue to find irresistible. “Collectively, they can’t all be right,” says Berteau. “Somebody’s going to end up losing.”

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