The financial woes of the U.S. were hardly solved by a deal to extend taxes at the end of 2012. In fact, over the next two months, the U.S. government faces a new confluence of deadlines: a potential default on its debt obligations, across-the-board budget cuts of nearly $1 trillion and a possible government shutdown. The combination of events has even the most seasoned budget planners on their heels.
“I've never seen a period featuring any greater budget uncertainty,” saysComptroller Robert Hale, who has worked with U.S. defense dollars since the 1970s. “It gives a whole new meaning to the term 'March Madness,' and I can't wait for it to be over.”
Government and industry planners are looking to navigate the madness as it becomes clear that regardless of sequestration, the Pentagon's investment programs are going to take a hit. The question is the extent to which the cuts will be directed and where they will fall.
In its final days, the 112th Congress averted a so-called fiscal cliff by extending tax cuts and delaying the budget penalty known as sequestration. Now the government has until March 1 to come up with a new agreement. But the Bipartisan Policy Center warns that the U.S. will hit the debt ceiling between Feb. 15 and March 1, putting pressure on lawmakers to reach a deal next month to increase the debt limit and substantially reduce the federal deficit.
The proximity of those two deadlines “implicitly ties” sequestration to the debt-ceiling debate says Todd Harrison, senior budget studies fellow at the Center for Strategic and Budgetary Assessments.
Whether sequestration happens is still a very open question. Answering it involves the ongoing three-way tussle over taxes, entitlements and discretionary spending, the first chapter of which was only partially addressed in an agreement between Vice President Joe Biden and Senate Minority Leader Mitch McConnell (R-Ky.) as 2012 turned into 2013. The delay to sequestration was added to the deal late in the process, Harrison notes.
Analysts and industry officials are fairly divided as to whether lawmakers will succeed in this round of deficit talks.
With a more Democratic Senate and a second Obama term, McConnell may be more willing to compromise. But the same spirit does not hold true on the other side of the Capitol, where House Republicans have not gone along with House Speaker John Boehner's latest proposals.
And if Democrats are unwilling to give ground on cuts to entitlement programs, Republicans could hold firm on sequestration, a defense lobbyist says.
According to the new law, the penalty of sequestration imposed for lawmakers' failure to reduce the deficit by $1.2 trillion would be imposed on March 1, Harrison explains. But new budget caps are imposed on March 27, the same day that the current continuing resolution expires.
If sequestration takes place, the cut to defense in fiscal 2013 is just $45 billion, down from a Pentagon-estimated $62 billion, according to Hale.
Hale and Deputy Defense Secretary Ashton Carter testified to Congress in August that sequestration would force a cut of fourJoint Strike Fighters in fiscal 2013, compared with the budget request. If sequestration does take place in March, it would represent a 9% reduction on every line item in the budget, Hale now says. That would include JSF production and research for 's prized fifth-generation fighter, though program officials will have to decide how those cuts are directed within each project line item.
Decreasing production quantities could force the government to renegotiate contracts—without much leverage, Harrison says, citing thetanker program as an example. The program is receiving $1 billion less than it expected under the terms of the fiscal 2013 continuing resolution. bid aggressively to win the contract. Now, if the government has to renegotiate, Harrison asks: “Are we in position to maintain a competitive price?”
A number of defense industry analysts believe that the deal on tax extensions paves the way for an agreement to avert across-the-board spending cuts.
“It looks like a small step, but I think it was quite a big one,” says Richard Aboulafia, vice president for analysis at the Teal Group. “Hopefully, it's a small bite out of a big balloon.”
According to Aboulafia, because those who were unwilling to compromise on spending issues were marginalized in the fight over tax increases, a deal on avoiding sequestration is more likely.
Loren Thompson, chief operating officer of the industry-backed Lexington Institute, expresses a similar view in a column in Forbes magazine: “When the chips were down, the parties proved to be flexible. So it seems a safe bet that the same thing will happen when more crises come along in March,” Thompson writes.
“The debt limit will be raised, the stopgap spending measure currently funding government operations will be replaced by something that avoids a shutdown, and the sequestration provisions of the Budget Control Act will be diluted,” he continues.
Industry experts project that even if sequestration is averted, the Pentagon could face cuts of $30-45 billion per year over the next 10 years.
“If we can plan it, it would be a glide-slope as opposed to a karate chop,” says Tom Captain, Deloitte's global leader for aerospace and defense. “That would be making the best out of a bad situation.”
If the Budget Control Act already takes 10-12% off the top lines of the major defense contractors, additional cuts are likely to reduce them by another 6-12%, Captain says. While a 25% total reduction would be a less severe drawdown than historical postwar averages, the abruptness and uncertainty of these budget negotiations mean neither government nor industry can plan efficiently, he says.
The best outcome, says Harrison, is for the government to provide a gradual, annual 2.2% decline in defense spending over the decade. The deficit savings would be the same as the sequester, but the gentle slope would allow the Pentagon to plan adequately for the change. But such an outcome is far from likely, he admits.
If lawmakers do reach a deal that still makes cuts to Pentagon spending, then defense companies that have been united in a “Second-to-None,” don't-cut-the-budget campaign will take to their individual bunkers, and a war for scarce dollars will begin.
The Pentagon already appears to be positioning to sell additional reductions. During a recent speech at the Brookings Institution, Hale noted that the Pentagon seeks to continue its strategy of improving the way it does business to achieve savings through what are known as “efficiencies.”
But a drawdown will mean changes—and they will hit modernization accounts first. “There's a long history and a good reason why early in a drawdown, the cuts tend to be heavily on the investment portion of the budget, because it takes us awhile to make force-level decisions and then we gradually draw down the size of our forces,” Hale says. “If we are allowed the ability to make choices, they will probably be investment-heavy at the beginning.”
In its fiscal 2013 budget request, the Pentagon asked for the authority to begin cutting bases and outlined current and future force structure cuts. It has also been begging Congress to make changes to military health care and entitlement programs. But last year, lawmakers continued to push back on all three fronts.
Expect the Pentagon to repeat those requests. Hale is putting the onus on Congress to give the Pentagon the tools it needs to reduce the budget. “If the Congress wants us to hold down defense spending and . . . they want us to reduce the number of civilian personnel, they need to give us authority to move ahead with infrastructure consolidation,” Hale says.
The 2005 base-realignment effort, which cost the government rather than adding savings, should not be used as a guide, he asserts. Rather, two rounds of base closures in the 1990s eventually provided an average annual cost savings of $2-3 billion per year, Hale adds.
The president, now past his final election, could push for a base closure round. And Congress has a year to put it forward that is not consumed with a presidential election. But, a lobbyist points out, midterm congressional elections are just around the corner.
The outlines of investment cuts are taking shape, says a Senate aide. The Army is transforming costly heavy brigades into lighter ones and aiming for an earlier down-select of one contractor for the Ground Combat Vehicle—both moves that could save dollars.
Once the initial block-buy of Littoral Combat Ships is completed in 2015, the Navy could opt to truncate the purchase of more vessels or down-select to one contractor in favor of purchasing Virginia-class submarines orships, the aide says.
Plenty of think tanks have offered up their ideas about how the Pentagon can extract dollars. Michael O'Hanlon of the Brookings Institution suggests a number of options, including halving the purchase of F-35 Joint Strike Fighters and scrapping the replacement program of Ohio-class submarines while continuing to make the older version. Both ideas would encounter significant resistance among lawmakers.
On top of all of these potential outcomes, the situation within the Pentagon is compounded by the fact Defense Secretary Leon Panetta is retiring and the approval of former Sen. Chuck Hagel (R-Neb.) as successor is still not certain.
Hagel, whose confirmation is under fire in part because he bucked the Republican Party's position on Iraq war policy, earned a reputation for backbone. “He's willing to say 'no' and alienate people,” says John Isaacs, executive director of the Council for a Livable World.