Opinion: Are Flat Pentagon Budgets The New Up Or The New Down?

Byron Callan January 26, 2021

The Biden administration probably will not unveil an outyear spending plan for the Defense Department until the late spring of 2021 at the earliest, and more likely it will come out with the fiscal 2023 budget submission in February 2022. The administration should, however, be commenting on some of the bigger changes as different reviews and assessments are completed before that budget plan is released.

Consensus now is that Pentagon spending will be flat at least in the first term of the Biden administration, though analysts are not clear on what this means. Will the Pentagon's budget be unchanged from the level that was appropriated for fiscal 2021? Will it be flat in inflation-adjusted terms, which means it would rise at 2% annually in current dollars? Or will the budget be flat in current dollars, which would entail a roughly 2% annual decline in Pentagon purchasing power, assuming inflation is 2%? Each would have different outcomes for the spending that would flow to contractors.

Defense optimists could argue that flat budgets historically have not lasted too long. There were periods in which budgets were flat over 2-4 years annually in the late 1950s, early 1960s and mid-1990s. Flat periods, however, were succeeded by growth—usually because of a crisis or a new military contingency.

No one has a working crystal ball that will show what is ahead for the 2020s. There are reasons to believe, however, that the 2020s are different. Although interest rates are at historic lows, the ratio of U.S. debt to GDP is at levels seen during World War II. There is pent-up demand for non-defense discretionary spending—notably for infrastructure, and an aging U.S. population will likely demand more health care and other “social” spending. “Endless wars” in the Middle East may temper Americans' willingness to engage in new overseas missions, unless a major provocation occurs that is akin to the 9/11 attacks. The flat budget period could last longer than the post-World War II era suggests.

Is “flat” good for contractors? That depends. Markets started to digest that U.S. defense spending was flattening in 2020. The largest U.S. defense contractors underperformed the S&P 500 in 2020 and are doing so again in the first days of 2021. The initial market verdict is that flat is not good.

The assessment might be true, but it is going to depend on two factors: how the Pentagon reallocates resources in a flat budget environment and how contractors change their strategies and portfolios.

A flat top-line defense budget could be positive if the Pentagon can successfully cut military personnel and operations and maintenance (O&M) spending. Both are tall tasks. Winding down operations in Afghanistan and the Middle East is not going to free up significant troop numbers, and in any event, both are apt to exert gravitational pulls from which the U.S. cannot easily break free. Global security risks are not going to allow the sort of force structure cuts that occurred at the end of the Cold War and the Korean and Vietnam wars. Readiness and training also will remain a priority in this environment.

Spending on military personnel and O&M that keeps pace with inflation may place even more pressure on investment. If those accounts grow at 1-2% annually, in a flat top-line period, that will put even more pressure on investment. Still, while there has been no indication so far, it is conceivable that the Biden administration will propose reductions in force structure and will attack O&M costs with more vigor. It will take 1-2 years at least to realize those savings, but they could be applied to modernize a smaller military.

For a number of years, the Pentagon attempted to retire older “legacy” weapon systems in order to fund new investment, but Congress has stymied efforts to muster out older Navy cruisers, aircraft carrier refueling systems and aircraft such as the A-10. The Defense Department could renew this line of attack, but it may be reminded of the old adage that repeating the same thing over and over and expecting a different outcome is the definition of insanity. The Pentagon will have to change its approach here by offering more incentives to states and districts that could be affected by the elimination of squadrons or units, and it has to be more forceful in confronting contractors whose net interests are harmed by such moves.

A final thought is how contractors' strategies might change. In 2020 and so far in 2021, outperformance was evidenced by small-to-midsize contractors that appeared better aligned with Pentagon investment priorities in artificial intelligence, autonomy, supply chain resilience and low-cost weapons. The largest contractors may be able to unlock value in a flat top-line environment if they can spin off segments that are stagnant or declining. Sprawling program portfolios are apt to perform more in line with market growth rates, and that is not a recipe for superior performance.

https://aviationweek.com/defense-space/budget-policy-operations/opinion-are-flat-pentagon-budgets-new-or-new-down