Unhappy about implementing ‘sequestration’ Leon Panetta had largely avoided talking about the planned reductions in spending
Robert Lutts, the president of Cabot Money Management, held on to one defense related-stock in his portfolio for nine years: the shares of FLIR systems, a maker of infrared technology. He liked the company’s management, and its prospects. He will still happily bend your ear about the company’s bright future.
Still, he sold the last share of stock in 2011, shortly after Congress agreed that it would scale back the Pentagon budget by 10% in 2013.
“We’ve steered away from things related to government budgets, bottom line,” says Lutts.
At least Lutts had a plan. The Pentagon and the defense industry have been facing down the same looming budget cuts with an old, if questionably effective, method: denial.
The portion of the fiscal cliff that has to do with spending cuts dictates that the Department of Defense will lose $500bn from its budget on January 2, 2013 unless there is new legislation to stop it. The Pentagon maintains that it is already in the process of cutting its budget by $487 billion over 10 years.
Leon Panetta, the secretary of defense, said in a memo this week that the Pentagon was starting to plan for the spending cuts, or “sequestration,” as it is known in Washington patois. His tone was best described as grudging. “Sequestration was never intended to be implemented and there is no reason why both sides should not be able to come together and prevent this scenario,” Panetta wrote. He also indicated that the Department of Defense would delay the impact. “These cuts, while significant and harmful to our collective mission as an agency, would not necessarily require immediate reductions in spending,” Panetta wrote.”
Both the Department of Labor and the White House-run Office of Management and Budget have instructed defense contractors not to worry about potential hits to their budgets if the Pentagon – their biggest customer – sees its budget cut by 10% after the fiscal cliff.
Mackenzie Eaglen, a defense fellow at the conservative American Enterprise Institute, has observed the magical thinking in the defense community with some bemusement. With thousands of defense contracts at stake under Congressional control, neither the Labor Department nor the OMB – nor the Defense Department, for that matter – can change what Congress has already dictated.
“People are really only seeing what they want to see,” says Eaglen. “Most medium and large defense contractors have not started detailed planning on budget cuts, so they’re going to be caught flat-footed … the executive branch has been leading contractors on, lulling them into thinking [sequestration] won’t happen.”
The problem is partially a kind of superstition. Just as in the movie Beetlejuice – where saying the name of the demon could make it appear – the defense industry is worried that speaking about cuts will manifest them. They prefer to remain vague. “When you reveal in detail the lists and impacts of things that are going to occur, there are people outside or in Congress who then say: ‘this doesn’t look so bad, I could live with it’.”
Eaglen believes the Pentagon can slow the effect of budget cuts long enough that it will take up to six months for, say, a shipbuilding company or aerospace manufacturer to see its Pentagon-supply business dry up.
The biggest issue of the fiscal cliff is what the Pentagon will do with its employees, who may have to be furloughed. The Department of Defense employs 3.2 million people – 718,000 of them civilians – and is the largest employer in both the United States and the world.
By comparison, WalMart, the second-largest employer in the US, has 2.2 million on its payroll.
The Pentagon is not eager to think about laying off its people and will delay that as long as possible, said Michael O’Hanlon with the Brookings Institution. “When it comes to furloughs in the civilian work force, that could happen in the summer – in the hope that it never has to happen at all,” O’Hanlon said.
The foot-dragging in preparing for the sequestration cuts is evident in the stock prices of major defense contractors, like Raytheon and Boeing, whose shares have actually jumped in value in the past six months.
Rebecca Grant, the president of defense consulting company IRIS Research, said the defense industry is used to – if you’ll excuse the pun – cliffhangers. Years of budget battles have accustomed many companies in the industry to preparing for rainy days. “The defense companies have a group have done a good job of holding on to cash,” Grant said.
Boeing has about $11.17bn of cash and liquid investments on hand, which is equivalent to a whopping 20% of the entire company’s value in the stock market.
Similarly, Northrup Grumman has $3bn of cash on hand, which amounts to about 17% of the company’s market value.
The defense cuts are not the only gears that are starting to grind.
The US Treasury is close to its debt limit. Treasury defines the debt limit as the amount that the government is allowed to borrow to pay for services like Social Security, Medicare, military payroll and tax refunds, among other things.
Currently, the debt limit is set at $16.39tn; the Treasury has already borrowed $16.31tn and expects to slam against the debt limit in two weeks, at the end of December. That’s according to the most recent daily financial statement from the US Treasury.
If the Treasury overshoots the debt limit, the US will not be able to pay the bills it has already run up this year – including payments to Social Security and Medicare recipients as well as the unemployed, who will be waiting for their checks.
After that, the Treasury’s only option to keep the US solvent is to take what it calls “extraordinary measures.” That could include selling financial assets, US-owned gold, stakes in stimulus projects, or even the government’s portfolio of student loans – all of which the Treasury considers impracticable.
Instead, federal spending would have to be immediately cut to help the Treasury meet its obligations. That kind of last-minute set of cuts, on top of the cuts already planned for the fiscal cliff, could cause governmental chaos.
As for the chances that Congress could break for Christmas and then come up with a deal in two days before the New Year’s break, that also seems more and more unlikely to many as time passes. House speaker John Boehner trudged into a press conference Friday wearing a hangdog expression and slumping shoulders. He announced his party’s failure to reach an agreement to avoid the fiscal cliff.
When a reporter asked him how a final agreement would be possible, Boehner glumly replied, “How we get there? God only knows.”