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Worries about the U.S. federal deficit have turned into a mania in recent years as trillion-dollar deficits have become the norm. Yet the national debate about the deficit has mostly ignored the key driver of our recent deficits: the bloated U.S. security apparatus. Instead, discussion has centered on two other issues: entitlement spending and tax revenue. Many on the political right have strictly focused their attention on reducing "entitlement" spending, particularly Medicare and Medicaid. Meanwhile, the political left spends most of its energy fighting to increase tax revenue by raising rates for wealthy Americans and closing loopholes.
In the course of this posturing, politicians have danced around America's military- and security-related spending problem. This totaled approximately $900 billion last year, and it will come close to that figure this year despite the recently enacted "sequester" that cut more than $40 billion from this year's military budget. Without cutting military expenses significantly, the U.S. will not find an acceptable solution to the deficit problem. However, at present, neither party seems willing to accept the political risk of arguing for a leaner defense budget.
Recognizing these competing forces is critical for promoting a healthy national debate about the deficit. It's also important for investors trying to understand the outlook for the U.S. defense industry. The growing obsession with deficits makes it more likely that eliminating (rather than merely reducing) the deficit will be the country's ultimate goal. If conservatives succeed in targeting a long-term balanced budget -- rather than a smaller deficit, which many liberals prefer -- entitlement cuts, while necessary, will need to be accompanied by significant defense-spending reductions.
Entitlement spending: The great canard
The growth of entitlement spending is a long-term problem for the U.S. government. Thus, conservatives who argue for "fixing" entitlements are not wrong, per se: The rapidly rising cost of health care is of particular concern. However, present-day entitlement spending is not the biggest driver of the federal deficit. Spending on the three major entitlement programs -- Social Security, Medicare, and Medicaid -- is typically blown out of proportion in debates about national fiscal policy. For example, the "Face the Facts" group highlights annual "mandatory" spending of more than $2 trillion as a major cause of federal deficits.
While it is literally true that mandatory spending exceeds $2 trillion, that figure is grossly misleading, because it ignores program-specific revenues. Social Security and Medicare are social-insurance schemes that are primarily funded by payroll taxes. Lots of money passes through those programs, but the net impact on the federal budget is relatively small (less than $200 billion last year).
According to the Congressional Budget Office, Social Security expenditures were $768 billion and Medicare expenditures were $551 billion in 2012. (The Social Security Administration reports spending of $786 billion; I cannot resolve that discrepancy.) However, excluding the effects of the payroll tax holiday, Social Security was overfunded. Revenue from the FICA payroll tax, interest on the Social Security Trust Fund, and taxation of benefits totaled $840 billion. Medicare ran a deficit, but spending of $551 billion was offset by total receipts of $334 billion, including payroll taxes and premiums paid by participants. On a net basis, the Social Security and Medicare combined deficit was well under $200 billion.
If we include Medicaid -- the third major entitlement program -- the cost of entitlement spending grows to a little more than $400 billion. While that total is nothing to sneeze at, it is clearly not the primary driver of the federal deficit, which was roughly $1.3 trillion last year. Entitlements are projected to become a massive draw on the federal budget in the future, particularly as the baby boomers retire, but entitlement spending has actually been a relatively small contributor to federal deficits over the past decade.
The military burden
The cost of security-related spending dwarfs the net cost of Social Security, Medicare, and Medicaid combined. The CBO's most recent (post-sequester) estimate of 2013 discretionary security spending was $751 billion. That primarily accounts for military spending but includes spending for related departments such as Homeland Security and Veterans Affairs. That total excludes mandatory spending related to benefits for veterans and members of the military, which is projected at $132 billion. Thus, total military and security spending will approach $900 billion, even after the recent budget cuts.
Obviously, some level of military spending is vital for our national security. However, by comparison to any reasonable standard, the U.S. spends far too much. China, which fields the second-most powerful military, plans to spend just $119 billion on the military this year, along with $124 billion on internal security. While these figures may be understated to some extent, Chinese military spending is undoubtedly a fraction of U.S. military spending.
Given the vast scale of U.S. military and security expenditures compared to other expenditures, the U.S. cannot afford to ignore defense cuts if it is to balance the federal budget. The cost of the military is a much larger driver of our recent deficits than entitlement spending, and defense spending could be cut substantially without grave danger to our national security. Historically, a 2-to-1 spending advantage over the nearest potential challenger has been considered more than adequate. The U.S. could cut at least $200 billion from the defense budget (currently more than $600 billion) while still exceeding that standard.
Taxes are not enough
Republicans may be overly focused on entitlement spending, but the focus of most Democrats on raising revenue is also misguided. If we exclude "pass through" social-insurance taxes, the CBO expects total federal revenue of $1.76 trillion in 2013, of which $224 billion is committed to "net interest." However, roughly $125 billion of interest owed to the Social Security and Medicare trust funds (which own government bonds) is excluded from that figure. After deducting both types of interest, the federal government has $1.4 trillion to pay its other bills.
As noted above, military- and security-related spending totals $900 billion. If that figure is allowed to stand, it leaves just $500 billion for running the rest of the U.S. government, maintaining our infrastructure, providing basic assistance to the poor, funding Medicaid, and covering the deficit of Social Security and Medicare (which may rise to as much as $250 billion this year). That is hopelessly inadequate, leading the CBO to expect a 2013 deficit of $872 billion despite sequester-driven spending cuts and the expiration of some of the Bush tax cuts.
While raising taxes again would narrow the deficit, federal revenue (excluding social-insurance taxes) would have to increase by 50% to fully cover the 2013 deficit. That scenario is out of the question, leaving Democrats with only a partial solution to a big problem. Increasing tax revenue cannot close the deficit gap, although it could help in conjunction with significant spending cuts.
A grand bargain
Given today's toxic political climate, I am skeptical that a grand bargain solving America's deficit problem will be found soon. If a such a bargain were to be forged, entitlement reform would have to be included, because the growing cost of medical care could easily overwhelm other cuts. But entitlement reform alone cannot do the trick. Making Medicare self-sufficient and cutting Medicaid significantly might reduce the 2013 deficit by 30% to 40% but would still leave the government at least $500 billion short of a balanced budget. Increased tax revenue would also likely play a part in any grand bargain. However, while more revenue could reduce the deficit a little further, it could not eliminate the deficit. (Incidentally, nonsecurity discretionary spending of $390 billion in 2013 is already lean and does not leave much room for cuts.)
Significant defense-spending cuts are therefore a necessary part of any viable strategy to balance the budget. Both political parties could continue to ignore reality almost indefinitely, but if they ever get serious about eliminating the deficit, major defense cuts are almost certain to occur. This is an underemphasized point in the national debate today. It is also an important point for investors in defense stocks to remember. Lockheed Martin (NYSE: LMT ) has been able to keep its F-35 Joint Strike Fighter off the chopping block so far, despite shoddy performance and massive cost overruns. Lockheed's massive reliance on U.S. military contracts could put it at risk if defense cuts were finally approved. General Dynamics (NYSE: GD ) is another company that is highly levered to military spending and could potentially face cuts if the U.S. reduces orders for the costly attack submarines it produces.
Investing in the defense industry today is equivalent to betting that the U.S. will never erase its deficit -- and so far, that's been a good bet. However, it remains to be seen whether we can regain control of our profligate spending.