How Will Budget Cuts Affect the U.S. Economy?

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"If we continue on the current course without making these modest adjustments now, the choices will only grow more difficult and painful down the road." 

U.S. Defense Secretary Chuck Hagel spoke recently on a new five-year military budget plan that would see the U.S. military reduced by nearly half a trillion dollars over the next nine years, or about 40% of current figures. With both personnel and equipment reductions expected, this means a smaller, slimmer military than the current juggernaut that is deployed around the world.

How the defense industry is reacting

Surprisingly, American defense industries have not reacted with great amount of alarm. Aeronautical companies such as Lockheed Martin  (NYSE: LMT  ) and Boeing (NYSE: BA  ) are trending toward their highest trading prices ever. Communications companies dealing with the American military such as L-3 Communications (NYSE: LLL  )  seem similarly comfortable with the cuts.

Given the slimmed down nature of future weapon development tests, this is surprising until one realizes that these larger groups are diversified into civilian markets as well (Boeing in civilian air transportation, etc). While Boeing does less military business than Lockheed (20% of revenue as opposed to Lockheed's 48%), the largest players in the defense industry are being retained for development efforts, such as Lockheed's recent $12 billion contract for a new long range bomber. 

Even then, some of the largest arms firms have considered furloughing or dismissing portions of their workforce in the past when previous budget cuts have been threatened. These personnel cuts have never materialized.

Overall, the U.S. defense industry seems to be collectively shrugging and looking to other markets for new revenue streams outside of the U.S. For example, Massachusetts-based Raytheon  (NYSE: RTN  ) just won a $655 million contract to sell Patriot missile systems to Kuwait.

This is not to suggest that other markets could completely make up for a $14 billion U.S. defense budget, but rapidly expanding militaries like China (increasing its defense budget by 12.2% annually) offer other opportunities for U.S. arms firms. If the potential Hagel cuts do manifest, they may end up meaning very little in the long term. 

Effects on the rest of the economy

However, lower and more local industries may be feeling the squeeze as reduced government contracts force the reduction of domestic U.S. bases and supporting businesses. That is, smaller amounts of personnel under arms in an area will need less support staff on a given base and contribute less to surrounding local businesses. Though losses may be negligible on the face of things, the missing revenues could cause regional economic issues.

Domestic manufacturing will also suffer. While contracts to major firms are already secure, lowering purchases will mean less business to organizations subcontracted by giants like Lockheed and Boeing (such as Boeing manufacturing subcontractor Mid-Continent Engineering).

 As things stand, some are expecting around 20,000 jobs to be lost as a result of budget cuts (outside of those positions lost in the military itself). With the possibility of further military spending cuts in the near future, the potential for regional issues will only get worse.

Not all bad news

Yet, having a slim military may not be bad for the U.S. economy in the long term. As detractors consistently point out, the U.S. military has a budget almost larger than the next largest 14 combined. If budget levels drop, this may permit money to flow to other areas of the U.S. economy. With the U.S. economy still far from completely stable, money saved from the defense cuts may be used to jump-start social or transportation projects. 

Naturally it is impossible to speculate as to where those funds might go, though the recent discussion over U.S. health care suggests that the industry may get a surge of funding to defray transition costs. Another possibility exists that funds could be injected to boost construction efforts, an area that has been lacking in recent months (though some just blame the weather).

Whatever the case, the U.S. defense industry should not be too worried about its financial future.

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Kurt Avard

A January 2014 addition to the Motley Fool team, Kurt Avard prefers to focus on the "dark" side of business and how it interacts with politics. Rarely writing on the same thing twice, he feels that, if he manages to convince you that the two are inexorably linked, he has adequately done his job. Follow him on Twitter @kurtsavard

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