The U.S. narrowly averted a debt crisis with the passage in August of the Budget Control Act of 2011. The last-minute drama and the wrangling of subsequent months sent the clear message that the U.S. will attempt to address its unsustainable long-term finances through cuts in discretionary spending. The failure of a specially appointed committee to agree on a fiscal adjustment package reinforces this view.
Under the approach outlined in the act, known as BCA 2011, adjustment falls on the discretionary portion of the federal budget, the minority share (38 percent) of federal spending; expenditures for security programs — the Defense Department and its partners — account for half of discretionary federal spending. This ensures the security sector will shoulder the majority of adjustment.
BCA 2011 and its aftermath indicate that the nation’s most serious security threat comes from uncontrolled growth of mandatory spending programs and the seeming inability to achieve a coordinated and sustainable long-term solution for the nation’s public finances. This carries important implications for security strategists and planners in three important areas.
First, the threat of a U.S. default that was raised during the BCA negotiations cast doubt on the long-term U.S. commitment to fiscal solvency. The resulting downgrade to U.S. credit ratings undermined U.S. credit quality and set the conditions for higher future borrowing costs. If the U.S. does not reform the trajectory of its finances, global capital markets will demand higher bond yields to compensate for more risky U.S. sovereign debt. The resulting spiral in interest costs will join other escalating federal budget expenses and dramatically reduce long-term U.S. fiscal flexibility. Instructive in this regard are the recent and ongoing eurozone sovereign debt crises, fueled by the perception that national governments and the collective body lack the commitment to enact sustainable long-range spending and revenue plans.
Second, budget adjustments outlined in the act fall almost exclusively on discretionary spending. This approach worsens already fierce resource competition within the minority share of U.S. federal spending. Large Defense Department adjustments will force strategic priority reassessments and alter the path of key programs, perhaps in a hastily devised manner. We can expect an erosion of highly specialized national security capabilities in other federal departments as reductions to these smaller agencies have a greater impact than reductions to the much larger DoD budget.
Finally, BCA 2011 strives for sustainability but leaves the underlying drivers of long-term fiscal instability unchanged. These include a revenue system that fails to provide resources sufficient to fund long-term priorities and plans that leave the trajectory of entitlement programs unchanged. The growth of mandatory spending, particularly in health care programs, represents the real driver of future deficits and the growth of federal debt burdens.
WHAT IS BCA 2011?
BCA 2011 grew out of concern that large and persistent deficits would render future U.S. government finances unsustainable. The best measure of this trend is the ratio of publicly held debt to yearly national output measured as gross domestic product (GDP). Debt to GDP ratios grew from 40 percent of yearly output before the 2007-2008 financial crisis to present levels of more than 70 percent and will rise to unmanageable levels in the future. Congress authorizes a maximum public borrowing level, which lawmakers must raise if the Treasury Department requires debt above this limit to meet national financing needs. If Congress does not raise the authorized level, the federal government must reduce its spending to match incoming revenue from tax collections.
Strictly speaking, this summer’s discussion of a default on U.S. debt holdings was inaccurate and premature. Treasury can avoid default by placing first priority on the payment of interest to existing bondholders and defer other payments until future revenues arrive. A failure to raise the debt limit would have triggered a roughly 40 percent reduction in federal spending once the Treasury’s authorization to borrow funds ceased. Spending levels in the months that followed would be erratic and unpredictable. Revenue flows to the Treasury vary significantly from month to month and would suffer disruption in the turmoil following such a sharp reduction in spending.
Nearing the self-imposed borrowing constraint, Congress and the Obama administration began negotiations early in 2011 to raise the statutory borrowing limit. Discussions quickly became an extended debate over desired federal spending levels. The resulting agreement, enacted hours before Treasury estimated the U.S. government would reach its borrowing limit, outlined $2.1 trillion in spending reductions to occur in two phases. The first package specified $900 billion in cuts to discretionary accounts, with roughly half allocated to security-related spending reductions and the other half spread among other discretionary categories. The reductions begin in 2013 and continue until 2021.
The second phase charged a bipartisan committee with the task of constructing by November a package of between $1.2 trillion and $1.5 trillion that the full Congress would vote into law by January. On Nov. 21, the special committee announced that it had failed to reach agreement. The main points of disagreement were a reluctance to increase tax revenues and structure reductions in mandatory spending programs.
As a safeguard against the committee’s failure, BCA 2011 outlines a mandatory $1.2 trillion package of spending reductions that substitute for the negotiated package. These second phase reductions follow with slight modification the same 50/50 defense/nondefense mix of the first phase. The reductions occur in the same 2013-2021 time frame, though with some discretion allowed in the timing of the reductions. The net result is the potential to impose $1 trillion in DoD spending reductions over the next decade, with further reductions to other portions of the security community. The implications of these cuts on capabilities are unknown, as the specific trajectories of reductions and allocations are unspecified. One analysis suggests that the DoD budget could decline by as much as 20 percent from levels identified in the 2012 Future Years Defense Program. Reductions on this magnitude would force immediate reassessment and changes to force sizes and structure, procurement timelines, personnel policies, risk assessments and strategic commitments.
BCA 2011 increases uncertainty in the security community through the turmoil it brings to future U.S. finances and budgets. In the wake of BCA’s passage, Standard & Poor’s downgraded its rating of U.S. debt from AAA to AA+. S&P based its move on the view that “elected officials remain wary of tackling the structural issues required to effectively address the rising U.S. public debt burden.” The failure of negotiations did not produce further downgrades, though Fitch ratings, another of the major rating agencies, changed its outlook for the U.S. credit rating to negative. Other major bond rating agencies withheld downgrades but issued statements of concern regarding the long-term U.S. fiscal stance and its impact on the quality of U.S. credits.
While subjective and controversial, the downgrade represents a significant vote of no confidence in the U.S. political will to reckon with its growing debt burden. Without credible reform, interest rates will rise in the long term, which will increase the cost of debt service. U.S. government bond rates remain low due to factors such as massive bond purchases by the Federal Reserve, foreign investors seeking to avoid even more turbulent foreign alternatives and weak demand for investment capital. How long these effects will endure is unclear, but at least one signal indicates that markets view U.S. debt as more risky. Credit default swap — a form of bond insurance — rates on U.S. government debt doubled in the run up to BCA 2011 before receding slightly.
The process of coming to agreement on deficit reduction packages and preference for discretionary spending reductions increases the level of resource uncertainty in the security community. DoD budget planners anticipated budget reductions of 6 percent to 8 percent for some time, a policy Defense Secretary Robert Gates began in the final year of his tenure. Defense Secretary Leon Panetta recently indicated that DoD would submit plans for $450 billion of spending reductions over 10 years from the Future Years Defense Program baseline to support the bipartisan commission’s work. The presence of large initial reductions and a follow-on package potentially more than double the initial levels increases uncertainty for planners.
Recent developments create even more uncertainty. Press accounts shortly following the supercommittee announcement indicate that DoD engaged in no planning for reductions beyond the $450 billion mark. With the automatic cuts known and sequestration now a forced event, further budget reductions are more likely to be rushed and haphazard. The security community is familiar with and adjusts to the pattern of buildup and reduction that accompanies the nation’s conflicts. However, unpredictable resource flows disrupt the multiyear processes required to create force structure and manage complex acquisition programs.
Election year maneuverings are sure to exacerbate this uncertainty. BCA 2011 is law, which Congress and the administration may change. However, alterations bring difficult choices and potential penalties. Repeal of BCA exposes lawmakers to criticisms of fiscal profligacy, invites further bond rating downgrades and worsens the nation’s fiscal outlook. Congress could elect to relax individual provisions and retain the overall objectives of BCA through spending reductions or revenue increases in other areas. This alternative requires lawmakers to inflict pain in other areas to protect favored priorities. In sum, BCA 2011 sets up a zero-sum game that pits security against popular entitlement programs and higher taxes.
Congress could elect to avoid hard choices in the election year and make its desired adjustments in the “lame duck” session following the 2012 elections. This alternative places difficult choices into an extraordinarily short decision space. The outcome is completely unknown, but the unambiguous result is a highly uncertain environment for leaders and planners and the real possibility that the full package of reductions will stand at year’s end.
BCA 2011 imposes stringent short-term reductions to a problem that is long-term in nature. In so doing, long-term problems remain unsolved after resource reductions occur. This will impose further constraint when, at some point, the U.S. government must reckon with the accelerated growth of mandatory spending in the remainder of this decade and next as the “baby boom” generation retires from the workforce. Simply stated, BCA 2011 postpones resolution of the most serious problems.
Immediate spending cuts further complicate the picture as they remove demand from an economy that is suffering from reduced consumer spending, business investment and demand for U.S. exports. Combined with other fiscal tightening already in the mix, demand will decline by 2 percent of GDP in 2012 absent changes. Tightening of this magnitude threatens an already sluggish recovery. Growth is essential to provide greater revenues that will reduce the federal deficit and strengthen the ability to service debt. Precipitous withdrawal of an important demand component has the potential to delay recovery and make the debt burden more severe.
Recent research indicates that sluggish growth follows financial upheaval of the sort the U.S. endured in 2007-2008. Reductions in the range of 1 percent real growth occur as debt holdings rise toward 90 percent of GDP. Recent economic performance seems to confirm this trend, as U.S. recovery lags and real growth struggles to reach 1.5 percent of GDP, the level we would expect if the U.S. follows the path of performance expected during recovery from a major financial crisis. It is easy to miss the significance of sluggish recovery from the numbers. A 1 percent reduction in real GDP growth implies that the pool of resources available for the U.S. to support strategic priorities grows at only 60 percent of historical rates. Compounded over a decade, this dramatic reduction in growth will have a sharp impact and greatly alter planning assumptions.
Ultimately, sluggish national output growth increases the debt burden and complicates strategic choices. Short-term austerity employed to address a medium- to long-term debt problem makes a weak recovery worse and elevates long-term risk. A more appropriate approach would establish binding reductions across the entire budget that phase in slowly and achieve control of the most rapidly growing spending. Instead, BCA concentrates its effects into a few short-term changes and leaves the long-term trajectory unchanged.
Revenues continue to be insufficient to fund U.S. government programs. BCA 2011 does not attempt to address this problem. As the U.S. develops a need for ever-larger sums from the capital markets, lenders will demand higher interest rates to compensate for risk. Interest costs will explode and begin to dominate federal spending as a new source of mandatory spending. Given these conditions, the federal government will have to seek further adjustment in its discretionary spending accounts. The result will be an intensified constraint on security resources.
The strategic remedies involve bitter medicine all around, but are still achievable. Recent research on the topic of fiscal consolidation concludes that a mix of three dollars in spending reductions to each dollar of tax increase offers the best results. Proposals that reform the tax code through the elimination of deductions and broad rate reductions on earned income increase efficiency and have a track record of yielding greater revenues. On the spending side, a reprogramming away from transfer spending toward improvements in infrastructure, education and research offer the opportunity for future growth and the ability to service higher debt levels. All of this, however, requires the reform of mandatory spending programs and popular deductions in the tax code, a politically difficult task.
Long-term fiscal risk carries important implications for security strategists and planners. Capital markets have placed the already damaged U.S. fiscal reputation on warning. Conditions exist that will increase borrowing costs absent spending reductions and revenue increases. Preliminary budget adjustments fall on discretionary categories and subsequent reductions appear likely to follow the same pattern. BCA 2011 leaves mandatory spending unchanged and ensures that future decisions will be more difficult. Recent polls indicate a public preference for entitlement programs to be a last priority for reform. Congress and the administration will have to exert significant leadership to alter the trajectory of mandatory spending and achieve meaningful fiscal sustainability that preserves flexibility in discretionary spending.
The early rounds of fiscal consolidation and their likely outcomes should convince security strategists and planners to expect even greater austerity in the future. Initial attempts at fiscal reform have harmed the U.S. credit reputation, forced haphazard adjustment onto a minority share of spending and deferred true resolution of the problem. Initial adjustments will be severe and future reductions are sure to follow in the absence of reforms to mandatory spending. In the long term, reductions to the DoD budget to a level of 3 percent from the present 4.2 percent of GDP and proportionate reductions to other security components outlined in long-term budget projections seem highly plausible.
National security professionals have the responsibility to provide maximum capability consistent with resources the nation provides through the political process. Professional responsibility includes an informed and objective assessment of strategic choices, risks and resource requirements to meet strategic priorities. DoD faces internal problems of its own “mandatory spending” in personnel and medical accounts and affordability of its investment programs that require urgent control. Broad scenarios that reflect reductions in the present decade from the 2012 baseline of 8 percent (the Gates/Panetta target), 20 percent (BCA 2011 maximum impact) and 30 percent (consistent with a reduction to 3 percent GDP share for defense) represent realistic guidelines for DoD strategic planners. These represent optimistic, realistic and worst-case scenarios for the future path of defense resources.
BCA 2011 represents in one sense a down payment on a sustainable long-term fiscal stance bought through stringent control of one portion of the federal budget. This is a necessary step for the U.S. to preserve strategic flexibility in the future. However, the formulation and construct of the act make a bad situation worse through damage to U.S. fiscal credibility, the use of short-term adjustments to address long-term problems, and an approach that leaves the underlying drivers of long-term instability unchanged. The act brings the point of severe adjustment closer and raises risk.
It is worth considering that the nation’s most significant security risk is not from an external source, but from the unsustainable and poorly planned trajectory of its own finances. AFJ