Fiscal Cliff Notes

The only things you need to know about the coming budget fight.

With the November 6 election, the shadow play over the defense budget and the fiscal cliff has come to an end. For the past 15 months, we have been entertained by a drama scripted in the Budget Control Act that appears to threaten a fiscal cliff for discretionary spending in January 2013. Defense has played one of the lead roles.

President Obama has argued that if Congress wants to eliminate the threat of automatic spending cuts, Republicans need only put revenues on the table. In an election year? Unlikely. And, soon after agreeing to the fiscal cliff, the stalwart "defenders of defense" in the GOP came down with a sudden case of buyer's remorse, arguing that national security would be threatened unless defense were somehow exempted from the planned cuts.

Senators McCain, Ayotte, and Graham manufactured a circus big top that traveled to bases and defense factories, spreading "fiscal cliff fear" as far as they could. The defense industry, with a big stake in the defense budget, enthusiastically joined the chorus, threatening the loss of a million jobs. (That is, they went along until it was clear that their politicking might backfire, so they drew back.)

It was always a show, theater for the electorate. The need to "defend defense" was always exaggerated. The American military is far and away the strongest in the world. Moreover, in recent years the United States has been spending more on defense, in constant dollars, than at any time since 1945. While losing $50 billion through "sequester" from the planned defense budget this fiscal year would pose management challenges, it would be survivable.

But now that the entertainment portion of the program has ended, it's time to get real. Here are the five things about the defense budget the next administration has to deal with:

1. We are in a defense draw-down. Defense resources will shrink from their FY 2010 peak, the highest level of defense spending in constant dollars that we have seen since World War II. Current projections suggest that military spending will still keep pace with inflation, but in fact defense budgets will go into a real-dollar decline. They will shrink because we are out of one war and about to leave another. The public is focused on jobs, the economy, the deficit, and the debt, and it wants these things fixed. And they will shrink because any fix to the nation's fiscal situation demands that everything be on the table. It is the only way a deal is possible, both budgetarily and politically. So it is high time to start thinking about how to manage a serious draw-down, instead of pretending that it will not happen.

The Department of Defense, the military services, the White House, and Congress are not there yet; all are whistling through the graveyard pretending that there is no draw-down and that resources will continue to grow, at least at the rate of inflation. But already the defense budget has shrunk in real terms: the base defense budget for FY 2011 was the same as FY 2010; FY 2012 was below FY 2011; and FY 2013 will probably not keep up with inflation.

There are discussions underway outside government about how to manage a draw-down that could look like the ones we have been through before -- Korea, Vietnam, the Cold War. During each of those, defense budgets declined 30 percent in constant dollars over ten years. The Center for Strategic and International Studies has a working group looking at what kind of military force would result from a 30 percent budget cut. Nearly two years ago, on the basis of work we did for the Rivlin-Domenici Debt Task Force, my colleague Matt Leatherman and I took a look at the options for a significant draw-down. The CSIS group is still crafting the options; we found that a force of 1.25 million troops (versus the 1.4 million we have now) would be able to execute national strategy and maintain global superiority.

2. Defense budgets and defense strategy are inseparable. Those who insist that defense budgets should be based on strategy and threat, independent of resources, do not understand this fact. Every strategy is resource-constrained; every budget disciplines the choice of strategic priorities. Acceptable levels of risk mediate this relationship.

This has always been true: Ask Eisenhower about how he traded off ground forces against nuclear forces ("massive retaliation") as he sought to balance the federal budget. Ask Nixon about how he changed the military force planning algorithm from 2.5 wars to 1.5 wars and sought regional strategic partners (like the Shah of Iran) as the defense budget declined in the early 1970s. Ask George H.W. Bush and Colin Powell about how they constructed a new force-planning algorithm (2 Major Regional Contingencies) around which to build the "Base Force," as the defense budget declined in the face of major deficit reduction efforts from 1985 to 1990.

It is silly to pretend there is no connection between budget and strategy; there is a connection between them for every country in the world. Budgets are a great way to discipline endless expansion of strategic appetite. And strategy and missions are essential to writing budgets. So we need to stop claiming, as Secretary Panetta did in his interim strategic guidance, that his budget decisions were strategy-driven. There would have been no need for an interim strategy review between the 2010 and 2014 quadrennial defense reviews had the budget not begun to flatten from previous projections.

3. The problem with the defense budget is not that it is too small. We spend more than we ever have. The problem the administration faces is that the parts of the budget that are out of control are, at best, only indirectly related to security needs. The fiscal discipline that is on the way will help focus attention on these major issues, which have been widely recognized for decades:

- No amount of "acquisition reform" has managed to keep defense programs from going well over budget. As the Government Accountability Office notes in its understated way: "For several decades, Congress and the Department of Defense (DOD) have explored ways to improve the acquisition of major weapon systems, yet program outcomes and their underlying causes have proven resistant to change." Services are incentivized to under-budget, lest the program not fit in the budget. Contractors are incentivized to under-bid, lest their program not fit into the budget. History suggests that the key ingredient to holding down cost growth is none other than firm, knowledgeable leadership and constant attention from the top of the Pentagon. David Packer, Nixon's deputy secretary of defense (and co-founder of Hewlett Packard), knew all about that and had a better record than most in stemming cost growth -- a record that has never been remotely matched.

- The military's overhead -- the "back office" -- is severely overweight, whale-like even. A 2010 McKinsey study concluded that the U.S. "tooth-to-tail" ratio was worse than 27 of the 28 other countries it surveyed, including China and Russia. A Defense Business Board study the same year concluded that 40 percent of DOD active duty forces were "never deployed." This back office has been as resistant to reform as the acquisition system. Secretary Gates tried to nibble at it before he left, but efficient management is not DOD's forte. Shrinking budgets may prove to be the most effective tool in streamlining and disciplining the back office, which plays, at best, an indirect role in the combat capabilities of the force.

- The third rail of defense spending, personnel policy, has become even more electric. Time and again, secretaries of defense have tried to halt the endless growth of military pay, health costs, and benefits. Here, Congress is at equal fault. It is too politically easy to boost the troops' pay. It is too easy to spread the military benefit net to cover more and more dependents, reservists, and retirees. And it is almost impossible to curtail a retirement system that deprives any soldier who has served less than 20 years ("cliff vesting") and then provide full benefits after 20 years, regardless of the age of the retiree. The military's Quadrennial Review of Military Compensation regularly reviews these rising costs, but its recommendations are frequently ignored. The usual tool for reducing personnel costs, as a result, is to reduce personnel (and that is happening). Leadership at the top, with the full support of the service chiefs, is the only formula that can lead to effective, long-term cost control.

4. National security will actually improve if the administration tackles these hard management problems. Controlling defense spending will accommodate the need for fiscal discipline while enabling us to better set priorities. Choices need to be made, but they are made in the most promising context imaginable: The United States faces no existential threat, and it possesses a global military capability that is second to none. In fact, it is the only military that has truly global capabilities; nobody else even tries. Budget reductions need not compromise any of that superiority, if disciplined management prevails. Then, policy-makers can wrangle over whether China is a military threat or a strategic competitor (there is a difference, and it has implications for defense spending). They can argue over whether the United States has a role as global stabilizer or police officer, or whether we have run the string on that option, given international resistance. They can sensibly address the U.S. role in counter-insurgency operations, making sure that a) there are such insurgents and b) they pose a danger to U.S. national security. Right now, we argue all these strategic issues, but only account for them at the margin of the defense budget; we just accept the whale as part of the costs of doing business. We pile on additional funds, rather than exert budget discipline, which only makes the management problem worse.

5. Sequester was set up to force a deal on taxes and entitlements, but that may not be possible before January 2, 2013. And there are at least some "cliff divers" who suggest that letting it happen might be a "not-so-bad" option. The White House might want to consider whether "embracing the sequester" could provide exactly the discipline the Department of Defense needs. Is it livable? I have already raised the question of a "fiscal slide" for defense. The collateral damage to other discretionary programs may be too great to make it worth the trip. But inside DOD, the sequester could force hardware choices the services have been avoiding and the cost control they need. It would put strong pressure on Operations and Maintenance funding, where much of the overhead is buried. And it might focus greater attention on personnel costs, particularly the problem of redundant health care establishment in each military service. Maybe taking a ride on the slide would help. Or, perhaps, as part of a bigger deal, a revised proposal that requires $50 billion in defense reductions over two years (rather than one) would incentivize the next secretary of defense to roll up his (or her) sleeves.

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