Deferring the Inevitable

Political and piecemeal Pentagon budget cuts can't hide the fact that there's no strategy behind the sequester drawdown.

Beyond the emotional and tragic tale of Army Ranger Cory Remsburg, President Barack Obama's State of the Union address didn't say much about defense, beyond an anodyne phrase: "And as we reform our defense budget, we have to keep faith with our men and women in uniform and invest in the capabilities they need to succeed in future missions." It has been clear that defense budgets have been going down for more than three years now, so why underline the obvious? Because it's unclear that the Pentagon has the message, or the defense industry, or Congress. The United States still doesn't have a defense plan that is strategically driven. And it has a super-human effort to avoid the inevitable by all players in the budget game -- the Pentagon, Congress, and the defense industry. No wonder they didn't get the memo yet.

What the country has, instead, is the same kind of defense drawdown we have seen before -- cuts that are spread around in lumpy bits and pieces. First, Washington cut projected dollars to buy hardware in the procurement budget, which always falls faster than the overall budget in a drawdown. But this happens piecemeal: The services try to take out things they don't want, and Congress puts some of them back in. Then, to balance the books, both the Defense Department and Congress slash and burn when it comes to the smaller stuff nobody sees and few lobby for, like trucks and ammo.

Next, the Pentagon goes after the size of the force -- first Gen. Ray Odierno, chief of staff of the Army, said the nation could not be defended with fewer than 490,000 in the Army. Then he said it was not secure with an Army smaller than 450,000. Then he got the memo, and he appears to have agreed that it will be 420,000 by the end of this decade. Did strategy drive this? Not a bit; budgets did. Which, of course, sets off a small war between the Army and the Marine Corps -- as it does every time -- over which is America's real ground force.

Meanwhile, the Pentagon and military service bureaucracies -- uniformed, civilian, and contractor -- continue to thrive. Their budgets don't fall as fast as as spending on hardware procurement and force size, but, as I have written, it now seems that there are 1.8 million people employed directly or indirectly by the Defense Department to manage the business of a military force of 1.1 million in uniform. (That's 340,000 uniforms doing commercial or civilian tasks, 800,000 civil servants, and about 700,000 contractors.) Any way you slice it, that's a heck of a back office, and it doesn't seem to disappear as readily as the dollars for forces and procurement do.

Why do we get lumpy and bumpy cuts and not strategic ones? It's all about the politics. Not only is politics "not beanbag" (as Mr. Dooley said), but it is the archenemy of strategic thinking. And it is the reason all the players in the defense world can assume that there is not really a defense drawdown -- that somehow the end of the sequester fights of the last three years also means the end of falling defense budgets.

Take a look at the Pentagon: The service chiefs have been playing ostrich for some time now. Even with a tough sequester last year, they hope for better days. The latest evidence? Somehow, they convinced the White House to plan to send up an fiscal 2015 defense budget in early March 2014 that -- though it complies with the post-sequester Murray-Ryan budget deal -- will trot out a little $26 billion teaser above the budget request. In the olden days, this was known as the services' "wish list," what they would love to buy if they had more money. Service secretaries hated this end run; now Defense Secretary Chuck Hagel and the White House have embraced it.

Moreover, the Pentagon already got its holiday gift from the appropriators; the same holiday gift they have received for the last decade -- money that doesn't count against the budget caps. They call it the overseas contingency operations (OCO) budget -- or war budget, for short. It has actually been a peace budget for years now, though -- a way for the services to avoid internecine warfare by having a kitty all could share. The OCO budget has been a refuge of scoundrels: buying equipment unrelated to the war, transforming the Army, and paying salaries that were due but wouldn't fit in the base budget.

Then there's congressional profligacy. In the fiscal 2014 appropriations bill, legislators showed some fancy fiscal footwork, shifting money back and forth between the war budget and the rest of the budget, raising the OCO funds by more than $5 billion above the administration's request, and then stuffing in more than $9 billion in operating expenses, as my colleague Russell Rumbaugh has pointed out. But why these contortions? To get that spending out of the base budget, leaving room for Congress to put back in the things their constituents make (but which the services wanted to cut), like the Global Hawk Block 30 unmanned aerial vehicle that the Air Force dumped and money to keep open the M-1 tank factory in Lima, Ohio, though the Army would rather let it close. Oh, and then there are things that the Pentagon never asked for, like $1 billion in equipment for the National Guard and Reserves.

And don't lose sight of the way everyone in Washington is running for cover on the tiny, little retirement reform buried in the Murray-Ryan deal -- the decision to provide less than a full cost-of-living allowance (COLA) to military retirees who are not yet 62 years old. Put on your battle caps, ladies and gentlemen -- the incoming rounds on that one are still reverberating. At this point, we'll never implement important reforms in military pay and retirement.

Let's not leave the lobbyists unscathed. The lobbies have returned to Capitol Hill. The defense industry did pretty well last year, economically, especially in the middle of a drawdown and a sequester. And the industry knows that effective lobbying can pretty much protect major defense programs. We commit an apparently unnatural act to do so: We shrink the size of the buy -- instead of 2,300 F-35s, we'll probably end up with under 2,000 -- and we stretch it out. This year, the industry did an even better lobbying job: The Pentagon gets enough money to buy 29 F-35s this year, the full production batch it had hoped for. But stretch will surely come in next year's budget.

So, when it comes to defense and national strategy, "it's the politics, stupid." But here's the problem. The defense budget will continue to fall. That's what it does in a drawdown, when the country is no longer at war. The Pentagon will try to deny that reality, and the president may avoid talking about it -- but if you look at the projected defense budgets starting in fiscal 2010, and then look back and see where they really went, the trend lines are always higher than the reality turned out to be. There's even a term for it -- a pitchfork graphic -- because that is what it looks like. But so long as hope springs eternal like this, the drawdown is going to be messy and unstrategic.

Worse, the safety net of the OCO is going to go away. Oh, it's great to have around now, but it'll get harder to give the Pentagon budget an extra, second budget, when Obama brings the troops home at the end of 2014. That means all the padding is going away and some real strategic budget planning has to follow. Watch this space. The inevitable is still inevitable, even if the services, Congress, and the industry have their hands over their eyes and fingers in their years.

Larry Downing-Pool/Getty Images


Slip Slidin' Away in Argentina

Does President Fernández de Kirchner have a plan to save her foundering currency?    

Last week, Argentina's central bank finally abandoned its hopeless battle to keep the peso at an artificially high exchange rate versus the dollar. Immediately afterward, the Argentine government decided to allow more purchases of foreign currency by its citizens. But the transition from the country's unsustainable currency regime is far from over -- and it could get much worse.

The initial devaluation of the peso came on Thursday, Jan. 23, as the central bank abstained from the purchases it had long used to prop up the currency. A drop of more than 10 percent on Thursday was followed on Friday by a smaller dip, with the peso coming to rest at about 8 to the dollar. It had hit 7 pesos just two days earlier.

Just eight months ago, Cristina Fernández de Kirchner's government had pledged not to devalue the peso. For years, it had been trying to make the central bank's job easier by restricting Argentines' sales of pesos in favor of foreign currencies. But as the bank's reserves dwindled, the risks implied by creating demand for pesos continued to grow. Last week was apparently the end of the line.

A more gradual pullback might have been preferable, but it was healthy to embrace the inevitable sooner rather than later. With the currency falling to its real value in a competitive market, there would be no more need for restrictions on trading. So far, so good, then? Not quite.

The signs of a problem began in the black market for dollars. For the past several years, the black market has operated in plain sight to fill Argentines' demand for dollars. Private traders sell dollars for many more pesos than the official rate to people who need them for travel, to invest, or simply because they think the peso will lose value in the future.

Before Thursday's events, the main black market rate, known as the "blue" dollar, sat at about 11.8 pesos. On Monday, after some ups and downs, it settled around 11.7 pesos. To an outside observer, the gap with the official exchange rate looked smaller, which would have been a sign of progress. But from the point of view of an average Argentine, the gap had barely changed at all.

The reason was in the fine print. The government announced on Monday that households with monthly incomes of at least 7,200 pesos would be allowed to buy $2,000 at the official rate each month, more than enough for most Argentines (or at least those with the requisite income). But there was still a surcharge on many of these transactions. For purchases and withdrawals from businesses and banks abroad, the previous surcharge of 35 percent was lowered to 20 percent. Before, the surcharge resulted in an effective exchange rate of about 7 x 1.35 = 9.5 pesos to the dollar. After the change in policy, the effective rate was 8 x 1.2 = 9.6 pesos.

In this case, no news was bad news. The greater availability of dollars should have reduced the gap between the official and black market rates, but neither really changed. Why not?

Argentines may now be skeptical that, having started the peso's slide, the government can also stop it. As the value of the peso drops, some businesses will be tempted to raise their prices more quickly. But with heightened inflation, a freely floating peso might fall faster as well. In the absence of a credible plan from the government for keeping prices in check -- its existing price controls have hardly done the job -- a downward spiral could ensue. To all appearances, uncertainty about prices and the peso is still generating demand for dollars in the black market.

So far, Fernández's government has done little to combat it. Last week, Axel Kicillof, Argentina's fourth economy minister in five years, and Jorge Capitanich, the cabinet chief, gave conflicting versions of the new rules for trading currencies, citing different surcharges for transactions (dramatized in this cartoon by Javier Rodríguez). On Monday, Jan. 27, Capitanich said the government would publish the names of every purchaser; he later reversed himself. Meanwhile, Kicillof promised to punish businesses that raised prices after the devaluation.

But to stabilize the peso, the government will have to fight inflation with more than rhetoric and threats. The process will not be easy, since inflation in Argentina is like the needle tracks on an addict's arm -- the ugly and unmistakable side effect of a long-term habit. For Fernández, the habit is spending.

During the global boom in commodities, Argentina's central bank printed pesos to buy the foreign currency earnings of the country's exporters. Rather than putting the resulting reserves into a sovereign wealth fund, the Fernández government used them to fund enormous increases in public sector salaries, infrastructure projects, and subsidies for energy and other essentials. These huge injections of cash into the economy did not come with equal growth in the production of goods and services, however, so inflation of more than 20 percent became commonplace.

If the government doesn't rein in its spending, then prices will keep rising while the peso keeps slipping. This process is not always orderly, and any moment of panic can lead to hyperinflation and bank runs. But with less than two years left in her last term, Fernández may be willing to take the risk.