Where The Defense Sector Is Headed

Issue Brief

The defense business is virtually the only sector of the U.S. economy where demand is driven by non-economic forces. In defense, the key driver is threats to national security. As a result, defense activity often expands at precisely the time when the rest of the economy is retreating. That pattern has led financial analysts to recommend the stocks of defense companies as “counter-cyclical” investments, meaning investments that will counter the trend in other holdings subject to the commercial business cycle.

It was this sort of reasoning that led Boeing, the biggest aerospace company, to organize its business as a balanced mix of commercial and military programs. In theory, the two segments will tend to counter-rotate, so when one is down, the other is up. However, although defense does not follow the rhythms of the commercial business cycle, some analysts think it does follow its own unique pattern. If you construct a graph of annual defense spending from the beginning of the cold war to the present, there appears to be a wave pattern connected to the waxing and waning of threats that keeps military outlays within a fairly predictable range.

Expressed in 2006 dollars, the pattern suggests that when the total value of military outlays approaches half a trillion dollars, it bounces off an invisible ceiling and begins to head down. Once this downward movement commences, it tends to continue until a fifth or more of the buying power in the overall defense budget has disappeared. That pattern played out after the Korean War, the Vietnam War, and the Reagan defense buildup. Some people believe it is about to unfold again.

One believer is Senator John McCain, who will take over the chairmanship of the Senate Armed Services Committee early next year if Republicans retain control of the upper chamber after midterm elections. McCain’s staff interprets the wave pattern in defense spending as a troubling portent of budget trends during his prospective chairmanship. It fears that he might assume the chairmanship of the committee at the crest of the most recent wave in spending, and then preside over a decline during following years.

McCain is too sophisticated to believe in mechanistic theories of market behavior, but concern that a contraction might be coming has led him to call for wholesale revision of the way the Pentagon buys weapons. Past experience isn’t the only reason to think he might be right. Although Pentagon plans anticipate that the buying power of the regular defense budget will stabilize toward the end of the decade at about $460 billion annually (in constant 2007 dollars), it is also assumed that supplemental appropriations for Iraq and Afghanistan will disappear in the same period. Thus, according to OMB budget tables, defense spending will decline from 4.1% of gross domestic product in 2006 to 3.1% in 2011. As a percentage of federal spending, defense will fall from 20% today to 16% in 2011.

Of course, none of this will come true if new threats arise. One attack like 9-11 can change the course of defense spending for the better part of a decade. But the paradox of military outlays is that when a strategy works too well, the will to keep funding it tends to wane. If Al Qaeda had mounted a new 9-11 style attack on the U.S. homeland once a year since 2001, military outlays today undoubtedly would be much higher than they are. But because there have been no follow-on attacks (at least in America), some people are beginning to suggest the atrocities of 9-11 were a fluke. That could lead to the kind of decline in spending Senator McCain fears — and a subsequent resurgence of danger that starts the cycle all over again.