How Inflation Could Kill Modernization of the U.S. Military
(Source: Forbes; issued Oct 22, 2018)
Here’s a scary number that nobody in Washington seems to remember. On September 21, 1981, during Ronald Reagan’s first year as president, the interest rate on the 10-year treasury bond hit 15.68%. At the time, the entire federal debt totaled less than a trillion dollars. But if the portion of today’s $22 trillion debt held by the public had to be serviced at that interest rate, it would cost Washington $2.5 trillion annually to carry its accumulated financial obligations.

Or said differently, it would require about three-quarters of all federal tax receipts just to keep up with interest payments on the national debt.

Fortunately, the ten-year bond is currently trading for around 3% rather than 15%, but as you have probably heard, we are now in a “rising interest rate environment.” The 10-year bottomed out at 1.37% on July 4, 2016, and has been climbing fairly steadily ever since. President Trump is blaming the Federal Reserve for raising rates, but that misses the point that when you reach full employment after a prolonged period of expansion, prices tend to rise without any action on the part of the government. That’s just how markets work.

This trend inevitably creates uncertainties about the outlook for defense spending, especially equipment outlays. Byron Callan of Capital Alpha Partners, arguably the most seasoned and astute observer of defense-industry dynamics, has been gently raising alarms all year long. As he observed in a note on October 5, “unless there is a willingness to raise taxes or tackle healthcare costs, higher interest outlays have to bear on the capacity to spend for defense.”

This isn’t just conjecture on Callan’s part. If you look at the Office of Management and Budget’s most recent estimates, debt service cost the government a bit over $300 billion in 2018 – the fiscal year concluded September 30 -- but will rise to $447 billion in 2020 and $619 billion in 2023. In other words, the cost of carrying the debt will double over five years. OMB forecasts are usually rosier than those of other outfits, in part because they assume cost-saving initiatives proposed by the White House will actually be implemented. In reality, Congress almost always pushes back.

Obviously, if the cost of interest on the debt rises at a much faster rate than tax receipts do, some adjustment in federal spending patterns will be necessary. There isn’t much evidence that Pentagon planners understand this. In fact, all of the military services are pushing modernization plans that reach peak spending in the middle of the next decade – precisely the point at which fiscal imbalances could produce a crisis. For instance, the Air Force expects to be buying new fighters, bombers, tankers and trainers simultaneously in 2025 while also recapitalizing space assets to make them more resilient.

How likely is that if interest rates spike during the intervening period? Not very. If the government were spending an average of 5% annually on debt held by the public across all of its various financing instruments and durations, the cost of debt service in 2020 would be around $900 billion. At 10%, it would be $1.8 trillion. Three years later, after trillion-dollar annual deficits have pumped up the scale of publicly-held federal debt to over $20 trillion, a 5% average annual carrying rate would result in a trillion dollars in debt-service costs per year (a fifth of the projected budget); 10% average carrying rates would cost the government two trillion dollars per year.

And remember, I’m not even including the $7 trillion in debt circa 2023 that is expected to be held by the government. By that time, Social Security alone will be costing the government well over a trillion dollars each year, and the combined cost of Social Security and Medicare will exceed two trillion dollars. So, it isn’t hard to see how a rising interest rate environment might spell doom for current defense plans.

But a fiscal crisis driven by rising rates wouldn’t impact every defense account equally. Modernization would be hit harder. Personnel costs and readiness always get higher priority than equipment purchases when money is tight, because failure to fund them adequately could have immediate and devastating consequences, whereas warships and bombers funded today won’t reach the force for years. Other things being equal (meaning no ongoing wars), purchases of military equipment tend to be one of the government’s lowest priorities when money is scarce.

This is partly a result of structural features the federal budget. About three-fifths of all federal spending consists of so-called “mandatory spending” – entitlements and interest on the debt – that is barely touched by the annual funding cycle. So, when money is urgently needed, Congress looks to the remaining two-fifths of the budget considered to be “discretionary.” That means defense plus non-entitlement domestic programs such as education, criminal justice and transportation.

It’s easy to say that military modernization only accounts for 5-6% of overall federal spending, but amongst the funds that can most readily be tapped, military equipment is more like 15% of the total. If you then remove the supposedly discretionary items that in political terms are must-haves, like border security and drug enforcement, military modernization bulks quite large.

So unless somebody finds a way to make supply-side economics work the way it was originally intended, military modernization is going to take a hit in a rising interest rate environment. How could it not when Washington has accumulated so much debt? Any attempt to reschedule the debt as candidate Trump rather fancifully proposed during the presidential campaign would collapse the global economy. We are stuck with the financial commitments we have made.

If the military services have any sense at all, they will buy new weapons now, because once interest rates rise, that option may be off the table.


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