As I argued in my recent paper Arming the Bug Hunt, military contractors should begin taking stock of how their businesses might fare under a severe economic downturn. The scale of the possible is not trivial. Writing in the Wall Street Journal recently, Robert Barro of Harvard University estimates that the United States faces a 20 percent probability of a drop of more than 10 percent in consumption in the near future. Barro draws his evidence from his recent paper with José Ursúa in which they correlate stock market valuations to economic activity around the world since 1870.
This might call, he acknowledges, for drastic action, but the actions of Mr. Obama’s team thus far have been unhelpful, and may prove drastically hurtful. For more on this, I recommend the panel discussion in January by economists John Huizinga, Kevin Murphy, and Robert Lucas at the University of Chicago’s Myron Scholes Global Markets Forum. The content of the commentary ranges from pithy to mathematical, but it’s certainly useful for deflating irrational expectations. “The Obama people,“ John Huizinga starts out, are keen on massive governmental spending in 2010 and 2011 because they’re concerned about possible the length of the current recession. However, unless one believes in macroeconomic multipliers mysteriously absent from evidence, recessions can’t be avoided. They can only be reallocated across time, and inefficiently at that.
What’s truly amazing about this particular brand of panicky politics, as John Cochrane points out in side commentary leading to a question, is that of all the current problems, failure to borrow and spend enough was not just missing from the list. Rather, it was a large part of the problem itself. Or, try the recent commentary from Peter Klein at the University of Missouri:
So, let me get this straight. We’re in a major recession triggered by a collapse in the housing market, itself the inevitable result of government policies, led by Fannie Mae and Freddie Mac, to get the wrong loans to the wrong people so they could buy the wrong houses. The Obama Administration’s remedy is not to let Fannie and Freddie die a long-overdue and merciful death, but to prop them up, to give them additional powers, and to subsidize private mortgage lenders who extend yet more credit to more borrowers who can’t pay it back, thus making what might have been a temporary misallocation of the housing stock into a permanent one. Brilliant!
Great. But what does this mean for the arms industry? There are only three possibilities for future spending by its largest customer, and none of them particularly good for the business:
- Spending is sustained by future tax increases. Christy Romer, the head of Mr. Obama’s Council of Economic Advisers, has argued that tax reductions only eventually lead to one thing—future tax increases—because that has been the pattern so far. That’s certainly possible, but it’s not a guarantee. Romer’s opinion is like arguing in the 1890s that heavier-than-air aircraft were an impossibility because no one had yet built one. If one thinks of the record in the United States from 1945 to 2007 (the range of Romer’s analysis) as somehow special and unrelated to the rest of the world, this myopia might work. Unfortunately for her model, the Chilean and Argentine examples from countries like Chile and Argentina show what else is possible.
- Spending is decreased to pay for future debt service. With planned federal borrowing of almost 13.5 percent of US GDP next year, we can all finally put to bed the notion that somehow the Democratic Party has fiscal discipline. That rate is more than twice Ronald Reagan’s post-WW2 record of federal borrowing. This is also called intergenerational theft, but that’s another matter.
- Spending is salvaged by shirking the debt. That works occasionally, and as noted, particularly in South America. The bondholders are told that they’re getting 25 cents on the dollar (peso, whatever), and are reminded that the debtor is a sovereign entity that can get away with that. This strategy does come at the expense of being able to borrow again, but that presumes that there’s actually a legitimate reason for the US federal to borrow money that kind of money.
Now, the people in charge in Washington DC might be playing at macroeconomics without understanding the micro-evidence, but that should not stop us from getting back to principles, and reviewing the microeconomic foundations of future customer demand. We all note the tension in Mr. Gates’ Pentagon between spending on systems designed for wars big and small. Consider this graphically in a two-product demand model with classical convex preferences and an inwardly shifting budget constraint. In plain English, think about a defense ministry that must choose how to allocate its procurement funds between buy kit meant for fighting big wars and small wars. That would cover most countries in the civilized world today.
For sake of argument, think about the big war and small war kit as fighter jets and armored trucks, respectively. In the diagram, the defense ministry’s optimal procurement basket, based on its preferences, is 50 of the former and 500 of the latter. In this particular case, shifting the budget constraint inward (as funding dries up) shifts the optimal procurement basket to 20 jets and 533 trucks. In this case, less money means buying more of something that’s cheaper—and that, in economics, is termed an inferior good.
Is it possible, then, that small-war weapons are inferior goods? That question is posed in the positive, economic sense, and should not be taken as a normative comment on their desirability (I am not, after all, Gian Gentile.) We could infer that spending patterns in Europe, where the drawdown in funding after the Cold War was more acute, do indeed suggest this. The Czechoslovak Army in 1989 had over 1,000 T-72 tanks; today, the Czech Army has just 30, but it’s buying new wheeled armored troop transports more suitable to counterinsurgency.
More likely, the patterns of demand are more complicated. Across Europe, where defense ministries have a few extra dollars to spend, they’re spending them on blast-protection, intelligence gathering, and unmanned aircraft—not more Eurofighters, whatever the tranche. This suggests that small war kit, while possibly yesterday’s inferior good, is today’s normal good: the thing on which you spend cash when you get it. Geopolitics introduces a healthy dose of path-dependence here, so the conventional tools of analysis may be insufficient. That, of course, will not stop us from working at the problem.
If there is path-dependence to demand, then scenario modeling is the tool. In general, I have found scenario planning, real options analysis, and methods like cross-impact matrix analysis to be very handy for helping clients figure out just what they’re up against. Descriptive narratives of how their customers might use their planned products in different versions of the future can make complicated portfolios of options more tractable. Technology planning is a critical part of this effort, but while many military contractors have an implicit approach, considerably fewer have an observable strategy. Trouble is, if things really are getting as grim as they could be, some of the leading companies in the industry might soon be recounting Sir Earnest Rutherford’s words:
"Gentlemen, we have run out of money. It is time to start thinking.”
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