THE BLOG
01/16/2013 10:48 am ET Updated Mar 17, 2013

Forget China -- What About the Threat of U.S. Government Spending?

America's $16.4 trillion brimming bucket of debt will quickly return Washington to the global spotlight as Congress enters yet another phase of negotiations that attempts to trade government spending cuts for an increase in the debt ceiling. But not all government spending contributes towards economic growth.

In May 2011, Congress faced exactly the same conundrum. The $14.3 trillion debt ceiling was about to be breached, the U.S. government was spending more than it received by around $1.6 trillion a year, and in order to fund obligations of Congresses past and present, a further increase to $16.4 trillion was required. 18 months later, a convergence of expiring tax breaks, the initiation of sequestration, and an over spend of $2.1 trillion dollars, has once again forced Congress into crisis response mode.

Remaining cautiously optimistic -- Congress does appear to display some unity over nurturing economic growth. With well over half of America's GDP coming from consumption (goods and services), the New Year's Eve fiscal cliff deal did avert tax hikes on 98 percent of American tax payers, reducing the likelihood of a double dip recession in 2013. By taxing individuals who earn over $400,000 and households over $450,000, Washington has increased its yearly revenue by $600 billion and dented future GDP by just 0.15 percent. Nevertheless, payroll tax breaks will expire for all (back to 6.2 percent from 4.2 percent), a policy move that is expected to increase revenue by $100 billion but take a 0.6 percent toll on income growth. In the main, growth remains a priority but it does not solve alone the problem of deficit and debt.

On the prickly subject of austerity, the best that Congress could achieve was a 2-month delay of sequestration (automatic spending cuts across Defense and Non-Defense discretionary programs to the tune of $110 billion a year over 10 years). Given the current overspend, $700 billion a year of additional tax revenue still leaves the U.S. with a deficit of $900 billion. Sequestration has caused all types of consternation in Washington yet it only services 12 percent of the remaining deficit, leaving roughly $800 billion to find a year, on top of a $16.4 trillion debt mountain. Rather sobering, especially when you consider U.S. treasury yields are testing all time lows equating to $360 billion in yearly interest payments. As the global economy recovers, it is likely that demand for U.S. treasuries will decrease which could force interest rates higher -- adding to the deficit problem. The probability of a default on American debt is highly unlikely given that its cause would stem from a failure to pay principal or interest. But as has been clearly demonstrated in Europe, the way the markets react is suppositional -- even the simplest strategy to proactively address government spending might instill confidence of investors and U.S. ratings agencies.

So what are the options? The basic formula for growth is as follows: GDP = Consumption (business and consumer) + Investment + Government Spending + Net Exports (exports - imports); this equation works for all countries and periods.

Roughly translated to the current predicament: Washington's acquiescence on a permanent extension in tax breaks has helped continue feeding consumption, adding (or preventing a decline) in America's real GDP by 1.25 percent - 1.75 percent in 2013. Investment from U.S.-owned assets abroad consistently earns more than foreign owned assets in the U.S. and Net Exports, (that currently hurt GDP by -0.3 percent) could improve slightly in 2013 given a combination of healthy export estimates from Boeing 787 sales (assuming current problems can be overcome) and low oil prices.

According to Keynesian economics, an increase in government spending during recessions is the most effective path to stimulating growth (John Keynes also advocated paying the debt off once on recovery and expansion). Paul Krugman recently wrote in the New York Times that "yes, debt matters. But right now, other things matter more. We need more, not less, government spending to get us out of our unemployment trap." But others vehemently contest the effectiveness of the $831 billion stimulus package on GDP and unemployment. Both arguments each have persuasive hypotheses but what seems to be missing is an appetite by the current administration to accompany stimulus with a transparent Comprehensive Spending Review (CSR) across all government departments.

Having been close to U.S. foreign policy and defense for over 20 years, the sums of cash involved with Defense and State department budgets to this day are staggering -- especially when contrasted against the rest of the world and somehow justified in the face of America's fragile economic landscape. For example, military expenditure in 2011 comprised almost 20 percent of federal outlays -- that is about $706 billion per year (including overseas contingency operations). America spends more than six times than China on defense ($106 billion), and around ten times more than Russia ($72 billion) -- why exactly -- to keep the Russians and Chinese in check?

The U.S. has been involved in two major wars since 2001 -- neither has involved expansionist intentions by China or Russia. For those arguing that colossal military might is required to deter a myriad of threats from North Korea, Iran, Pakistan, Syria as well as al Qaeda then America might be well placed to implement a little austerity with its foreign policy. Invading Iraq proved a fruitless and illegitimate exercise in 2003 and Al Qaeda camps in Afghanistan were obliterated in the following months post 911, forcing most of the senior AQ leadership into Pakistan. Since then, both conflicts, as well as the support that America provides to the Pakistan Army, are estimated to have cost the U.S. some $4 trillion, according to the Eisenhower Research Project -- 25 percent of current federal debt. Looking forward, America will also provide some $3 billion to fund the Afghan National Army beyond 2014 whilst other countries are expected to contribute $1 billion -- for how long is yet to be determined.

In terms of capability and manpower, America's deployed nuclear arsenal still reflects levels of lethality more suited towards Cold War threats; U.S. ground force levels represent an ability to fight two major wars; and the Pentagon has an outdated health care system. Reform across these areas alone would save the US tax payer $86 billion over 10 years. Nuclear capability, manpower and benefits are, however, highly emotive subjects that generate well-fielded arguments to justify current spending levels. What should not be disputed are the unacceptable inefficiencies in military equipment procurement through delays and cancellations that have cost the American taxpayer $50 billion over the last 10 years.

Moreover, the 'fifth generation' F-35 fighter jet, yet to hit the frontline, is costing the U.S. tax payer $400 billion (42 percent over initial estimates), will be six years late into full production and is not performing to user specified requirements. The $40 billion Gerald R. Ford aircraft carrier program is also expected to run $4.2 billion over budget. Defense expenditure should be driven by Foreign Policy -- now would be a good time to re-access commitments through the mechanism of a Strategic Defense and Security Review.

So should the U.S. economy not be in better shape given that its defense industrial base benefits directly from yearly budgets including $100 billion on procurement, $80 billion on research, development, testing and evaluation, $80 billion on sustaining acquisitions related to current wars and $300 billion spent on operations and maintenance? The U.S. tax payer would have every right to question value for money -- 2012 third quarter GDP was 2 percent and since the recovery began at the end of 2009, only two calendar quarters out of 13 have shown annual GDP growth at better than 3 percent. The debt consequence of American spending on defense and overseas foreign policy interventions, contrasted against any stimulus benefits to U.S. economic growth are overwhelmingly out of balance. At a sixth of the defense budget and a foreign policy that has avoided prolonged major conflicts in distant lands, China's economy appears to be reaping the benefit of less spending.

A U.S. default is not on the cards, not at the moment at least, but markets and investors will mark the next round of America's homework on its proactive ability to devise a more affordable financial plan. American foreign policy does not need to have a footprint in every corner of the globe, or pursue divisive strategies that place soldiers in far and distant lands for decades. Washington does not need to maintain a nuclear arsenal befitting of a Cold War arms race and the sums of money that are poured into the procurement chasm are scandalous. Interventionist foreign policies need to have tangible benefits to homeland security and commitments need to reflect affordability. A complete overhaul in government expenditure needs to occur in the form of a comprehensive spending review and more specific to Defense and State departments -- a Strategic Defense and Security Review. China's military capability maybe relevant but the one threat the US would be wise to address is excessive government spending -- and paradoxically, less fighter jets, tanks and ships might be the answer.

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