US defence spending
Barack Obama inherits a federal budget running at a US$407bn annual deficit, according
to predictions made in the FY2009 budget, an economy in the midst of crisis, rising
unemployment and a shattered financial system. He also becomes Commander in Chief to
a military fighting wars on two fronts.
However, healthy majorities in both legislative houses of government should enable
Obama to steer his agenda through government with greater ease than many of his
predecessors have enjoyed.
Among the subjects that will be of interest through Obama’s first term will be the US
defence budget.
The history of US defence spending
The US now procures almost all of its new defence equipment on a cost-plus basis. In
cost-plus procurement there is open book accounting, which gives the Department of
Defense (DoD) complete visibility on companies’ financial performance. These companies
are then allowed to make a specified margin on different segments of spending. The US
has modified this approach to enable companies that complete orders on time and on
budget to earn slightly higher margins. Under this regime the customer carries the risk
through the programme development, and although the margin upside is capped, there is
no margin downside if the programme overruns.
The recent ramp-up in US defence spending, driven by the continuing operations in Iraq
and Afghanistan, has put current US spending at levels last seen in WWII. Despite the
peaks for the Korean and Vietnam wars, and the Reagan build-up, the overall trend has
been for spending to reduce as a proportion of GDP, as shown in Figure 258. As stated
previously, this is typical of the pattern of global defence spending.
Despite the upturn in spending since 2000, US defence spending as a proportion of GDP
remains close to the all-time lows reached after thirteen years of defence-related cuts at
the end of the Cold War.
Since the Iraq invasion in 2003, President George W. Bush had become increasingly
reliant on supplemental war spend. In 2008 this took US defence spending from a base
budget of US$481.4bn, to a total of US$678.4bn. According to the US Office of
Management and Budget data (OMB), and the Congressional Research Service, the wars
in Afghanistan and Iraq have so far cost the US in excess of US$808bn. This compares
with US$670bn spent in Vietnam and US$295bn in Korea, but is still dwarfed by the
US$3.2trn that the US spent on World War II. Moving forward, operational spending will
likely continue to be a major drain on resources.

While the global economic crisis and the change of president add uncertainty to the
defence budget, it is unlikely that base US defence spending will be cut near-term due to
operational requirements. Military equipment is wearing out quickly after its high utilisation
in war zones, the installed base is ageing and strategic threats appear to be rising rather
than falling. We think it likely, however, that future growth will be more muted, and
completely new systems be introduced later than planned. In our view, the biggest risk to
spending will be if operational commitments last for much longer.
Previous economic crises
In past economic crises, the US defence budget has proven relatively resilient. When
budgets have been cut, it has been for political rather than economic reasons, for
example, the decline that occurred in US spending following the Cold War. When
economic times have been difficult or unfavourable, the US has always managed to find
the money to fund its defence expenditure and to support the high-value jobs that the
industry creates. We expect this to continue to be the case in the near term.
Savings and loans crisis and the establishment of the RTC, 1989
The US Savings and Loans (S&L) crisis created the largest banking collapse since the
Great Depression, and ran through much of the 1980s. As Figure 259 shows, between
1980 and 1988, 563 S&L companies failed, 333 underwent supervisory mergers and 798
initiated voluntary mergers. By 1989, half of all US S&L banks had failed, as had the
Federal Savings and Loan Insurance Corporation (FSLIC), which had been created to
insure their deposits.