August 24, 2012    Volume 19, No. 13

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Sequestration Exposes U.S. Dependence On Defense Manufacturing

By Richard A. McCormack

Sequestration is already having an impact on the U.S. defense industry and if it is fully implemented starting in early 2013 the overall economic consequences would be severe, according to defense industry executives, economists and elected officials. Without any guidance on whether federal budget cuts of $110 billion will be implemented early next year -- $55 billion of which would fall on the Department of Defense -- defense contractors are already paring back.

Meanwhile, other federal agencies that provide services such as food inspection, border patrol, airport passenger screening, air traffic control and most every other aspect of federal activity save for entitlements, would be facing layoffs that could total 617,449 federal workers. The total projected loss of jobs if the federal budget were pared back by $110 billion next year could be more than 2.1 million.

"We are already seeing the impacts of potential sequestration budget cuts," says David Hess, president of Pratt & Whitney. "Companies are limiting hiring and halting investments -- largely due to the uncertainty about how sequestration cuts would be applied."

Lockheed Martin CEO Robert Stevens says it is imperative for companies to plan for the impact of sequestration, since there are no assurances that it isn't going to happen. "It is the law of the land and we have no choice but to do our best in planning its execution," he says. Lockheed Martin is curtailing hiring, reducing investment and scaling back on training programs. The company hires more graduating engineers from U.S. universities than any other American company, and it receives one million resumes per year. But those graduates are starting to question whether it is worth entering the industry if in a year's time they won't have a job. "We want them because they are smart but they are smart enough to realize that they will look at other options for their careers," says Stevens. "Our near-term horizon is completely obscured by the fog of uncertainty. [Sequestration] is blunt force trauma. It will tear the fabric of our industry and impair our domestic agencies. Sequestration is a doomsday device used as a threat that was never supposed to happen, but the effects are being felt right now with deferred investment and lost talent. It's a huge disruption to our business."

Lockheed Martin is already downsizing. It has eliminated 1.5 million square feet of space and expects to reduce its footprint by another 2.9 million square feet by 2014. It has reduced its workforce by 18 percent over the past three years, laying off 26,000 workers to its current workforce of 120,000. Its pace of hiring has "slowed considerably," says Stevens. "It might be flattering to believe our industry is robust, but that is fiction. [Sequestration] would be devastating, impacting advanced manufacturing operations and accelerating the loss of skills and knowledge. It will undermine the defense industrial base and the industrial base beyond defense."

The defense industry is required by law to provide employees with 60-day notice of an impending layoff, as is required under the Worker Adjustment and Retraining Notification (WARN) Act. Since Congress and President Obama have not considered an alternative to mandatory spending cuts that were part of the law (the Budget Control Act of 2011) raising the debt ceiling in Aug. 2011, defense contractors will start issuing layoff notices in early November, a week before the presidential election. "We will comply with the law," says Stevens. Lockheed Martin is expecting a 10 percent across the board cut in the Defense Department's budget, "but since we don't exactly know who will be affected by layoffs or whether any plant closings will be necessary, absent legal or contractual relief, our best judgment is that we may have to notify a substantially higher number of employees [than 10,000] beginning in the third quarter of this year that they may not have a job if sequestration takes place," says Stevens. "We do not look forward to making those notifications, but we have a legal and ethical obligation to tell our employees what we know and what we can share."

Once Lockheed has a sense of what is being cut, it will move quickly. "Since these reductions involve a defined dollar amount for the fiscal year, every day or week of delay in making necessary cost reductions can mean even deeper cuts might be required later in the fiscal year, or production costs will be higher than necessary and there will likely be a dispute as to who will pay for these costs," says Stevens. "So our judgment is that we need to be ready to act as closely as possible to day one of the Act."

Defense contractor EADS North America has already started the process required of notifying states of potential plant and facility closures as required by the WARN Act. "We have notified Congress and governors of those places where we have plants," says company CEO Sean O'Keefe. Adds David Hess, CEO of Pratt & Whitney: "We have a fiduciary responsibility to plan based on the laws that are on the books today."

When potentially hundreds of thousands of employees working for defense contractors start receiving layoff notices under the WARN Act, it will unleash a political firestorm, says Sen. Kelly Ayotte (R-N.H.). For elected representatives "who are sitting back using sequestration as leverage for whatever political interest they have as some kind of game of chicken, that will be a clarifying moment for them because to put it in perspective, [swing] states like Virginia could lose 136,000 DOD jobs and 71,000 non-defense jobs for a total of 207,000 jobs; for Florida, it's 79,000 jobs; and for Pennsylvania it's 78,000 jobs."

An economic model of sequestration budget cuts run by Stephen Fuller, director of the Center for Regional Analysis at George Mason University, found that 2.14 million people would lose their jobs if Congress and the President can't figure out how to avoid the mandatory $110 billion in cuts. There would be the loss of 473,250 defense industry manufacturing workers, 98,593 construction workers, 82,898 retail workers, 48,059 health care workers and 15,025 state government jobs. The biggest job loss would occur among federal workers: 617,449, from food inspectors, to FBI agents and diplomats. "The federal workforce gets hit very hard," says Marion Blakey, president of the Aerospace Industries Association, which commissioned the study. "It's an unemployment Armageddon. It's a genuine catastrophe waiting to happen."

The cuts from sequestration would amount to 175,000 jobs every month for a year. The impact would be immediate, since cuts are scheduled to take place on January 1, three months after the start of the fiscal year. The total loss of GDP would be $215 billion, says Fuller, accounting for two-thirds of the projected 2 percent growth in GDP (or $315 billion). "This doesn't push GDP negative, but it undercuts the strength of the economy, such as it is." Reducing the workforce by 2.14 million would add 1.4 percentage points to the current unemployment rate. "We take payroll spending down by $40 billion right off the top, which translates into a whole lot of lost business which drives the economy," says Fuller.

Consumer spending "is already rock bottom at depression levels," Fuller adds. "Think of what happens when the economy stops. Innovation stops. People don't take risks and invest in new products. They don't expand. We see it during times of uncertainty."

With the military's payroll of warfighters and officers exempt from the sequestration cut, most of the money will come out of procurement and modernization accounts -- therefore affecting contractors to a much larger degree. If the cuts go into effect, the U.S. will have the smallest ground force since 1940, the smallest Navy since 1915 and the smallest Air Force in the history of the country, says Sen. Ayotte. "This decimates the finest military in the world. We would be shooting ourselves in the head."

Cities that are overly dependent on federal spending are preparing for more economic pain. Twenty-five percent of all jobs in San Diego are tied to military spending, says city Mayor Jerry Sanders. The city "has the largest concentration of military personnel of anywhere in the U.S., and $32 billion comes out of the military sector every year in our economy," he explains.

But San Diego's reliance on federal spending runs deeper than just the military funding that would be lost. Five million people cross the border between Tijuana and San Diego every year, making it the busiest land border crossing in the world. If the Customs and Border Protection's budget is cut, it would reduce the number of border inspectors, slowing entry for 50,000 vehicles per day. The current two-hour border delay already costs San Diego's economy $7 billion a year.

Furthermore, San Diego's port moves three million tons of goods per year, all requiring inspection. Cruise ships deliver another 5 million tourists a year to San Diego, many of whom must go through Border Protection. The final "pillar" of San Diego's economy is innovation. University of California San Diego is the fifth largest university recipient of federal research grants. "When those grants stop coming, the research stops and job production stops," says Sanders. California, he adds, could lose 225,000 jobs due to sequestration.

Phoenix Mayor Greg Stanton says his city's economy is also dependent on federal spending. The aerospace industry "is one of the leading industries in the state of Arizona," he notes. The industry would lose 35,000 jobs in Arizona. "These are the best jobs we have in our community," says Stanton. "The full impact of the cuts would be about 50,000 jobs lost. Sequestration is the number-one threat to our local economy -- that would put our state and city back into recession. It's the exactly wrong direction we should go locally and nationally. We are mayors not inside the Beltway. We represent mainstream America. It will affect people in ways we don't realize."

Fuller of George Mason agrees, saying that as federal facilities close, it will create "friction" in the economy. "These cuts will have to come quickly and closing facilities will have consequences," he says. "We haven't measured those."

One of the unmeasured costs could come from having to restructure or cancel defense contracts. In an effort to save money, the military signed multi-year contracts. Cancelling them in mid stream would lead to potentially tens of thousands of court cases. "This is a recipe for endless argument, litigation and gridlock and it will ultimately drive up costs to the point that they exceed the savings that sequestration was enacted to produce," says Sean O'Keefe of EADS North America. "The administrative effort to implement it would be much more disruptive than anything else. It's going to implement and force a number of contract penalties on terminated programs. Those definitions are in dispute as to how they will be applied."

Stevens of Lockheed Martin says that his company's 40,000 suppliers won't sit still with contract modifications. Many of them will file claims "for the adverse cost impact of the disruption" sequestration will have on their business, he notes. "And then we will be compelled to assemble this portfolio of requests for equitable adjustments or claims and pass that along, as the prime contractor, to our government customers. We have no guidance on how that number of requests for equitable adjustments and claims will be managed.

Another issue is how to deal with reduced funding for weapons programs that will continue, as the government reduces the quantity of purchases and production cycles are drawn out. "The cost of capital for second- and third-tier suppliers will go up as progress payments are disrupted," says O'Keefe. "The Prompt Payment Act penalties will apply as well."

Other suppliers will go out of business, and those that have commercial operations will turn away from defense, leaving the military vulnerable to the loss of critical component suppliers. DOD will have less choice and it will have to pay more for the products it needs. There will be "consequences" due to the loss of "competition to maintain cost competitiveness," O'Keefe adds.

At the hearing of the House Armed Services Committee, the defense contractors, who are engaged in the most active lobbying campaigns in a generation, were asked how they would deal with massive budget deficits. Should the U.S. government throw fiscal prudence out the window and just keep spending? Should the $110 billion in cuts come entirely out of already strapped domestic discretionary programs? Do they favor tax increases to fill the budget gap?

"I think everything has to be on the table at this point," said Hess of Pratt & Whitney, adding that it was "the job of Congress to figure this out and not industry."

All the economic blood-letting would be caused by the loss of $110 billion in the federal budget in one year, an amount that is about equal to the $109 billion the federal government is borrowing per month to cover its deficit.

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