Early last week one of my colleagues at Advisor Perspectives asked about the correlation between GDP and Defense spending. I pondered the question over the weekend, which also prompted me to think about defense spending in general and how it has changed over the years.
For openers, here is a chart based on data from the Bureau of Economic Analysis (BEA) showing nominal National Defense Consumption Expenditures & Gross Investment, a quarterly data series that is a subcomponent of GDP stretching back to 1947 (FRED series FDEFX).
At first blush the growth in spending since the turn of the century looks astonishing, and of course the government's response to 9/11 with wars in Iraq and Afghanistan were largely responsible for this surge.
But let's make two changes -- one to the data itself and the other to the way its depicted. The next chart is adjusted for inflation using the GDP deflator but chained in Q4 2012 dollars. Also, I've changed the vertical axis to a log scale to give an accurate visualization of the relative change in spending over time.
It doesn't take much knowledge of history to recognize some key features in the chart: There was amazing surge in spending associated with the Korean War (1950-1953) that was trimmed after the war ended and leveled out for a decade. The increase that began in 1965 is a fingerprint of the Vietnam War. It peaked in Q2 1968 and gradually declined to pre-Viet Nam War levels by 1975. The Iran Hostage Crisis (1979–1981) and the Reagan years saw steady rise in defense spending to an interim peak in Q3 1987, when it was becoming clear that the threat from the Soviet Union was waning. The decline that followed took us to a trough in Q1 1998 that was comparable to the spending level during the Viet Nam War peak. Then the attack on the Trade Towers and its aftermath triggered another cycle of spending that peaked in Q3 2010.
It is interesting to note that the government's calculations of quarterly GDP dates from the second year of the Baby Boom. How have these cycles of defense spending correlated to the overall US economy during these 65+ years? Here is a look at National Defense Consumption Expenditures & Gross Investment as a percent of GDP. The Advance Estimate of Q4 2012 GDP puts defense spending at 5.0% of GDP. The interim peak was 5.7% in Q3 2007. The historic low in this data series was Q4 2000 at 3.7%.
All of the charts above have recessions highlighted. A quick glance confirms what we might expect -- that defense spending is impervious to recessions. In fact, the spending by the Department of Defense has been a reliable source of economic stimulus during virtually all the recessionary periods.
Which brings me to the topic of sequestration and defense spending. This is a politically supercharged topic that I'm reluctant to debate. But I would point out that the latest OMB report (PDF file) on the subject explains that sequestration would cut the discretionary defense budget by $54.667 billion annually. The OMB reports that the overall defense budget for 2013 is $672.88 billion of which $525.4 billion is discretionary. Thus, sequestration would trim about 8.3% off the overall Pentagon budget. That is indeed substantial.
Discretionary defense budget cuts of this magnitude will have a significant impact on GDP far beyond the government consumption expenditures and gross investment subcomponent. The military spending cuts will have a ripple effect on gross private domestic investment and will trim the personal income that drives the largest component of GDP, personal consumption expenditures.
If sequestration indeed happens, as increasingly looks to be the case, the US economy will be in for an economic struggle that will greatly increase our risk of a recession.