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Firms, policymakers struggle amid Western defense cuts

By Peter Apps, Political Risk Correspondent

WASHINGTON (Reuters) - Whether or not America's politicians can find a way to sidestep the brutal automatic military cuts of sequestration, the era of rising Western spending on weapons and wars is over.

That reality increasingly is challenging major arms manufacturers, spurring them to look for new markets, cost cuts and mergers. It is also confronting policymakers with difficult political and strategic choices as new rivals, particularly China, spend more on their armed forces.

U.S. military spending still dwarfs that of other countries - the equivalent of the next 13 nations' spending by some estimates - but the global military balance is clearly shifting. With European states already cutting, the London-based International Institute for Strategic Studies this year reported that Asian military spending outstripped Europe's for the first time in several centuries.

U.S. lawmakers may well avoid or delay automatic across-the-board budget cuts that would hit the military hard and are set to begin on January 2 if there is no deal on deficit reduction. But few see the United States avoiding military budget cuts in the next few years given that the government's debt burden has now surged above $16 trillion and continues to rise.

Republican presidential challenger Mitt Romney has pledged to increase Pentagon spending, particularly on the Navy. But he could find himself struggling to keep that promise if he defeats President Barack Obama next month.

U.S. strategic options may soon be defined more by what Washington can afford than by what it believes it needs.

"For the first time in our history, we may be facing a moment where we really do not have the money to do exactly what it is that the experts or the policy advisers ... suggest is the right thing," said Todd Harrison, senior fellow at the Center on Strategic and Budgetary Assessments. "Budget cuts could end up determining the shape of U.S. policy."

'THOSE DAYS ARE OVER'

That would be a far cry from the last decade, when military cost control was often of secondary importance as the United States waged wars in Iraq and Afghanistan.

"Whenever we found a problem, we cauterized it with cash," Undersecretary of Defense for Industrial Policy Brett Lambert told a meeting of Reuters defense and aerospace reporters last month. "Those days are over."

That is a reality some industry executives have quietly conceded. They have been pinning their hopes for growth on more sales to civilian government agencies and emerging states - an approach that has prompted viciously competitive battles for business with India, Brazil and the Gulf.

Attempts to fold Britain's premier defense firm BAE into its larger European rival EADS were in part an acknowledgement of shrinking markets - even if differences between Britain, France and Germany ultimately killed the deal.

Meanwhile, U.S. defense firms have already begun laying off staff and closing facilities to reflect lower demand and the $487 billion in cuts already planned for the next decade.

U.S. defense spending in 2012 will total $612 billion, down slightly from 2010's $691 billion peak as operational contingency spending specifically earmarked for the Iraqi and Afghan wars fell, according to the Pentagon.

The core Pentagon budget - with the cost of the wars excluded - is now $531 billion. As things stand, defense takes up around 20 percent of the entire federal budget, roughly the same as Social Security and massively outstripping federal spending on transportation, education and science.

But overall U.S. military spending is now expected to drop for the first time in more than a decade, with the Pentagon proposing a base budget of $525 billion and war spending of just over $88 billion in the fiscal year that began October 1. When inflation is taken into account, it has been falling since 2010.

The sequestration cuts would strip just over 11 percent from Pentagon spending. While that might not seem devastating, the pain would be shared indiscriminately - including in areas seen as increasingly vital, such as special operations and cyber warfare.

Only on Thursday, U.S. Defense Secretary Leon Panetta warned that unnamed foreign actors were targeting U.S. computer control systems that operate chemical, electricity and water plants, as well as transportation.

If the budget cuts go through as planned, more than 1 million jobs could be lost at U.S. weapons plants and in the surrounding communities, according to some estimates. Earlier this year, Lockheed Martin warned it might be forced to make 10 percent of its workforce redundant.

But the campaign to stop sequestration, some suspect, could simply be the start of a much larger battle.

DEFENSE FIRMS PUSH BACK

It's now a mantra for top Pentagon officials and the wider defense sector that cuts beyond the $487 billion already planned would make nonsense of Washington's entire national security strategy, which was unveiled only last February.

"Defense has already been cut through the muscle and we are now into the bone," said Marion Blakey, chief executive of the Aerospace Industries Association (AIA), pointing to 50 "significant sized" projects the Pentagon says it has already canceled. "I wish we lived in a safer world, but we don't."

One of the three cardboard-mounted cartoons she often carries to meetings delivers a blunt message to politicians.

"Defense cuts equal job losses" reads one, a 1930s-style pen and ink image of a line of muscular defense workers marching directly into a polling booth. "Workers return the favor."

Not everyone agrees. Opinion pollsters say defense often tops the list of areas where the public would like to see cuts, while fatigue over the last decade's wars makes new overseas commitments hard to sell.

Some experts argue further efficiencies and cuts are more than possible. They suggest buying more flexible systems and using special forces, drones and new technology to replace more expensive traditional equipment.

"The companies will put up a fight (against cuts)," said former U.S. Navy Secretary Richard Danzig, now chairman of the Center for a New American Security think tank. "But as long as the civilian and military leadership stick together, I don't think the companies will win."

In Washington, a city full of defense lobbyists and where major firms help fund many private foundations that help draft policy, there is no shortage of authorities pointing to potential threats.

China almost invariably tops the list, with its military spending perhaps only a fifth of that of the United States but by some estimates doubling every five years. Long-standing troublespots such as the Middle East also have not gone away.

The argument from the AIA and others, however, goes well beyond the strategic - essentially saying that defense projects themselves are effectively a common good, driving economic activity and innovation at a difficult time.

Some are openly skeptical, even within the industry.

"We shouldn't build a carrier because it creates jobs," said Mike Petters, chief executive of shipbuilder Huntington Ingalls, the largest employer in several U.S. states including Virginia, whose votes could help decide the November 6 presidential election. "We should do it because we decide we need an aircraft carrier."

'YET ANOTHER SWITCH'

Critics say European military purchases are already often dictated less by strategy than by the conflicting needs to reduce deficits while supporting "national champion" defense firms like Britain's BAE or Italy's Finmeccanica.

When Britain's newly elected government began its strategic defense review in 2010, it found itself severely limited by the cost of cancelling expensive pre-agreed contracts such as the purchase of two new aircraft carriers.

Already over budget, costs surged further this year after the government changed its mind twice on whether to fit one of the ships with catapults for conventional aircraft or to simply rely on vertical-takeoff jets.

One key reason costs escalate so fast, defense executives argue, has always been the shifting and excessively complex demands from government and military buyers.

"The war fighter almost always wants to add yet another switch," said Petters at Huntington Ingalls. "I think it's our greatest challenge as an industry."

Former Lockheed chief executive Norm Augustine famously predicted in 1984 that by the middle of the 21st century, a single fighter aircraft could be so expensive that the U.S. Air Force and Navy might only be able to afford a single airframe that they would share between them on alternate days.

Now, with coffers emptying, governments may have no choice but to ask themselves whether something less than "best at all costs" could get the job done.

"If you're chasing after a pirate with a Kalashnikov in a small boat, you don't necessarily need to do it with a multi-million dollar destroyer," British Chief of the Defense Staff David Richards told a Washington audience in May.

(Additional reporting by Marcus Stern, Jim Wolf and Andrea Shalal-Esa; Editing by Warren Strobel and Xavier Briand)

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