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Pentagon review protects weapons for now, but uncertainty abounds

U.S. Defense Secretary Chuck Hagel listens to a question during a briefing on the Defense Department's FY2014 budget at the Pentagon in Wash
U.S. Defense Secretary Chuck Hagel listens to a question during a briefing on the Defense Department's FY2014 budget at the Pentagon in Wash

By Andrea Shalal-Esa

WASHINGTON (Reuters) - Defense Secretary Chuck Hagel's rollout Wednesday of a long-awaited strategic budget review left big weapons programs unscathed for now, focusing more on cuts to Pentagon overhead, compensation packages and troop levels.

But the review did not resolve the budget uncertainties that have plagued U.S. weapons makers for nearly two years, and even cuts in the overall size of the military will result in fewer new equipment purchases in years to come, analysts said.

Hagel told reporters that coming up with $500 billion in budget cuts required by law over the next decade under the sequestration process - on top of $487 billion in cuts already begun - required tough trade-offs between the size of the military and weapons programs.

He said those decisions would be made in coming months as the Pentagon prepared its budget plan for fiscal 2015, with President Barack Obama having the final say.

Top U.S. weapons makers like Lockheed Martin Corp, Boeing Co, Raytheon Co and others have been anxiously awaiting details of the Pentagon's four-month Strategic Choices and Management Review, worried that specific weapons programs might be scrapped to save money.

The companies posted higher earnings for the second quarter as a result of cost-cutting, but many forecast weaker revenues in 2014 and said backlogs were easing as mounting budget pressures began to take their toll.

Hagel warned that choosing size over capabilities would trigger a "decade-long modernization holiday" that could undermine the U.S. military's technological edge and could undermine the defense industrial base.

Preserving the military's ability to project power would entail less onerous cuts in ground forces, ships and aircraft, but would lead to cancellation or truncation of many weapons programs and efforts to beef up U.S. cyber defenses, Hagel said.

If the military chose high-end capabilities over size, it would protect certain programs, including Lockheed's F-35 Joint Strike Fighter, a new bomber and submarine cruise-missile upgrades, as well as cyber operations and special operations forces, Hagel said.

The result would be a smaller, technologically dominant force, that would be able to "go fewer places and do fewer things, especially if crises occurred at the same time in different regions of the world," he told reporters.

'NOT AS BAD AS IT MIGHT HAVE BEEN'

Byron Callan, analyst with Capital Alpha Partners, said Hagel appeared to lean toward the latter option, partly because of the damage that cutting modernization programs would do to the country's defense industrial base.

But even cutting the size of the military could undermine current plans for buying 2,443 Lockheed F-35s, he said.

"The capability option is a positive for slivers of industry, but force structure cuts will reduce the size of the F-35 buy and impact a wide range of other programs," he said in a note to investors.

Todd Harrison, defense analyst with the Center for Strategic and Budgetary Assessments, told Reuters that cutting size in favor of high-end capabilities was more in line with the department's current strategy, and better suited to responding to increasing threats around the world.

"If you focus on capabilities over capacity, that means you can develop the future capabilities that you need to operate in a more contested threat environment," he said.

Loren Thompson, chief operating officer of the Lexington Institute think tank, said the Pentagon did not attack weapons programs as hard during this review because it had already canceled numerous arms programs, including the Army's Future Combat System, or FCS, and an airborne laser, in recent years.

"The Obama administration spent the last four years killing unneeded weapons programs, so now it is left with the programs that are really essential," he said.

He said weapons makers still faced challenges, even if the administration opted to shrink the size of the military since that would result in fewer ships, aircraft and other equipment that needed to be maintained and upgraded.

"This news is not as bad as it might have been. However, if you're going to cut the size of the force and have fewer aircraft carriers or fewer bombers, then obviously companies are not going to be booking as much revenue," he said.

(Reporting by Andrea Shalal-Esa; Editing by Peter Cooney)

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