Why Ron Paul's Proposed Military Cuts Could Ruin the Economy

Perhaps the most intriguing development in the Republican US presidential nomination race has been the ascendancy of Ron Paul. Although it seems unlikely that he can win the nomination, he’s managed to carve out a dedicated support base of voters. The key to his appeal has been his back to basics approach. He wants to drastically cut taxes, balance the budget, and severely limit the powers of the government. Only through a free market, Paul believes, can America return to prosperity. One way he would achieve his goal of a balanced budget is by cutting government spending on the military. "War is never economically beneficial except for those in position to profit from war expenditures," Paul said in the US House of Representatives back in 2004. Taken at face value, Paul’s arguments against military spending can be persuasive. Yet, it ignores certain, important realities. The US federal, state, and local governments now spend about $6 trillion - or 40% of the nation's GDP - annually. This spending is directly responsible for 20% of the production cited in the official US GDP number, which is currently at about $15 trillion according to the International Monetary Fund. The federal government spent roughly $1 trillion of its budget on national defense in 2011. That estimate includes the budget of the Department of Defense ($700 billion) and Department of Homeland Security, “international assistance” costs, interest payments on debts from past wars, and spending by other agencies like the Department of Energy or CIA on programs that can be considered part of the country’s national defense strategy. So, let’s say that Paul is elected president and manages to cut the national defense budget in half. Now, the US is only spending $500 billion. At first glance, that seems like a modest cut, especially considering Paul’s fierce anti-spending stance. He'd want to cut more than that. Still, the effects on the US economy would be immediate and painful. Assuming that the US GDP is still $15 trillion, such cuts would reduce the national GDP to about $14.7 trillion, a 2% loss.

In 2010, the US GDP only grew by 3.03%, and much of that growth can be directly attributed government spending. In the two years before that, US GDP growth was negative.  A 2% loss in GDP from spending cuts – which would be impossible to replace right away - would make posting positive quarterly GDP numbers that much more difficult. For example, half of GDP growth in 2Q 2010 was from government spending. Weak or negative GDP numbers would wreak havoc on the markets and could easily plunge the US into full-fledged recession. That would be bad news for most investors. The US economy has been slow to recover since 2008, and can’t afford many major setbacks. Maybe the only stocks that would truly benefit from such news would be gold and, to a lesser extent, silver stocks. Gold and silver have long been viewed as safe havens in times of crises. It should come as no surprise that 64% of Paul’s investment portfolio is in gold and silver mining stocks. If Paul was elected president, or if his budget ideas were ever adopted in full, it might be wise to join him and invest in Market Vectors Junior Gold Miners ETF GDXJ or Global X Silver Miners SIL. Of course, the traditional counter-argument to claims that government spending is necessary is that any loss in spending would be offset by the savings that could be passed onto Americans through tax cuts. It’s a position often championed by Paul. However, Americans are already paying the lowest share of their income in taxes since 1958. When they do have more spending money, they tend to quickly pass it on to the developing countries that produce the goods Americans covet most.  Apple’s APPL iPhone alone added about $2 billion to the US trade deficit in 2009. Furthermore, the gains in GDP from retail spending are often not as pronounced as the headlines would have the public believe. In fact, only about 44% of consumer spending is in retail. Though the official corporate tax rate seems high at 35% for corporations making over $18,333,333 a year, thanks to loopholes the federal government is actually collecting less in taxes as a percentage of GDP from major corporations than it used to. Would General Electric GE - which paid zero US taxes in 2010 – invest more in the US if corporate tax rates were lowered? Or what about Exxon Mobil XOM, which managed to pay nothing in US income taxes in 2009? The answer to both is probably not. Instead, major corporations would likely continue to invest abroad, where developing markets presently offer more attractive growth potential. Small businesses are often viewed as the main employers in the US, but recent tax breaks for small businesses have also done little to stimulate US hiring. Many small business owners maintained that they would only hire more if the economy recovered. Underemployment in the US remains rampant. If the US economy is going to recover to pre-2008 levels, government investment will have to be one of the main drivers. In an economy where corporations are heavily investing in foreign countries and one-fifth of the GDP depends on government spending, it’s too late for Paul to preach small government. Cutting the national defense budget at time like this would be shortsighted, and not just because of its direct effect on the GDP. CNN Money called weapons the hottest export in the US in early 2011, and Obama has identified weapon sales as one of the keys to increasing US exports over the next half-decade. Without the government’s national defense spending, the arms industry would quickly whither. Defense contractors like Lockheed Martin LMT, Boeing BA, Northrop Grumman NOC, and General Dynamics GD would be hit hard. Those companies are expecting some downturns in the arms market even without Paul’s proposed cuts. Eventually, spending cuts have to happen. Standard & Poor’s downgrading of the US credit rating last summer proves that major federal budget deficits can’t go on forever. That being said, kneejerk reactions like Paul’s proposal to cut $1 trillion in spending and eliminate five cabinet departments in one year would be disastrous for the economy. Government spending will need to be reined in gradually over time. Otherwise, the US economy will quickly be in for a world of hurt.