Monthly new orders for defense contractors of capital goods increased to $22 billion in April, with the 12-month sum of $225 billion 27% higher than in the same period last year.
That growth rate is likely to increase as the months with lower spending in early 2025 drop out of the yearly calculation.
The shot in the arm for manufacturing is already boosting GDP and the labor market, where 25,000 new manufacturing jobs have been added in the first five months of the year.
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We think that a second-half increase in defense outlays and the $1.5 trillion budgetary request to bolster defense spending will be a tailwind to GDP in the second half of this year and next.
At the same time, however, additional defense spending will be pressuring inflation highetr, with increased demand for goods most likely outpacing supply as a draw on scarce industrial and technological goods competes with a historical cap-ex super cycle driven by the construction of AI infrastructure.
The Iran war has resulted in a special supplemental request of $87.6 billion to support replenishment of the U.S. weapons stock.
But it won’t end there. The Pentagon will need more money to support a buildout of the emerging drone and robotics technologies and the supply chain to support that.
In the end, the special supplemental measure is likely to exceed $100 billion, which will provide a tailwind to GDP.
Capital goods include small arms and ordnance; communications equipment; aircraft; missiles, space vehicles and parts; ships and boats; and search and navigation equipment; not to mention everything that goes into the supply chains that support them.
Because of the demand for similar goods used at earlier stages of production by both the defense and tech sectors, one should assume that scarce resources will become more expensive and that by the end of the year we will be talking not about guns versus butter but guns and butter as inflationary pressures rise.
Budgetary considerations
According to the Congressional Budget Office, the Defense Department’s fiscal year budget request totaled $961 billion, including $113 billion in funding provided by the 2025 reconciliation act.
Most of the reconciliation funding would be allocated to acquisition.
When adjusted for inflation, the budget request was one of the largest in 50 years, the CBO found.
Is this a one-time allocation? The CBO said the defense budget could be interpreted in three ways:
- As a one-year increase.
- As a short-term increase to modernize forces, similar to the Cold War buildup in the 1980s.
- As a permanent increase in the enduring cost of defense.
Without sufficient guidance, the CBO chose to consider the overall budget as a one-time request.
In our evaluation, the need to replenish supplies and develop new capabilities like drones and robotics will result in higher defense spending.
We see the government’s investment in the private defense contractors as already having an impact on the labor market, which will translate into greater household spending, adding to GDP growth.
But if that government spending goes unfunded, there needs to be consideration for the squeezing out of other investments that are essential for sustained growth.
The lessons of other periods of increased military spending are that while defense spending is necessary, it does not automatically translate into longer-term growth and can cause inflation.
The takeaway
More than half a century ago, the American public entertained a debate of guns versus butter, and the political class chose neither.
Instead, they choose guns and butter and the result was the unleashing of the “Great Inflation” between 1965 and 1985.
Whatever one’s budgetary preferences are, it is quite clear that expansionary fiscal policy via the defense channel is going to compete with the structural transformation of the economy through private sector technological investments.
This would create conditions in which both inflation and interest rates rise as the public sector and private firms chase scarce capital and resources.
When the choice is guns and butter, it might be a good idea to consider the longer-term consequences of purposefully running the economy hot and the risk around higher inflation over the medium to long term.
