Economic Outlook Hinges on Fiscal Choices

State’s defense industry on edge over sequestration decision

By Bill DeRosa

On January 4: just days after Congress passed a “fiscal cliff” agreement that, as a first step, raised taxes, took a pass on addressing spending, and delayed sequestration for two months: 500 Connecticut business leaders came together in Hartford to hear leading experts on economic and fiscal policy discuss what lies ahead for the national and state economies.

As it turns out, a lot will depend on fiscal decisions made in Washington over the next few weeks: and in Hartford between now and June 9, the close of the 2013 General Assembly session.

The 2013 Economic Summit & Outlook, presented by CBIA and the MetroHartford Alliance and sponsored by Webster Bank, was held at the Marriott Hartford Downtown and featured presentations by Joan K. Woodward, executive vice president at Travelers and president of the Travelers Institute; Christine M. Cumming, first vice president and COO of the Federal Reserve Bank of New York; and Dr. Nicholas S. Perna, economic advisor to Webster Bank.

The event also included a panel discussion on federal defense cutbacks and the consequences of sequestration: deep across-the-board cuts in federal defense and other spending, currently set to take effect in March.

Fiscal Sanity

She noted that the last couple of years have not been good ones, fiscally speaking, for the United States, citing the downgrade of U.S. debt in 2011 resulting from political gamesmanship over extending the debt ceiling, the failure of the Simpson-Bowles National Commission on Fiscal Responsibility and Reform, and the fact that we have already reached the $16.394 trillion federal debt ceiling.

Whether Congress and the administration can achieve fiscal sanity depends largely on how they choose to address three major issues that must be resolved before the end of March:

• The debt ceiling. Extending the debt ceiling would allow the Treasury to continue borrowing (issuing securities) to fund expenditures already approved by Congress. Failure to extend the ceiling would not only risk another downgrade by the rating agencies but also “precipitate a global financial collapse, when a risk-free instrument [U.S. Treasury bonds] becomes risky,” said Perna. He added that anyone who argues that the debt ceiling should not be raised “is playing with fire.”
• Sequestration. Allowing sequestration to take effect: automatic spending cuts totalling $1.2 trillion over 10 years in defense and other domestic programs: would be potentially disastrous for Connecticut, whose economy relies heavily on its defense-related companies, from hundreds of small manufacturers in the supply chain to huge defense contractors like Electric Boat, General Electric, and United Technologies.
• The continuing budget resolution. In the absence of a formal appropriations bill, passing another continuing budget resolution would avoid the temporary shutdown of certain federal government functions and programs. The current continuing resolution was signed by the President on Sept. 28 and expires March 27.

Resolving these issues quickly and responsibly and getting the national debt under control is a “business imperative,” said Woodward, who showed summit attendees a brief clip of Overdraft, a documentary about the dire consequences of the nation’s debt crisis produced by Travelers with PBS.

Woodward called the federal fiscal crisis the most important economic issue of our time, adding that her company is extremely concerned about it “for economic growth, for economic competitiveness, for young people, and for our business.”

CBIA News spoke with several summit attendees who agreed that fiscal sanity is a business imperative.

“We need an end to the drama coming out of Washington,” said Bob Sobolewski, president and CEO of cooling equipment manufacturer ebm-papst Inc. in Farmington. “We need stability in our fiscal policy so that we and our customers can predict what the playing field will be and adapt to it.”

Jay Sheehy, CEO of building materials distributor Kamco Supply Corp. of New England in Wallingford, agreed, arguing that uncertainty is the biggest downside to the fiscal issues afflicting the state and federal government.

“We all know we have to pay taxes,” said Sheehy. “We all pay significant taxes and business fees. So we accept that, we accept our responsibility. But the uncertainty that comes with continually escalating deficits without some control is, for me, the largest single risk.”

A Matter of Timing

The Fed’s Christine Cumming also believes it’s time to work on deficit reduction, but she warned that in a still-fragile economy, timing is important.

“There’s no question that we need to fix the trajectory of fiscal policy,” she said. “But at the same time, you can really overdo it if you do too much too early and really end up taking the life out of the economy.”

Perna agreed, arguing that aggressive deficit cutting after a recession can be problematic.

“Cutting deficits in the short run gives you Greece, gives you Ireland,” he said. “What’s happened there is that the deficit reductions, the austerity [measures], have made the recessions worse. It’s like throwing someone into debtor’s prison and wondering why they can’t pay you back. The ideal deal would be one that actually provided some [economic] stimulus near term and ironclad measures to reduce the deficit longer term.”

Cumming explained that in December, the Fed announced that it would be buying Treasury and mortgage-backed securities in a new round of stimulus, or quantitative easing, in the hope of lowering long-term interest rates and stimulating economic activity. She said that in this case, rather than limiting quantitative easing to a specific time period, the Fed would keep buying securities until the unemployment rate falls below 6.5% or the inflation rate rises above 2.5%, and as long as inflation expectations are stable.

“We’re going to do this as long as is necessary to make sure that the economy recovers,” said Cumming.

State Budget: ‘It’s a Spending Problem’

At the state level, of course, carrying over budget deficits from year to year is not an option. Sobolewski, Sheehy, and other summit attendees believe that in the aftermath of the massive 2011 Connecticut tax increase, it’s time to focus on the spending side.

“Two years ago, they passed the largest tax increase in state history,” said Jason Howey, president of precision manufacturer Okay Industries Inc. in New Britain. “Now they have to figure out how to have a leaner, more efficient government, and they have to do something about spending. It’s a spending problem.”

“We have to realize that it’s easy for many taxpayers to relocate to more favorable tax climates,” said Sobolewski. “As long as we keep making it easy, they’re going to go ahead and leave. We just can’t chase our high-income taxpayers out of the state and expect to continue to be competitive and avoid budget deficits.”

Mark DiVenere, president of metal stampings manufacturer Gemco Manufacturing Co. Inc. in Southington, would like to see the state handle its budget the way private-sector organizations have to handle theirs: and that means making tough choices.

“The thing is, I have to get my own fiscal house in order. When the recession hit in 2008 and 2009, difficult decisions had to be made. Right now, I don’s see that the state is making those,” he said, adding that even after the 2011 tax increase, the state is still facing budget deficits. “So where are we going to go for more dollars?”

That question is now squarely in front of state legislators, who are working on a new biennial budget for fiscal years 2014 and 2015. In the process, they’ll have to figure out how to close a $1.16 billion budget gap projected for 2014 and a nearly $1 billion deficit for the following year.*

‘How Do We Get Out of This?’

Perna raised that question during his summit address and proposed that at least part of the answer involves making state government more efficient and more cost-effective.

“We’re still doing things the old-fashioned way,” he said. “The private sector has completely restructured itself. If you went into Webster Bank today, it looks nothing like it did five or 10 or 20 years ago. Sure, there are computers all over government, but I’m not sure we’re doing things differently to the extent that we could. And that doesn’t mean doing less; it means doing things a lot better.”

Several summit attendees identified the need to reform the state employee retirement benefits system as a key to solving Connecticut’s long-term fiscal problems, a position that CBIA strongly supports. Over the last two decades, spending for state employee retiree health benefits has grown by 1,395% and pension costs by 187%: growth that has begun to crowd out state investments in education and other key budget areas.

Those benefits, said DiVenere, “are clearly unsustainable and have been for the last 10 or 12 years. It’s not the state employees: they’re great people. It’s the system that needs to change.”

Eileen Hasson, president of I.T. consulting firm The Computer Company in Cromwell, is also concerned about the long-term effects of

continued growth in spending for state employee retirement benefits, especially given demographic trends.

“With more people retiring and everyone living longer, I don’t think you need to be a financial wizard to wonder who is going to pay for that,” she said. “If you’re a public servant who has worked 25 years and may be 50 years old: that person’s got potentially 30 or 40 years of receiving state benefits,” which, she pointed out, are very rich benefits compared to what’s typically available in the private sector.

Sheehy believes a more disciplined approach to fiscal policy will make Connecticut a more business-friendly state, which in turn will accelerate economic recovery.

“More business investment equals more jobs, more prosperity for people,” he said. “For every employee there’s an employer. You need to have solid businesses that can hire people, train them, develop them, and retain them for long periods of time. It’s in everybody’s interest to have that happen.”

A growth-oriented business climate, in turn, will help keep the state on solid ground fiscally by increasing tax receipts, said Howey.

“What’s really going to get us out of this mess is a growing, thriving economy that creates jobs. That’s how you increase revenue, not by increasing tax rates, because that makes people leave.”

Growth Ahead?

So, what are the prospects for a growing, thriving, job-creating economy in the near-term? Nationally, the signals we’re getting are mixed, said Cumming.

“The recovery is showing some very good, strong signs, and it’s also showing some more worrisome signs.” She cited decreasing household debt, recent strength in the housing market, and growth in consumer spending as positive indicators.

Similarly, Perna noted optimistically that there is considerable pent-up consumer demand for cars and housing: a good sign when it comes to near-term economic growth.

When it comes to B2B, Hasson’s firm, with locations in four states, has already seen pent-up demand materialize: in her case, for I.T. services.

“Companies are doing better,” she said. “I.T. demand in general has grown. I think with the problems of the last four years, there has not been a lot of development money going into I.T., and now there is huge demand.”

On the downside, Cumming noted that although unemployment nationally has dropped (to 7.8% at press time, compared with 8.8% in Connecticut), “it’s come down mostly because people have stopped looking for work.”

She also pointed out that several indicators that had been showing strength have flattened over the last three quarters, including business fixed investment, exports, and industrial production.

The outlook for Connecticut, Perna believes, is promising, particularly looking ahead to 2014. The consensus is that the state will recover 5,000 to 7,000 jobs this year, he said, but “next year is the year that things should look pretty good. By that time, what’s behind us is the fiscal cliff, what’s behind us is the problem in Europe (we hope), so we should get very decent job growth in 2014. How much? Twenty thousand to 25,000 jobs. So if we can hang on in 2013, 2014 is the year.”

But, added, Perna, that’s all contingent on sequestration not taking effect, mainly because of the dramatic negative impact it would have on the Pentagon’s budget.

Crunch Time for State’s Defense Industry

Defense is big business in Connecticut. So it’s no surprise that the potential for sequestration has many of the state’s defense contractors and suppliers: and their employees: on edge.

Just how big is Connecticut’s defense industry? It accounts for approximately 50,000 jobs and $25 billion per year in economic activity, says Bob Ross, executive director of the state’s Office of Military Affairs, an agency charged with supporting the defense industry and military organizations in Connecticut, including the sub base in Groton.

“That’s approaching about 10% of our economy,” says Ross. “Connecticut ranks eighth in the nation as a defense contracting state and third on a per capita basis.”

Given such high stakes, what can be done to ensure that this critical sector of our economy stays strong in an era of reduced defense spending?

That was a question at the center of a summit panel discussion that featured Ross; Jay DeFrank, vice president of communications and government relations at Pratt & Whitney; Colin Cooper, CEO of aerospace components manufacturer Whitcraft Group LLC in Eastford; and Oz Griebel, president and CEO of the MetroHartford Alliance, who served as moderator.

Let’s Hope Churchill Was Right

According to DeFrank, the possibility that sequestration would be allowed to take effect has already had an impact through the defense industry supply chain in terms of dampening hiring and capital investment. If it happens, however, the impact will be much worse.

“In one study done for the Aerospace Industries Association, George Mason University put Connecticut among the top 10 states most at risk for the effects of sequestration,” said DeFrank. “In fact, 42,000 jobs could be affected [in the state]. Many of those job losses would be in small businesses.”

DeFrank noted that when the nearly half-trillion dollars in defense cuts made in 2011 are combined with the half-trillion that’s at risk if sequestration goes into effect in March, “you can see how threatening an entire industry with a trillion dollars in cuts can quickly cascade down to states, communities, and individual businesses, costing jobs and jeopardizing capital investments at a time when we’re struggling to recover from the recession.”

He pointed out, however, that as damaging to Connecticut as sequestration could be, given the long-term U.S. fiscal picture, “it’s just a harbinger of what is going to be a long and challenging trend.” But he believes that trend may actually represent an opportunity for those who “early on, take the long view and position themselves for the future.”

DeFrank and Ross are optimistic about the chances for avoiding sequestration.

“I’m a believer in what Winston Churchill said: that the Americans always come to the right answer after they’ve exhausted every other possibility, ” said DeFrank.

Strategies Going Forward

For DeFrank, one of the keys to ensuring a strong Connecticut defense sector is for the industry and state government to recognize that the budget environment we’re in is long-term and that we have to adapt. “We cannot be captives of how we did things in the last century,” he said.

Colin Cooper of Whitcraft believes the state legislature could help by taking a cost-benefit-analysis approach to legislation, noting that the benefits of some programs may go to one economic sector, but the cost falls on others.

“Manufacturing sometimes feels that companies are looked at as revenue streams for government programs. So, really, a cost-benefit approach to things [is what’s needed],” he said.

DeFrank recommended that the state take several actions, including partnering with industry to retrain displaced workers to provide them with the skills needed for complex, high-tech manufacturing. He also called for long-term predictability and stability in areas of government such as the tax code: in particular, the administration of tax credits.

Connecticut’s Strengths

Fortunately, Connecticut has several advantages that will help companies here adjust to the new reality of smaller federal defense budgets.

“The good news is that the defense businesses in Connecticut are some of the most competitive in the nation and the world,” said DeFrank. “We have to be. It’s the only way you can continue to operate profitably in such a high-cost environment. And we have that critical mass that fosters innovation here. High-tech manufacturing companies, world-class educational institutions, and a highly skilled, highly trained workforce.”

In addition, Connecticut is not likely to see cuts as deep as in other defense-heavy states. “I expect that over the next five or 10 years, we’re going to see about a 10% cut in defense contracting in the state,” said Ross. “That sounds like bad news, but relative to other states, it’s good news.”

Other states in the top ten for defense manufacturing will see closer to a 20% reduction, and Florida and Pennsylvania are looking at 30% to 35% cuts in defense contracting.

Why is Connecticut so lucky, comparatively speaking?

“The reason is that we’re building the right things at the right time in history,” said Ross, noting that the Pentagon’s national defense strategy calls for the very things that Connecticut manufactures: jet engines, helicopters, attack submarines, and ballistic missile submarines.

“We should feel very good about where we are and what the future looks like relative to everybody else,” said Ross, with one caveat: “unless sequestration is applied.”

Bill DeRosa is editor of CBIA News and can be reached at bill.derosa@cbia.com.

* At press time, the state budget deficit for the current fiscal year was still $40 million, albeit down substantially from a high of $415 million due to rescissions ordered by the governor in December.