Why the Pentagon Fails Audits Year After Year After Year

0:00Your best restaurant location gets 5 star reviews. How do you make every location like your best location? Your best paper mill has been operating at peak productivity. How do you make every mill like your best mill? Your best data center has optimized every drop of water. How do you make every data center like your best data center? The answer is Ecolab. Better performance, better outcomes, better impact. Ecolab. Now every location is your best location. The Chase Inc. Business Premier card is a pay-in-full card with flexibility made for business owners who make things happen. Earn a total of 2.5 % cash back on every purchase of$5 ,000 or more.

0:41Plus, earn unlimited 2 % cash back on every other purchase, giving you unlimited earned potential to invest cash back into your business. Inc. Business Premier is part of a suite of credit cards from Chase for Business, designed to meet your needs every step along the way. Learn more at chase.com forward slash business card. Chase for Business. Make more of what's yours. Accounts subject to credit approval. Restrictions and limitations apply. Cards are issued by JPMorgan Chase Bank and a member FDIC. Hello, OddLots listeners. I'm Joe Wiesenthal. And I'm Tracy Allaway. Obviously, mostly we've been talking a lot about the trade war lately, the tariffs.

1:18But there are other things going on in the world. And in fact, there are some episodes that we've recorded prior to all this that we still want to publish. That's right. So what you are about to hear is an episode we recorded way back on March 18th. It feels like it was a lot longer ago, but it's been basically a month. And with everything that was happening in markets, all the trade announcements, the tariffs, we've had to put this one on hold. But we want you to listen to it. It's a really interesting topic and still very, very worthwhile to hear about it. Right. We're going to be talking about the Pentagon budget and things like that.

1:56If it feels a little dated, the conversation, that's because it is dated. But take a listen. I still think that you'll find, you know, there is still no world in which the nature of defense spending is not an important question, is not something interesting. So even with everything else going on in the world, you should take a listen. Here we go. Bloomberg Audio Studios. Podcasts. Radio. News.

2:34Hello, and welcome to another episode of the Odd Lots podcast. I'm Joe Weisenthal. And I'm Tracy Alloway. Tracy, we've hinted on the podcast a few times over the last several months who want to do more on defense. And we're going to start ramping it up. I don't think it's a hint, Joe. I think you've said it pretty explicitly. But it is interesting, right? It does seem like it should be a good topic for us, right? It's a huge chunk of the economy. I think it's like the U.S. government's biggest line item in terms of expenditure. It's either defense or interest rate payments on its bonds. Yeah, that's right.

3:05It's definitely number one or number two. And so it is worthy of additional study. I agree. And, you know, I think it's actually really important for us because, you know, we talk about industrial policy a lot. And defense is the one area where that is never wavered, right? Like it's always been the government is the primary buyer, purchaser, but there are these private companies and they also sell overseas and stuff. And it's always been about staying at the leading edge of tech. And probably if you're like thinking about like industrial policy in other areas, like whether it's cars or batteries or semiconductors, I just assume there must be a lot that we can learn from how it works in the defense world.

3:48As a military brat, I feel comfortable saying as well that it's kind of also connected to a social safety net. Yeah, that's right. You have health care tied to military service. You've got cheap groceries tied to military service. I used to love that. So it's interesting from a number of perspectives. What blows me away, though, is you hear that statistic every once in a while that the Pentagon has never passed an audit, which raises all these big questions about if this is the biggest expenditure or one of the biggest expenditures for the U.S., how is it possible that we don't actually seem to know where the money is going?

4:28No, I think this is a great question. And I think that what you articulated there is just a great way of sort of entryway to understanding defense with a simple question. Because, like, I've seen those headlines. So late last year, headlines, Pentagon Fails Seventh Audit in a Row. And then I read the headline, but I don't know what that means. I don't know what it means to, like, you know, it's not like a private company. I don't know what audits really mean in the government. I don't know if there are any consequences. I don't know why it is. Is it because of malfeasance or is it just because of its sheer size?

4:58I mean, it's, you know, the Pentagon, absolutely enormous. So I think like, yeah, we should have said, what does that mean that they just keep failing all these audits? Well, it also raises an existential question of why are we even bothering to do audits if we keep getting the same results and nothing seems to change. That too. That's a great question. Anyway, we're going to finally get some answers to at least this question of what it means that the Pentagon keeps failing audits year after year and year and what it says maybe about how we do defense spending. I'm very excited. We have the perfect guest.

5:29We're going to be speaking with Julia Gledhill. She is a researcher at the Stimson Center, has written quite a bit about this, has been recommended to me as someone to talk to about Pentagon and defense spending. So, Julia, thank you so much for coming on OddLabs. Thank you for the invitation. It's great to be here. What is a Pentagon audit? Apparently, we've never passed one, and we'll get into why. But what does it even mean for the Pentagon to get audited? Yeah, this is an important question. And I think Tracy is hitting the point on the nail here in that what's the point of doing the same thing over and over and expecting a different result?

6:02That is, in fact, the definition of insanity. And so in thinking about what the purpose of an audit is in a Pentagon context, it's important to remember why we audit in general, right? Companies undergo audits to assure stakeholders that management is accurately presenting a company's financial performance and position. In other words, audits help investors and lenders determine the financial value of a company. So how does that apply to the Pentagon? Well, the Pentagon audit assesses how well the agency is managing taxpayer dollars. The difference is that unlike stakeholders and companies, taxpayers can't simply opt out of funding the Pentagon when it fails an audit.

6:41But the agency-wide consolidated audit of the Department of Defense looks at DOD financial statements, but also internal controls over financial reporting, as well as compliance with relevant laws and regulations. What does an audit actually entail for the Pentagon? Because I imagine, you know, when I think about the Pentagon, it's this huge, sprawling industrial military complex. I imagine it must be quite an undertaking to try to get granular detail on where money is going. It absolutely is a major undertaking, which explains why the DoD has not only failed so many audits in a row, but only started to do consolidated audits agency-wide in 2018.

7:26So the Pentagon audit is done by independent public accounting firms in collaboration with the Department of Defense Inspector General Office, which is the internal watchdog within the Pentagon. And what they do is conduct independent audits of several different DOD components. These can include the military services, but also combatant commands, field activities like the Defense Logistics Agency. And then the Department of Defense Inspector General puts all of those independent audits together in one consolidated agency-wide audit and comes to a conclusion. Notice that I say conclusion and not opinion, because in the case of failing a Pentagon audit, the Pentagon has actually received disclaimers of opinion repeatedly, which means that the agency department wide was unable to produce the financial statements necessary for auditors to form an opinion, an audit opinion on the quality and sort of accuracy of financial reporting throughout the agency.

8:33But it includes a lot of different components and it is indeed quite laborious. So the goal is for the independent firms to be able to form an opinion. And when we read a headline that says they failed the audit, it means they can't even get the documents and the financial statements together so that they can form an opinion. Like explain to us what that word failure means in this context. Yeah. So I think that the former comptroller of the Department of Defense has explained this quite well. And in describing a disclaimer of opinion in the context of auditing, he basically said that this is a red light, right?

9:11So is an adverse opinion, which is another level of there are going to be material persistent weaknesses in financial reporting throughout DOD entities. And then you have a yellow light, which is a qualified opinion. And then you have an unmodified opinion. This is the goal in the Pentagon audit process. which is considered a green light. And only a few of DOD components have actually achieved this green light, which means that the financial reporting internal controls generally can be trusted and assumed to be consistently accurate. What happens when the Pentagon actually fails an audit? Because I imagine, like, in theory, there should be consequences.

9:54But the fact that it keeps happening, as I mentioned, suggests that there probably aren't. Yeah, there are no consequences, much to the disappointment. Exactly. Imagine a company failing an audit and their investors saying, well, we're going on ahead anyways. And so, no, there are no consequences for the Pentagon when it repeatedly fails audits. And yet the audit is supposed to give us taxpayers some trust that the Department of Defense is spending our money efficiently and wisely. But unfortunately, and much to the disappointment of components like the Marine Corps or the Defense Threat Reduction Agency, which have received these green lights, these unmodified audit opinions, they are not rewarded for receiving green lights in the auditing process.

10:48And, you know, the Marine Corps is still struggling to, you know, get their boats. So it's an important question. And unfortunately, there are just no consequences because appropriators are not reading a 400-page audit report on the Pentagon before deciding what to spend on national defense. So they failed the audits, or at least they can't even put together an opinion. What's happening? Why can't they? When they're going in there and they're looking for documents and evidence that the money is being tracked roughly in accordance with how it should be and that the various divisions are – what are they seeing when they go in there that causes them to not be able to produce an opinion?

11:28Sure. Well, one failure point that I love to point to is DOD's difficulty in tracking property and inventory records across the military services. One of my favorite examples of why does this matter? Who cares? Why do auditors go in and look at inventory records and flag this as a weakness in their audit reports? Well, a few years ago, 2019, the Department of Defense Inspector General flagged errors in the Navy's property and inventory records. And as a result, the service ended up finding a warehouse that was mysteriously absent from its property records. And they've lost a whole warehouse. Amazing.

12:07Indeed. And inside, they found$126 million worth of spare parts. Wow. Now, in the context of the Pentagon budget, what is$126 million when we're talking about a near trillion dollars, depending on how you count it? But they found these spare parts for a number of different aircraft inside that warehouse. And they were actually able to fill over$20 million in spare parts orders without having to procure new ones. And so the scale of this issue is unknown, right? Because we have a pervasive inventory and property record keeping issues throughout DOD. And importantly, the Government Accountability Office has actually flagged inventory issues since the early 80s, since 1981.

12:54And this is relevant, for example, to the most expensive weapon program in U.S. history, the F-35 fighter jet. Now, the reason I bring it up is because, you know, OK, you have an example of the Navy finding all these aircraft parts and being able to fill orders. So what does that mean in the context of a now$2 trillion weapon acquisition program, which is the F-35? Well, you have the GAO, the Government Accountability Office, saying that F-35 parts in the possession of contractors are likely significantly understated. So the government has all these spare parts are government owned, but typically possessed, controlled by contractors.

13:34And the GAO has flagged this issue for a long time because it means we could be overbuying on spare parts as a country. The Department of Defense Inspector General has likewise expressed this concern and in 2021 found that, you know, the Army, for example, was forecasting spare parts needs and was only accurate 20 percent of the time. Again, why does that matter? Because they ended up overstating how many spare parts the Army needed by over$200 million. The military writ large, all the services together actually overshot their spare parts needs by nearly a billion dollars. So this matters when you can't keep track of your property in the possession of contractors.

14:15It must matter from an operational or execution perspective as well, right? If there was a military emergency and we can't find the spare parts that we need because we've never been able to track them, that's problematic. Oh, absolutely. I mean, you look back to the early years of the war on terror. I mean, I meet a lot of veterans who, when I talk to them about these issues, they say, oh, yeah, we were hiding. you know, parts to maintain our equipment in our bunks because we had no assurances that we were going to be able to maintain, to repair the equipment that we need to do our jobs. So it is a readiness issue and one that the DOD absolutely needs to rectify.

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15:52Giving teams across your organization an easy way to order from a huge variety of restaurants, all on one platform. All while consolidating your corporate food spend so you can control costs, streamline billing and payment, and simplify reporting. EasyCater, your business tool for food. To learn more, visit EasyCater.com slash podcast. I have to imagine that if one of the problems is sort of implied here about overordering spare parts, I would guess that the major weapons suppliers, the defense contractors, don't really mind that problem. That's exactly right, Joe. So, in fact, the DOD has actually requested inventory records from Lockheed Martin before for the F-35 program.

16:40And Lockheed Martin said, oh, well, it's going to cost us a bunch of money to track down this information and provide the reports, essentially disincentivizing the government from requiring that in the military contract. And I wrote a piece about this a couple of years ago. And it's insane because you have contractors who have government-owned property in their possession, but they control all of the tracking mechanisms. And even when government asks, they say, oh, well, what are you paying us to provide you with information about government-owned property? Hmm. Just on the contractor point, I always wonder about this, but who does the U.S.

17:16actually compete against when it's buying military stuff? Because I would think with a trillion dollar budget for defense, the U.S. is probably putting in the biggest orders. And so could they, in theory, dictate the price or at least ask for a volume discount or something? I mean, on the F-35s, for instance, like the U.S. has hundreds now versus other countries that have, I think, a few dozen. Yeah. So this is the problem with the monopsony market, right? Monopsony klaxon! Sorry, that's a trigger word for us. You have one buyer, but you also in a lot of cases have one seller. And that is the genius of the arms industry, right?

18:03With the F-35 program, they have politically engineered it such that it exists in, I think, all 50 states now. Lockheed Martin has an interactive map, so someone can fact check me, but it is like 46, if not all 50 at this point. So every politician in America has some reason to preserve the status quo because they have workers. Is that the idea here? That's exactly right. Because jobs, even though we know that military spending is a lousy jobs creator in comparison to other types of government spending. So, you know, I guess if the Pentagon has failed seven audits in a row, I guess by implication, eight years ago or nine years ago, there was no mandate for an audit, period, because it must be a relatively new thing.

18:50Can you talk to us a little bit about how that came about, the requirement to audit, and how the military contractors sort of try to shape the process of tracking acquisition? Sure. So this is a question I get a lot. Was there accountability before the Pentagon started consolidated agency-wide audits? So the answer is yes, but not to the same extent that we have today. So in 1990, Congress passed the Chief Financial Officers Act, which required federal agencies to prepare financial statements for audit. And the DOD submitted component financial statements to the DOD IG for that purpose, but did not undergo the thorough audit that we see today.

19:39And in fact, the number of components included in the agency-wide audit tends to vary a little bit every year. Sometimes it's 28, sometimes it's 27. But it is absolutely true that contractors shape nearly every aspect of defense policy because of their power and influence on Capitol Hill. And a major lever for that power and influence is, in fact, the sort of jobs creation that they lean on for these weapon programs. And I actually think it's an interesting question because now you see the current Secretary of Defense, Hegseth, really embracing the audit in his quest to improve military readiness.

20:24And on its face, that is a noble and worthy goal, right? It remains to be seen how that actually shakes out in this administration. I only hope for the best and very much encourage the administration to take this seriously because I do think that it matters, again, when you have, for example, military services overbuying spare parts at the expense of the taxpayer. However, I think that it's noteworthy when you see news a month ago about the secretary saying, OK, we're doing budget reshuffling to reorder DOD funding and channel it toward Trump's priorities, President Trump's priorities. And one of those exemptions from potential reductions in these budget reshufflings was the audit.

21:11Of course, so was nuclear modernization and many other things. And that is important for military readiness and we actually should work toward passing an audit. However, it's important to note that even if the DOD passes an audit, that doesn't justify the money that the DOD is spending because we should be able to achieve more for less. And we have not seen that in recent decades. Right. Just on this note, I kind of want to back up and ask a big picture question. But, you know, Joe alluded in the intro to the fact that defense spending has historically been, it's always been there. It's always been with us and it's always been pretty big.

21:50I know that you can benchmark it to GDP and it's come down as a percentage of GDP, but I think we can all agree that$1 trillion is still a pretty big number. So why did that happen and why is it that we just accept that defense is kind of untouchable or by its nature going to be this huge line item? I'm so glad you brought up percent of GDP. I love to talk about this. I think that it's one of those macro indicators that conceals more than it reveals, right? So the distribution of military spending has changed a lot over time. But we're so beholden to this idea of a gigantic military budget to keep Americans safe because of its legacy after World were to in bringing the United States out of sort of the trenches of the Great Depression and stimulating the economy.

22:46Of course, any significant government spending would stimulate the economy and sort of offset the effects of underconsumption. And yet we've just been sort of ingratiated with this idea that military spending is so integral to our economic growth, when in fact, there's a lot of economic research out there that says, you know, sort of ever-expanding military budgets can have a depressive effect on long-term economic growth. Why? Because it impacts productivity, right? So World War II, the sort of narrative in sort of dominant historical discourse is we have this productivity miracle. No, it was a production miracle.

23:27We spent a bunch of money on military industrial output, But that had a depressive impact on productivity over time. So I argue that this is actually bad for the economy long term. But we are, as a country, I think so dedicated to this idea that the military budget is sort of a core part of our economic engine. And unfortunately, that's not true anymore because, again, the distribution has changed over time. It's a lot more capital intensive. It's not necessarily this sort of vehicle of upward economic mobility that it used to be because it's not as focused on labor. Of course, yes, you have the GI Bill.

24:06Yes, you can get a free education. That's all very important and good, and we should absolutely do that. But we're spending more and more money on research and development and procurement. Who does that benefit? It benefits electrical engineers, not the working man. So just on this note, in preparing for this episode and looking you up, I noticed that for your undergraduate thesis, you did an econometric study to test the relative impacts of various types of defense spending on income inequality. That seems really interesting. I don't know if you remember your undergrad days or your work, but what did you find in that?

24:43So I actually just gave you the short pitch on my paper, which did find, and I had an R squared of 96%. So explanatory value was good. But I tested this hypothesis that military spending is good for jobs, good for people, good for the economy. And I did that by disaggregating the base budget into the major categories, some of which I just described, research and development, procurement, personnel, operations and maintenance, you know, the big ones. And I actually found that procurement in research and development had exacerbated income inequality over the eight years of the Obama administration.

25:21That was my time span. And I actually know someone at an academic institution writing on the same exact topic now. So I'm very happy that that person will be soon publishing a paper because I did not publish mine. But yeah, I mean, I wanted to test this idea that military spending is good for the economy and it's military Keynesianism, right? This is the idea that we've all been fed. And I think that lawmakers really grasp onto because it's a convenient veil for what are frankly often conflicts of interest, whether that be congressional members owning and trading stocks or receiving campaign finance from arms manufacturers.

26:02And I think it really distorts the way that we talk about defense policy, the military and its role in our economy. If I could play devil's advocate for a second. One of the major sources of anxiety right now in the U.S. economy is not about jobs, although maybe the labor market is weakening, but the unemployment rate is still kind of low. It's mostly this concern that the U.S. is not at the technological cutting edge in many areas that are at least in some way adjacent to the military. And of course, you know, people love to tell you it's like Silicon Valley got started off, you know, from it was all military funding.

26:40And that's why we have chips. And that's why we have compact chips and small computers because they needed to be put in small spaces, etc. When you talk about all of the R &D spending that they do or even the capital expenditure, isn't that like when we think about productivity, do we get positive spillovers from the research that's being done by today's weapons manufacturers that are then transmitted to the rest of the economy? Yeah, this is something I've really been grappling with. I'm writing a paper right now on the defense industrial base. Yeah. And you're absolutely right. I mean, industrial policy is super hot right now.

27:14Of course, like Robert Reich, I think, said this in the 90s, industrial policy is back. But the thing is, we've always had industrial policy for military contractors. To your point, Silicon Valley wouldn't exist without DARPA and ARPA-E grants. And in my view, I sort of see this in the context of our economic resilience and vitality long term. OK, I'm an elder Zoomer. I'm pretty much the oldest you can be and still claim to be Gen Z. And I think about my future and I see military investment as mortgaging our futures on exquisite, expensive platforms, even in the software realm. That's not to say that I don't think there is an innovation happening.