Do We Need to Re-think Defense Industrial Policy?
The nation’s defense industrial base is a significant national asset and a major strategic advantage. Over the past 50 years it has also shown itself to be the world’s best. As noted defense analyst Barry Watts, a former director of the Pentagon’s program analysis office has written, “if one had to choose a ‘military-industrial complex’ that has stood above all others since the early 1940s, and continues to do so today, the American military-industrial complex would surely be the one most people and most nations would choose.”
But the “military industrial complex” referenced by President Dwight Eisenhower in his 1961 farewell address is not what exists today. Back then, in the top 100 companies listed on the Fortune 500, 15 were exclusively or significantly involved in the defense program and accounted for nearly 30 percent of the top 100’s annual revenue. In the latest Fortune 100, only four companies make the list, with the largest (Boeing) being two-thirds commercial aircraft, the second largest (United Technologies) slowly exiting the defense market and the fourth (General Dynamics) holding the number 88 slot. In short, the “complex” basically has become a niche business.
Former Defense Secretary William J. Perry recently commented that when he gathered the major defense industry leaders for a dinner in 1993 and informed them that the end of the Cold War would bring a significant reduction in the defense program, he suggested they significantly restructure their businesses. Perry recalled his expectation that this restructuring would result in “leaner” companies, not necessarily fewer companies. But what happened was a major consolidation where more than 30 companies merged into five—the current “top tier” companies.
Anytime a market goes from many competitors to a few, the inevitable result is less competition—meaning upward pressure on prices and the potential for lost vibrancy and technical innovation. These trends can be offset if the market is able to entice new entrants into it in pursuit of greater revenue and margins. This has not happened in the defense marketplace, where those who have been in it continue to exit even as the Pentagon calls for more innovation and lower prices.
So what is going on? The current defense industrial base, consisting primarily of publicly traded corporations, is both lean and highly consolidated. As with all companies seeking improved earnings and margins, today’s companies constantly are seeking ways to reduce overhead and eliminate unnecessary infrastructure. For example, the large Quonset Point facility in Rhode Island where General Dynamics once produced submarines during the Cold War is a shadow of its former self. Because the Virginia-class submarine program is much smaller than its predecessors, about two-thirds of the facility is gone. The buildings were bulldozed. Excess staffing and infrastructure costs money, and for a market where future revenue growth is uncertain in a period of budget turmoil and sequestration, all of the major defense firms aggressively have gone “lean.”
But if leanness was inevitable after the Cold War, so was consolidation. Between 1991 and 1998, the consolidation period for defense, the Pentagon’s procurement accounts were reduced some 70 percent in real terms, and major programs such as the B-2 bomber and the Seawolf submarine were reduced drastically. The result has been a much smaller market, with fewer major programs and—unsurprisingly—fewer companies.
This leaves the Defense Department with two choices. It can either decide to manage the industrial base through some form of industrial policy, or it can attempt to make the market more attractive for new entrants by increasing potential rewards and lowering barriers to entry—many of which it has created itself.
Reports circulated widely that senior defense acquisition leaders were both surprised and unhappy when United Technologies Corporation (UTC) recently decided to sell its Sikorsky helicopter unit to Lockheed Martin, a step that further narrowed the defense industrial base. The Pentagon basically had no mechanism for stopping this move. Ant-trust laws and regulations can stop or discourage mergers, but there are no major policy tools to stop a spinoff, divestiture or closure. Establishing such tools would be a major intrusion of government into private business that likely would find legal and political resistance. This would be a most heavy lift.
So what is the option? United Technologies reportedly sold Sikorsky because its potential for revenue growth was uncertain, and its margins were less than half of UTC’s commercial holdings. If the Defense Department wants to encourage those in the defense marketplace to stay and others to enter, it has to make the marketplace attractive. This means addressing three issues.
First, the government has to remove the uncertainty of market potential by seriously addressing the budget doubts that exist. In addition to the programmatic chaos left from the 2011 Budget Control Act, current policies and budget limitations force the Pentagon to rob Peter—its modernization accounts—to pay Paul—its personnel and operations accounts. More than one company has left the defense business because of fatigue from program uncertainties, unexpected cancelations and unfilled projections.
Second, the Pentagon has to understand that it has become itself a barrier to entry. Jacques Gansler, a former undersecretary of defense for acquisition, has noted that the volume of federal regulation and code has doubled over the past three decades and is now more than 180,000 pages. In addition, a Government Accountability Office (GAO) report states that compliance with these requirements has cost nearly $1.7 trillion over the past 15 years. Bearing such costs, and tolerating the intrusiveness of a customer who conducts extensive audits of contracts, payments and supply chains, is unappealing to many who might otherwise participate.
Finally, there is the issue of profits. The firms in Silicon Valley that the Defense Department is courting are accustomed to addressing a rapidly changing technological landscape, taking risks and—where successful—achieving margins commonly above 30 percent. The government would never allow such margins, much less accept the risks that accompany them.
Today’s defense industry is small and getting smaller. It remains innovative, and it is also lean. It likely would be even leaner except for the compliance costs associated with the market itself. When the Air Force’s Long-Range Strike Bomber (LRS-B) contract was awarded, all senior defense leaders stated that the award had nothing to do with the industrial base. But the question remains: “Should it have?”
The Defense Department has a choice. It either has to develop both an interest in managing the defense industrial base, and ask Congress for the necessary tools; or it has to make the defense marketplace more attractive through lower regulations, less risk aversion and greater earnings potential. In the absence of such specific steps—or some combination of them—despite the concerns expressed by experts such as Perry, an already small defense marketplace will inevitably get smaller.
M. Thomas Davis is a former defense industry executive and a retired Army officer. He is the author of numerous studies and articles on defense management policies.
