Defense Budget: Industrial Policy Debate: Should the Pentagon Pick Winners and Losers?

Article excerpt

The last time the United States drastically cut spending on new weapons systems, defense contractors were told to merge of else they would perish.

The industry over the past two decades consolidated into a handful of mega-corporations. Now, a new drawdown in big-ticket weapon spending is approaching, and companies are wondering what will be the survival strategy this time around.

Industry executives and trade associations have called for the Defense Department to take preemptive action to protect key sectors that are considered of strategic importance to national security. That would require the Pentagon to continue to fund selected research-and-development programs even if those systems were not likely to be needed in the near future. Advocates of centrally planned industrial policy contend that unless the Pentagon decides ahead of time what sectors of the industry should be kept alive, budget cutbacks in major weapon systems will jeopardize portions of the industry that, once vanished, cannot easily be reconstituted if the United States needed to mobilize for a major war.


U.S. Code Title 10 requires that the Defense Department consider the industrial implications of its major weapons program decisions, says defense industry analyst Joachim Hofbauer in a Center for Strategic and International Studies report. "Developing and collecting standardized metrics to measure the value of individual defense programs to the industrial base constitutes a crucial prerequisite for complying with this regulation. Yet, today the Department of Defense largely lacks such metrics," says Hofbauer.

But despite an abundance of laws that require defense industrial planning, the Pentagon historically has shown little appetite for picking winners and losers, and has been more comfortable with a laissez-faire approach.

After the Cold War ended, the Defense Department stepped out of the way and for five years let contractors consolidate at will. The Pentagon finally drew the line in 1997 when it stopped the merger of industry giants Lockheed Martin and Northrop Grumman.

A repeat of the mergers and acquisitions frenzy of the 1990s is improbable, considering how much smaller the industry is now. But the Pentagon still should be prepared to cope with the "industrial consequences" of future budget decisions, says Undersecretary of Defense for Acquisition, Technology and Logistics Ashton Carter. "We'd be fools to not pay attention to that," he says during a recent Council on Foreign Relations talk in Washington, D.C.

Industrial policy mandates have existed since the 1950s but most administrations have avoided picking winners and losers when budgets have gone south, says Gerald Abbott, directory of industry studies and professor emeritus at the Industrial College of the Armed Forces. "During the Reagan administration there was a time when if you used the word 'industrial policy' you got fired," he says in an interview.

The Pentagon essentially has three choices, Abbott says. It could only award contracts to companies that it wants to keep alive, it could return to the arsenal-style government-owned industry model, or it could treat defense contractors like public utilities by guaranteeing a certain amount of work and returns for investors.

But none of these alternatives is ideal because they lock the government into a corner, says Abbott. "The trouble with industrial planning is that once the government writes up a list, it's almost impossible to change the darn list."

A case in point is the U.S. national stockpile of critical materials. "Once you put something in the stockpile it is impossible to get it out even if it is no longer needed," says Abbott. "You create a whole bunch of vested interests that want to continue to sell those materials to the government."

Another impediment to industrial planning is the power structure in Washington, he says. The largest five companies have far more influence than emerging smaller companies. "So if you did industrial planning you'd protect the old gorillas and not the young startups," says Abbott. Under that scenario, "How do you encourage new companies with new technologies to enter the game?"

These issues have been debated for years and there are never easy answers, says Abbott, who was a member of the DAPA (Defense Acquisition Performance Assessment) procurement reform blue-ribbon panel in 2006.

The engineering and weapons-design work force is a critical asset that the Pentagon can't afford to lose, but nobody really has defined what specific skills within that work force are the essential ones to keep. These decisions also have to take into account the demographic trends that point to an already aging work force. During a drawdown, companies will stop hiring so the aging trend will be exacerbated, says Abbott. "This is not a trivial problem."

Even the largest defense contractors are uncertain about what specific skills they should save, says Joel Johnson, executive director of the Teal Group, an aerospace industry research firm.

Many U.S. companies have shifted their focus away from aeronautics in the direction of information technology, systems integration and project management, says Johnson. "How interchangeable are the aeronautical engineering and IT skills?" he asks. The defense industrial base also is being undermined by a U.S. culture where the accepted mantra is that everyone needs a college education while nothing is being done to promote skills such as welding and machining, which take up to eight years to master, he laments. "We shouldn't assume that every skill that is critical to this industry requires a college degree."

Abbott says the best way for the Defense Department to retain today's skilled workers is through hand-picked "prototyping" programs where small teams of designers and engineers would build small numbers of airplanes, ships or tanks. That would be hugely expensive, says Abbott, and the prototypes may never see full-scale production. But it may be the only option if the Pentagon really wants to hang on to experts.

The most likely outcome of this debate will be a continuation of the status quo, predicts Abbott.

"There'll be a great deal of rhetoric and not much action," he says. "I've heard the rhetoric for too many years."

When money is tight, the political powers will play more heavily, decisions will be based on who can argue the most convincing case, not on an industrial base master plan, he says. "There is no magic formula to get the right answer. It becomes a judgment call."

If the United States were to have a real debate on industrial base issues, the place to start would not be defense but the larger manufacturing sector, Abbott contends.

"We have no policy relative to manufacturing," he says. "If there's one critical area of our economy is the manufacturing base. And we're just letting it wander while it's being gobbled up and chewed up.

"We can't get our hands around something as important as the manufacturing base, let alone get our hands around something as transitory as the defense industrial base," he adds. "I think the defense industrial base is important but the manufacturing industrial base is far more important, and we can't solve either one."

Abbott says it may take several years for the downturn in defense procurement to force drastic actions such as mass layoffs or closures, but that eventually the cutbacks will be felt. The restructuring that occurred in the early to mid-90s resulted from procurement budget cuts that started in 1986, he says. By 1996, procurement spending had dropped by two-thirds.

Budget projections by TechAmerica, an industry association, show a flat defense budget over the next decade, but forecasts a significant downturn in procurement, research and development dollars as spending shifts toward personnel costs.

Acquisition and R&D accounts now make up 34 percent of the defense base budget. Assuming a flat budget and growth in personnel a bit above inflation, modernization accounts 10 years from now will be down to 25 percent of the budget, according to TechAmerica estimates.

Unless the Defense Department decides to reduce the size of the force, procurement spending will continue to be squeezed, says budget analyst Steve Daggett, of the Congressional Research Service.

He estimates that the average service member costs 45 percent more--including salary and benefits after adjusting for inflation--than in 2000.

Industry analyst Jim McAleese, of McAleese & Associates, says he is certain that the Obama administration has effectively flat-lined defense spending for the foreseeable future. But many major decisions have yet to be made regarding how money will be allocated within a flat budget. "I would caution you to really pay attention to Defense Secretary Robert Gates' vision," McAleese says in an interview with Federal News Radio. "I believe he is fundamentally using the QDR [quadrennial defense review] to put the finishing touches on his legacy. Gates wants to "optimize" the Army for long-duration counterinsurgencies, he says. "The priority in the Army will be investing in a world-class quality combat force, that is well-supported, and that the soldiers' families are well-supported." The upshot is that many of the expensive weapons systems that the services have been accustomed to buying will no longer be affordable.

As budgets for weapons shrink, some companies may exit the defense industry simply because the military will not have enough money to keep everyone in business. At the Air Force Association's recent annual symposium, the service's chief of staff, Gen. Norton Schwartz, was asked whether the Air Force worries about the erosion of the industrial base in areas such as engineering and manufacturing.

"It's a real issue," says Schwartz. "It's something we all worry about."

He says the Air Force would endorse "selectively maintaining industrial capabilities that would permit a surge or a more rapid ramp up of a program," but it would have to be "well justified, because each dollar that we use to maintain the industrial base, as strategically valid as it might be, is a dollar taken away from something else."

The upcoming selection of a contractor to build a new aerial refueling tanker is expected to become highly politicized precisely because of the lasting impact that program will have on the industrial base. Schwartz, however, does not believe that industrial-base implications should be a factor in the selection of a tanker manufacturer. The Air Force should choose the winning tanker based on the value to the taxpayers and on whether it is suitable for the military mission, Schwartz told a private gathering of defense contractors. "Considerations of whether we are maintaining domestic engineering and manufacturing is a Defense Department responsibility, but should not enter in the source selection process," Schwartz says.

Army suppliers, meanwhile, are wondering whether the service will keep alive the production lines that surged for the Iraq war. Many contractors, such as body armor providers, are now facing declining orders and excess capacity.

"Somebody has to decide who lives and who dies in this industry," says Marc King, vice president of armor manufacturer Ceradyne. Before the war, armor was a "boutique industry" that only produced small quantities of ballistic plates. At the height of production in 2006, the company employed 1,100 factory workers. Now plants are operating at 40 percent capacity and 600 workers have been let go, he says. Given the drops in orders, the company eventually will have to shut down facilities, says King. "The Army has not indicated their plan for how to sustain the industrial base for body armor."

Johnson, of the Teal Group, says the armor surge illustrates why Pentagon officials are so blase about industrial policy. They assume that the industry will respond when there is ah urgent need, he says. When the military was short of armor, the industry ramped up, and now that they don't need as much armor, they expect some factories will close. "There's the notion that Defense Department is big enough that it can more the industry, and that industry will adapt to whatever it needs," says Johnson. Concerns about preserving industrial capabilities have been heard over and over and, somehow, "We always soldier on."