The Uncertain Lifeline

June 1, 1988

Washington, D. C.—After many years of neglect and abuse, the defense industrial base has finally sunk to the point that the Administration and Congress can no longer ignore the problem. It emerged as a major issue recently when the realization set in that other countries are overtaking us in high-technology manufacturing, that do­mestic industry is losing defense business, and that the US is rapidly becoming dependent on foreign sup­pliers for critical military items.

“There is no doubt that we are today more dependent on foreign sources for critical components in our weap­on systems than we have ever been before,” says Sen. Jeff Bingaman (D-N.M.), whose Senate Armed Services subcommittee is investigating the de­fense industrial base and related trade policies. “That is largely the re­sult of the increasing internationali­zation of high-technology and other defense-related industries over the past forty years.”

In his FY ’89 report to Congress, Secretary of Defense Frank C. Carluc­ci said that ‘we are continuously as­sessing our vulnerability to foreign dependency for critical items. Through these efforts, we have identi­fied problems in the machine tool and electronic areas and are highly con­cerned with the situations developing in the precision optics and bearings industries.”

The Pentagon admits that the US advantage in military trade is drop­ping, but says that sales are still ahead of purchases. “Our declining defense trade balance is not attribut­able to increased defense imports but rather to a loss of international mar­ket share,” Dr. Robert B. Costello, Un­der Secretary of Defense for Acquisi­tion, told Congress March 29.

Senator Bingaman says that “for­eign military sales by American com­panies have been halved from 1980 to 1986, going from $14.8 billion to $7.1 billion. Our defense trade balance with NATO has gone from a high of 4.8:1 down to 1.6:1 during the last five years, and those figures do not take into account nondefense offsets to which our firms must agree to gain market access.”

The net export value of military sales is often negated by such “off­set” agreements. These are side ar­rangements—perhaps unrelated to the main sale—that require some in­dustrial or commercial compensation as part of the package deal.

“Offsets have increased in the last decade from fifty to 160 percent of the value of the sale,” says Sen. Alan J. Dixon (D-Ill.). “I believe that setting up a marketing system for hams or for­eign cars or promoting tourism for a foreign country has no place in the sale of weapons.”

Far more serious, Senator Dixon says, is that “US firms have trans­ferred technology to foreign govern­ments used to develop critical de­fense systems as part of offset ar­rangements.” Thus fortified, foreign suppliers are better able to compete against US companies in the world market.

“A number of our allies are now competing against us using technol­ogy developed in the US,” Senator Dixon says.

Surge Capability Slim

These new aspects of the problem come on top of older ones that have worried the defense community for a long time. A steady parade of Pen­tagon reports, confirmed in 1980 by congressional inquiry, warned that US industry could not expand its pro­duction to meet a wartime mobiliza­tion in less than eighteen months. It is not possible to surge the output of even the most important weapons and war materiel much faster than that.

Gen. Robert T. Marsh, USAF (Ret.), Chairman of AFA’s Science and Tech­nology Committee, has participated in numerous surge studies con­ducted by the Air Force. In most cases, he says, the finding was “that all you could really do by way of surge was sort of empty the pipeline. You could push a little faster, up your rates a little bit for things that were already in the pipeline. Then came the big dip, twelve to twenty-four months while the lower-tier [supplier and sub­contractor] surging took effect.”

Moreover, General Marsh says, the surge studies typically have a built-in weakness. They examine only one weapon system at a time. “We never could figure the intersections,” he says. “If you’re surging AWACS radars and surging Phoenix missiles, we don’t know the extent to which they’re depending on the same guys for the same critical components.”

The shortage of such suppliers has long been recognized as a major in­dustrial-base deficiency. Half of the small specialty firms that once sup­plied high-technology parts to the prime systems contractors have ei­ther disappeared or left defense work. The chain of suppliers often reaches down for four or five levels. Neither the Defense Department nor the prime contractor know who all of the suppliers are how many of them are foreign.

According to a March 24 report by Tim Carrington in The Wall Street Journal, “Pentagon strategists re­cently discovered that if war broke out, Soviet bombers could gravely wound the [United States] simply by attacking a small German plant thirty miles west of the Czechoslovakian border.

“The plant makes all of the high-purity silicon the US buys for chips in thousands of missile guidance sys­tems. Destruction of the plant would stall US missile production for months, crippling the West’s capacity to resupply its forces with missiles.”

In response to a query from AIR FORCE Magazine, the Defense Depart­ment confirmed Mr. Carrington’s re­port, but said that steps are being taken now to correct the situation.

A task force of the Defense Science Board concluded last year that the next generation of advanced semi­conductor chips will probably be made by Japan, not the US. If so, the United States in the 1990s will either buy foreign semiconductors or settle for second best in its weapon sys­tems.

Thus the armed forces are not only unable to count on domestic industry for mobilization but are also becom­ing increasingly dependent on over­seas sources to meet their needs in peacetime.

“Buy American” Lawsuit

In a lawsuit filed April 8, the Nation­al Council for Industrial Defense ac­cuses the Pentagon of granting blanket waivers to the Buy American Act without fully considering the con­sequences. It says that in pushing off­shore procurements, a staff of inter­national advocates” in the Defense Department not only hurts domestic manufacturing and technological leadership but also leaves the US de­pendent on plants and facilities that are ‘within easy bombing range of the Soviet Air Force.”

This newly formed lobbying organi­zation claims a membership of 5,200,­000, mostly drawn from defense sup­plier and subcontractor firms and several AFL-CIO labor unions, but says it is “not anxious to reveal the names of member companies” for fear that reprisals might be taken against them.

In its aggressive and rather flam­boyant attack, the Council charges that a “buy foreign” policy causes “a dangerous weakening of the US de­fense industrial base, particularly at the second- and third-tier subcon­tractor levels.”

These are the levels that most fre­quently lose business because of off­set concessions.

The main objective of the lawsuit is “to compel the Department of De­fense to comply with those laws that are intended to preserve our indus­trial base by giving a preference to the procurement of American-made de­fense products.”

How Much Independence

Opinions differ about the extent to which the United States can or should aspire to independence in its defense industrial base. The question is one of degree. Virtually no one who has studied the problem thinks the US could afford to rebuild a World War II style “Arsenal of Democracy.” An­other consideration is allied coopera­tion.

A recurring complaint of the allies about arms standardization is that, traditionally, the US has always sold weapons to the Europeans but never bought anything much from them. They called for the establishment of a “two-way street” in military sales. Congress and the Defense Depart­ment have put special emphasis on cooperative research and develop­ment the past few years.

“Our national security needs can­not readily be met with US resources alone,” Dr. Costello said in his state­ment to Congress. “We must cooper­ate with our allies to reduce wasteful duplication of development efforts, to promote commonality and interoper­ability among US and allied forces, and to achieve urgently needed economies of scale throughout the ac­quisition and logistics cycles. Our do­mestic industrial base is critically important, but we must not allow our­selves to use this issue as a shroud for protectionism.”

Secretary Carlucci testified that “national weapons programs have led to the deployment of six types of main battle tanks, six types of fighter air­craft, and a plethora of antitank mis­siles and armored vehicles within NATO.” He added that “we project our investment in cooperative programs will increase from the current three percent of research, development, test, and evaluation [RDT&E] resourc­es to twenty-five percent by the year 2000.”

Senator Bingaman acknowledges the value of allied cooperation and has supported collaborative develop­ment and production. He says, though, that “while such programs help us in making the best use of the Alliance’s limited resources for de­fense, they inevitably increase our for­eign dependency.” He further points out that allied governments practice protectionism regularly.

The United States, Senator Binga­man contends, has not been “as vig­orous in pursuing US economic inter­ests as our allies have been in pursuing their own. Our allies seem better able to recognize that while we are political and military allies, we are also economic rivals.”

How We Got Here

As the issue heats up, questions arise about how the US defense in­dustrial base could have deteriorated to its present state. There is no single or simple answer. And the trouble has been developing for a long time.

First, there have been big changes in the makeup of industry, both in the United States and internationally. Heavy “smokestack” industries have declined in economic importance as high technology has moved to the forefront. The United States is no lon­ger so dominant as it once was in the global business arena. More and more, commercial interests and inter­dependencies cross national bound­aries. Technological advancement, especially in electronics, has created an enormous demand for high-tech­nology consumer products. For ex­ample, the US armed forces, once the primary customers of the semicon­ductor industry, currently buy just three percent of the total quantity pro­duced.

Commercial and consumer sales now drive the technical product mar­ket. Suppliers have followed the shift in the market. They also found that their commercial lines gave them bet­ter profits, more stability, and less trouble than defense work. Mean­while, ironically, these widget makers were becoming more important to de­fense. Between 1950 and 1980, the share of defense work sublet by prime contractors increased from nine per­cent to forty-one percent. One of the most intense areas of subcontracting is electronics—which is also the main pillar of technical superiority in mod­ern weapon systems.

According to the Defense Science Board, the growing Japanese advan­tage in semiconductors is chiefly a result of their better ability to produce these chips in large quantities at very low cost.

A number of people, General Marsh among them, believe that stunted productivity may be the most funda­mental problem of all with the US de­fense industrial base. Defense con­tractors have not invested in capital improvements that would have made them more productive and efficient.

“The defense industry suffers from insufficient capital investment, result­ing in excessive touch labor and hence less than desired quality and productivity,” General Marsh said in testimony to a Senate subcommittee on March 30. “This in turn leads to unduly high costs and reduced inter­national competitiveness. These weaknesses exist throughout the prime and lower tiers of the industry. A perplexing characteristic of the de­fense industrial base is an over­capacity in a number of areas at the prime supplier level but a shortage of qualified suppliers for many critical materials and components in the low­er tiers.”

Failure of defense industry to mod­ernize is a problem with multiple roots of its own. Economists have been lecturing for years about the proclivity of American business in general to emphasize short-term profits over long-range development. In the semiconductor industry, stock is traded at a breakneck pace, the vol­ume of turnover being equal to a com­plete exchange in ownership every six to nine months. Management is under pressure from investors who want their earnings quickly.

Harsh Policies Hurt

Part of the fault, however, lies in the way the government has structured incentives and disincentives for busi­ness. The defense industry—unpopu­lar with the public and perceived widely as a threatening “military-in­dustrial complex—has been treated more harshly than most.

A February 1988 study published on behalf of the Aerospace Industries Association, the Electronic Industries Association, and the National Securi­ty Industrial Association examines the effect of policy changes from 1984 to 1987 on capital formation in de­fense industry.

“Business is fundamentally about risks and returns,” the study says. “As essentially the only purchaser of highly specialized defense equip­ment, DoD controls both sides of the risk/return balance (at least for major systems procurement). In the period we have examined, DoD and Con­gress decided to adjust what was viewed as an imbalanced risk-return relationship. Unfortunately, it reduced rewards and increased risks simulta­neously, with not one but multiple un­coordinated adjustments. At the same time, Congress significantly in­creased the industry’s capital require­ments (by reducing progress pay­ments and deferred tax financing).

“While some in DoD now claim in­dustry is much more like commercial industry, Wall Street is saying it will not provide it with capital at the same rate as commercial industry. Wall Street might provide the capital if it saw the opportunity for high returns (as it does for biotechnical compa­nies, for example); the industry might live with the low profits if the govern­ment provided more of the financing and did away with cost-sharing, fixed-price development, and other unrea­sonable risks. But, as matters current­ly stand, the government has stepped out, Wall Street is unwilling to step in, and the industry is unable to.”

It is not only the large prime con­tractors who feel the government has been clumsy in its use of carrots and sticks. Dennis M. Biety testified to the Senate Armed Services Committee on March 30 for Pneumo Abex Corp., a first-tier supplier of hydraulic sub­systems. He said that his firm, which does about half of its business in mili­tary sales, is typical of the subcon­tractor base.

Mr. Biety said that suppliers and contractors see DoD as chasing short-term savings with policies that would be counterproductive in the long run. He said that firms at his tier are finding it “increasingly inad­visable to invest in the development of advanced technology or manu­facturing capability for defense sys­tems.”

Proposals and Solutions

The Pentagon, Congress, and in­dustry are all hacking away at parts of the problem.

Centerpiece of the effort to regain US competitiveness in semiconduc­tors is Sematech, an industry consor­tium that just opened its permanent headquarters in Austin, Tex. It will work on improved equipment, mate­rials, and techniques for semicon­ductor manufacturing, not on the de­sign of chips. It was production ability that enabled Japan to overtake the United States in the semiconductor market in the early 1980s.

Sematech will not emphasize mili­tary applications in its research, pointing out that defense consump­tion of semiconductors is a small share of the total. The Defense De­partment says that its role in Sema­tech has not been decided yet. The guiding idea at Sematech seems to be that the proper way to help defense is to restore the domestic semiconduc­tor industry to a strong position in the commercial market.

Target financing for Sematech is $1.5 billion over six years, with $600 million of that coming from the feder­al government and member compa­nies paying most of the remainder.

The Pentagon’s own Manufacturing Technology (ManTech) and Industrial Modernization Incentives Program (IMIP) are older and broader initia­tives that share with industry the cost of upgrading the defense production base. There have been some suc­cesses, notably in assembly, castings, forgings, and factory automation. The Air Force is the only service that has shown real interest in ManTech, though. Funding has been modest, and industry has been reluctant to make capital investments to improve productivity.

Legislative actions are also pend­ing. Senators Bingaman and Dixon, along with Sen. Phil Gramm (R-Tex.) and Sen. Timothy Wirth (D-Colo.), are sponsoring the Defense Industry and Technology Act of 1988. It would re-weight the balance among risk, re­ward, and profit in defense procure­ment in a way that is more favorable to industry.

The Defense Department has al­ready backed away from the use of fixed-priced contracts on develop­ment programs for which the out­come is but dimly foreseen. Acquisi­tion officials have also seen their error in forcing contractors to pay big por­tions of the R&D cost on high-risk de­velopments even though the produc­tion award might go to a different contractor or the product might never be built. Part of this was a realization that the policy was unfair. Perhaps more motivating, though, was the dis­covery that contractors were refusing to bid on losing propositions.

In April, Senator Dixon introduced an amended version of his Defense Industrial Base Preservation Act, which he says “would eventually elim­inate the growing number of offset arrangements.” He concedes that “earlier drafts were protectionist in nature,” but claims the revision “does not close the door to our friends and allies overseas.”

At best, these measures might ame­liorate the defense industrial base problem. They would not solve it. Even if all of the proposals were adopted immediately, the United States would still lack the capacity for wartime mobilization and surge. It would still depend—to an unknown extent—on foreign suppliers. Com­mercial demand would continue to drive the high-technology market.

The most encouraging sign is that concern about the defense industrial base is spreading. If the public, Con­gress, and Administration officials stay worried enough for long enough, the United States may slowly work out of the hole it has dug itself into.