Defense Contraction a Necessary Reaction

The defense industry’s headlong consolidation into a handful of mega-firms is rapidly approaching a climax. The future shape of the industry, depending on the outcome of government antitrust deliberations, is largely apparent today.

The deal struck by Raytheon last week to buy the defense assets of Hughes Electronics for $9.5 billion seems to cap an unprecedented wave of mergers that has realigned an industry that underwent little change during the entire Cold War.

The speed with which the industry has restructured strikes some observers as unsettling, even unseemly. Critics who for years assailed the industry’s size and influence now decry its contraction, and hint at dark motives behind federal policies promoting consolidation.

Congressional critics jumped on executive compensation plans in some mergers that they claim amounted to “payoffs for layoffs.” Others have lamented the apparent loss of competition, fearing the Pentagon will face a tightly controlled industry with little financial or intellectual rivalry.

Before this revisionist interpretation gains a firm footing, it is worth looking carefully at what has happened and why.

First, there is nothing inevitable about the existence of a vast defense industry containing multiple sources for every conceivable military system. Before the Cold War, U.S. peacetime defense spending averaged about 1% of gross domestic product each year, which was far too little to sustain a dedicated defense base in the private sector. Instead, the government maintained a network of public shipyards and arsenals that was supplemented in wartime by mobilizing commercial companies for military production.

The Cold War was the first time in U.S. history that high peacetime defense spending was sustained for decades, and it made possible the emergence of a big, diverse defense industry.

But the threat that drove Cold War defense budgets has now dissipated, and the Pentagon must reduce its costs accordingly.

Downsizing of the defense industry, combined with increasing Pentagon reliance on commercial products, reflects a return to the traditional approach to providing for military equipment.

Second, the wave of defense mergers and acquisitions is a textbook example of how markets respond to a long-term decline in demand. The buying power of the Pentagon’s weapons procurement budget has shrunk by two-thirds since 1985, the peak year of the last Cold War defense buildup.

In 1993, then-Deputy Secretary of Defense William Perry predicted that “the defense industrial base is going to be contracted to about one-third of what it was in the mid-1980s.” That is precisely what has happened, although the downsizing is not yet complete.

There is nothing mysterious or conspiratorial about this process. In February, the Clinton administration will request a fiscal 1998 weapons procurement budget of about $45 billion, which may sound like big money. But it means equipping the armed forces for an amount equal to five months’ worth of sales at Wal-Mart.

It is obvious that the Pentagon cannot afford to sustain half a dozen military aircraft producers when it buys fewer than 200 aircraft per year, or a similar number of shipyards to build five or six naval vessels annually.

Third, rather than discouraging innovation, the wave of mergers and acquisitions is favoring those areas of electronics that policymakers expect to yield the biggest technological payoffs.

The mergers promote survival of a smaller number of healthy enterprises, rather than of a larger number of weak suppliers that are in no position to take risks.

A few companies, notably Northrop and Martin Marietta, figured out early on that electronics was the future of the military market. That’s why Northrop fought so hard to acquire Grumman and Westinghouse’s defense operations, and why Lockheed Martin was so eager to acquire Loral.

Fourth, the wave of mergers is not eliminating valuable industrial facilities and essential jobs. It is rationalizing an industry burdened with overcapacity and rewarding those companies that have proved capable of competing over the long run.

Although we should not minimize the trauma and dislocation associated with over a million defense workers losing their jobs, we also should not expect taxpayers or consumers to subsidize inefficiency. The nation’s success in global commerce depends on allowing market forces to eliminate inefficiency.

The fate of McDonnell Douglas’ operations in Long Beach in the wake of the Boeing-McDonnell merger is a case in point. The military side of the operations will thrive for the foreseeable future because it builds the C-17, the most impressive military transport ever developed.

The commercial airliner operation will not fare so well, because its products have long since ceased to be competitive in global markets. The merger does not foster this outcome, it merely responds to it.

Finally, it is worth reflecting on the difference between the Pentagon’s efforts to rationalize its internal activities and the more vigorous process underway in the private sector.

Whereas private companies have moved decisively to respond to changing market conditions, the Pentagon has been nowhere near as successful at streamlining its infrastructure.

Despite strong support from Perry, efforts to outsource such activities as data processing and maintenance to more efficient private-sector firms have been stymied by Congress and the Pentagon’s own bureaucracy.

Bear, Stearns & Co. Vice Chairman Denis Bovin, a Pentagon advisor and a key player in industry consolidation, points to the slow pace of Pentagon reform as indicative of what happens when market forces are stifled.

Bovin estimates that if the Defense Department attacked its own internal management with the same fervor that the defense industry has downsized, it could save well over $10 billion annually.

Therein lies the bottom line on defense industry consolidation. It may be unsettling, but it is driven by economic forces that cannot be ignored. An entire industrial sector is adjusting to fundamental changes in its business environment, and it is doing so with impressive agility and sense of purpose.