Revitalizing the Arsenal of Democracy

April 1, 1984

At the end of 1980, the House Armed Services Committee Industrial Base Panel headed by now retired Rep. Richard Ichord put out a report entitled “The Ailing Defense Industrial Base: Unready for Crisis.” The report stated that “the general condition of the defense industrial base has deteriorated and is in danger of further deterioration.” It pointed out that there were no ongoing programs to address industrial-base efficiency or preparedness issues. There were no plans, no procedures, no organizations, and no actions. In summarizing the report, Rep. Melvin Price (D-Ill.), Chairman of the House Armed Service Committee, stated: “in the event of a war, the US defense industry would find it almost impossible to expand its weapons production suddenly and dramatically, in the numbers necessary to sustain a prolonged conflict.”

Coming from a normally pro-defense group, these were very strong words. However, they were backed up by two additional reports that appeared at almost the same time — one by the Defense Science Board, which comprises many leaders of defense industry and is chaired by Robert Fuhrman of Lockheed, and the second by a panel commissioned by Air Force Systems Command and headed by retired USAF Gen. Alton Slay. These reports had similar conclusions as to the poor health of the “arsenal of democracy.” They, too, found major peacetime problems with economic efficiency and serious obstacles to rapid response in times of crisis.

Some of the specific problems that were highlighted are: lack of capital investment for productivity enhanced; lack of long-term R&D investment; lack of labor stability; inefficient use of facilities, meaning underutilization without surge capability; significant bottlenecks, especially at the lower-tier supplier base; heavy dependence on single suppliers, thus providing no competition after the initial award; and a growing dependence on foreign sources for critical defense parts and materials.

How Did We Get Here

Clearly, something needs to be done to improve the health of America’s defense industrial base. But first we need to understand how we got into this position.

Essentially, there are three causal factors, the first being the longstanding policy that America’s deterrent posture to prevent all forms of conflict rested on our strategic nuclear forces. The concept of “mutual assured destruction” was believed by many to be sufficient to prevent any Soviet adventurism. Second, if any conflict does occur, the “worst case” (and therefore “the one for which we should be prepared”) would be a sudden attack by the Soviet Union on Western Europe that would, it was believed, either end quickly or escalate rapidly to nuclear warfare. Third, in the post-Vietnam era America shifted its budget priorities dramatically from national security to social programs. In constant dollars, the military procurement account dropped from the end of the 1960s to the middle of the 1970s from a level of $44 billion per year to $17 billion per year.

Under these “demobilization” conditions and given the emphasis on a no-warning, short, intense conflict in Central Europe, it was only natural that all available dollars were focused on buying equipment for a “come-as-you-are” war and that there was a total de-emphasis of industrial preparedness actions. Over the past fifteen years, there has been little or no money spent on the industrial base. Until the current Administration, even guidance that the Secretary of Defense gave to the military services explicitly deemphasized industrial preparedness.

But there are clear signs — from both the executive and legislative branches — of the growing recognition of the need for “revitalizing the defense industrial base.” Part of this initiative comes from the realization that a restructuring of the way Defense does business is necessary to reverse the long-term trend of rising equipment costs. (This recognition has led to demand for “procurement reforms” from Congress and DoD’s acquisition “initiatives” from former Deputy Secretaries Frank Carlucci and Paul Thayer.)

But there is also a growing recognition that, as the Soviet Union has achieved parity in nuclear weapons, there is a need for greater focus on conventional warfare and on the role that industrial preparedness can and should play in all four prongs of America’s national security posture: deterring war (by being prepared); encouraging arms-control agreements (by covering a possible “breakout”); assuring that if war does break out it can be maintained below the nuclear threshold (by being able to support a protracted conflict); and assuring that the US will be able to achieve its national objectives in any military conflict (by maintaining our technological leadership and our flexibility to respond to a wide range of contingencies).

Thus, there is a strong and growing argument for some resources to be spent on industrial preparedness as a complement to the far-larger and badly needed expenditures on conventional and strategic forces. However, along with committing these resources, there is a growing recognition of the need for policy changes that will realize the needed improvements from the dollars expended both for preparedness and especially for the efficient procurement of new weapon systems.

In order to understand what appropriate actions must be taken in restructuring the US defense industrial base, it is desirable to look first at a few of the specific problem areas in more depth.

Shortage of Critical Parts Suppliers

The first of these areas is the growing problems at the lower tiers of the defense industry. One normally thinks of our industrial base in terms of the large prime contractors — the giants of the defense industry. However, the industry is truly a “dual economy,” and it is at the lower tiers — the subcontractors and parts suppliers — that some of Defense’s most critical problems have gone unrecognized.

During the post-Vietnam cutback in defense expenditures, the prime contractors were kept alive — mostly through foreign military sales — but the lower tiers rapidly left the defense industry, in many instances never to return again. Even as defense expenditures turned around and began to build in the second half of the 1970s, the lower tiers continued to shrink. This trend toward fewer and fewer lower-tier defense suppliers can be accounted for by such things as lower profit, small volume, one-year orders, cyclical demand, special military requirements, market uncertainty, excessive regulation, and extensive government paperwork. Taken together, these conditions explain why defense business appears far less attractive to the lower-tier firms than comparable civilian business.

By the end of the 1970s, it was becoming clear that significant supply problems existed in such areas as castings, forgings, electrical connectors, semiconductors, and precision bearings — items utilized by almost all weapons systems. The absence of firms interested in doing defense business at these lower tiers and the increased demand for defense goods resulted in rapidly rising prices and extremely long lead times on deliveries from the few remaining, highly specialized defense suppliers — many of whom were sole suppliers for these critical items.

As defense budgets are increased and the quantities of complete weapons systems requested goes up, the number of lower-tier suppliers does not expand correspondingly, as it would in a normal market. This phenomenon is caused by the high barriers to entry that exist for new firms that might otherwise be drawn into the defense marketplace.

In addition to the above-noted undesirable characteristics of doing business at the lower tiers of the defense industry, the unique acquisition practices of DoD discourage prime contractors from developing multiple sources for lower-tier supplies. For example, these practices frequently have the perverse impact of rewarding cost growth in the form of cost-based contracts. Prime contractors have little incentive to seek competitive supplier prices under such conditions. Moreover, prime contractors are not generally rewarded for increased efficiency so there is a tendency to avoid the added front-end costs and administrative complications of qualifying additional — competitive — suppliers.

Thus, the easiest and often only option the prime contractor has is to go to the same supplier that he has used for the small quantities bought previously. These suppliers, displaying monopolistic tendencies, simply add the increased orders to their already existing queues and raise their prices. Both of these trends have been documented extensively over the last few years. The two or three years that it takes to get some of these critical parts is not due to the manufacturing time itself but rather to the fact that the current suppliers are already at full capacity operation and to the failure of the supplier market to expand.

The saturation of the few, highly specialized suppliers and the absence of capacity expansion either at these firms or through new entries cause the bottlenecks and the resultant rising costs and increasing lead times at the lower tiers. This, in turn, causes corresponding increases in costs and lead times in the vast majority of complete weapon systems. This has been amply documented over the past years.

Offshore purchasing of parts is an option being used increasingly by many defense prime contractors in solving these lower-tier problems. This naturally raises the foreign dependency issue — a historically critical one for defense procurements. Yet the trend has clearly been in the direction of a growing list of foreign suppliers of critical defense-related parts and subsystems ranging from precision glass through specialty forgings. Many of these foreign suppliers are the sole source for critical items.

In some cases, the US firm is buying its defense-related equipment offshore because it simply cannot obtain it in a reasonable time period or at all in the United States. In other cases — such as electronics components — the offshore purchases are tied to commercial demand for lower costs. DOD is simply too small a buyer to change this trend. In a growing number of cases, the offshore purchase of defense parts or subsystems is connected with an “offset agreement” for weapon system foreign military sales. Under these agreements, a foreign country buys a weapon system from the US and the selling firm in turn agrees to buy — or help sell in the US — parts and subsystems from the foreign country.

Extra Capacity at the Prime Contractors

Interestingly, the second of the industrial base problems is the inverse of the lower-tier situation. At the prime-contractor level we frequently find considerable excess capacity — empty or underutilized plants and old and inefficient capital equipment. Naturally, if a plant is not being utilized, there is very little incentive for capital investment in modern manufacturing equipment.

Take the aircraft industry, for example. In the 1950s the United States bought more than 3,000 fighter planes per year, and in the 1970s down to around 300 fighter planes per year. Yet the structure of the aircraft industry remained largely the same, with essentially the same number of plants.

In order to pay for the high overhead of these facilities, often containing mostly engineers writing proposals for new programs, it has been necessary to reduce the quantities and slip the schedules of those few aircraft programs in production. And the existence of these empty or underutilized plants does not even assure surge or mobilization responsiveness due to the bottlenecks in the lower tiers. In fact today it would take more than three years for a warm (in-production) aircraft factory to increase its output appreciable from its low, peacetime levels in order to meet a crisis or war demand. The existence of an empty aircraft plant does not assure that you can get the needed landing gears or electronic parts that you require to increase production.

Labor Instability

From the above discussion, it would appear that there are probably more firms and plants than are required in the military aircraft industry. Since there are only a few aircraft programs awarded every decade — and then to only one firm for each program — this means that there is bound to be a great deal of labor instability in the industry. When a new contract is awarded to a firm that has previously not had much business, the skilled labor force has to be hired and trained — only to be laid off when the contract is over.

The third problem, then, in the defense industry is the cyclical hiring and firing of thousands of defense workers. This cyclical employment pattern diminishes the efficiency that one would like from a work force. It is inefficient to hire and train workers rapidly. It is also inefficient to be laying off people because they tend to slow down considerably when the work force is being reduced. Yet no consideration of this desired work force stability is explicitly introduced into the defense acquisition decision process.

For example, the decision to build much of the B-1B in Columbus, Ohio, at a facility that has not built an aircraft in decades necessitates the creation of an enormous work force. When the 100 planes are completed, these workers will likely face a fate similar to the 17,000 workers who were laid off in Los Angeles, Calif., when the Carter Administration terminated the B-1A.

Lack of Continuous Competition

The fourth dominant characteristic of defense industry in contrast to the civilian economy is the absence of continuous competition — i.e., the market incentive to cut prices. In the defense business, there is usually fierce competition for the initial award of a new weapon system. Since all competitors know that this is the only new program coming along in this business area for perhaps five to ten years, those currently without business know they must win the contract if they are to stay in that business over the next decade. Additionally, since they realize that only one award will be made and that subsequent to that award there is an almost 100 percent probability that the program will change as it progresses (thus voiding the original contract), there is incredible incentive to “buy in” in order to be sure of winning the contract.

Thus, the government creates an under-priced program with a monopoly supplier. In such a situation, it is obvious why costs are likely to grow rather than shrink during the life of the program.

Clearly, all of the four major problems described above are strongly interrelated. The difficulty of doing defense business at the lower tiers (small volume, single-year buys, program uncertainty, specialized requirements, etc.) results in a disincentive for firms to enter or stay in business and, thus, in a diminishing number of lower-tier suppliers. The all-or-nothing prime contractor competitions for the award to a single supplier results in labor instability and — for the losers — excess capacity. In addition, the lack of continuous competition results in the absence of incentives for the prime contractor (once he has won an award) to make capital investments to lower his price or to create competition at the lower tiers in order to lower the suppliers’ prices.

Since the Department of Defense is the sole buyer — as well as the banker (through progress payments), the regulator, the specifier, the sponsor of research and development, and even the court of claims (on protests) — the government has the responsibility to concern itself with the structure, conduct, and performance of the industry that it creates. Government policymakers are starting to come to this realization. However, the government has traditionally taken the position that the free market will create the necessary economic efficiency and surge capability that is desired. While this is clearly the preferred solution, it is an impossible condition to create when the market consists of a single buyer and usually a single or a few suppliers.

Under these unique market conditions, the relevant economic theory is the “theory of the second best.” This theory calls for the government to gain visibility and, where appropriate, take corrective actions to create conditions of economic efficiency and surge capability. By taking actions on specific weapon acquisitions that will create conditions conducive to natural market forces — for example, continuous competition for a given system or critical part — the government can then step back and allow its desired objectives to be achieved through market forces rather than through regulation.

Policies to Consider

Consider the following six example policies to improve industry performance. Note that in each case the corrective action for defense would directly and explicitly address a major problem of the overall US economy.

Strengthening the domestic industrial infrastructure. The Defense Department must gain visibility into and, where required, get involved in maintaining R&D, production stability, and competition in such critical lower-tier sectors as parts and subsystems. The studies noted earlier indicated that there are major problems and bottlenecks in these areas. Single suppliers exist for a variety of critical parts on a significant number of weapon systems. The government, in such cases, should not select the second firm; it should simply require that there be at least two suppliers for each of these critical items.

Improving worldwide competitiveness and reducing dependency. The government should sponsor R&D on products that are both critical to defense and currently supplied only by foreign sources. This would promote domestic production and export competition on future generations of the equipment. Such a posture would be far better than establishing trade barriers on current military equipment, which would only lead to higher prices and have little log-term effect.

Achieving maximum US economic gain from defense investments. The government should encourage civilian and military production in the same plants. Currently, Defense Department policies and regulations discourage this coproduction. Joint production would reduce overhead costs through increased volume, increase technology transfer from defense R&D to the civilian economy, allow a more rapid surge of military production during a crisis by shifting workers from the production of civilian goods, and reduce the impact of cutbacks in defense spending that come from program terminations or arms-control agreements.

Encouraging major new technological advances. In traditional weapons systems (ships, planes, tanks, etc.), the Defense Department has been extremely successful in achieving technological advancement. However, institutions must be created and funding provided for the rapid development, production, and deployment of major new, nontraditional technologies and systems — the ones that promise dramatic, qualitative changes but threaten established, traditional military and industrial organizations.

Stimulating lower prices and improved quality. DOD should create a second source for many products where the United States depends on a single domestic supplier. Such a move would allow continuous competition to moderate prices, drive up quality, stimulate innovation, encourage capital investment, and broaden our base for mobilization. In areas with excess, old industrial capacity, the market should be allowed to force down the number of firms to a few that are modern and competitive.

Implementing an industrial strategy. The Defense Department must explicitly introduce industrial-base considerations into major decisions on planning, budgeting, and especially program acquisitions. Such issues as labor stability, plant capacity utilization, and modernization can formally be considered in this way. This would replace the current situation of allowing a “buy-in” or a political award to a plant that is far less efficient than others that are already modernized and under-utilized.

Restoring the “Arsenal of Democracy”

Actions such as these would serve to revitalize the defense industry through a restructuring of the industrial base, thereby creating a strengthened, competitive, free-enterprise industrial structure. Additionally, these actions would simultaneously strengthen the overall US economy while shifting the defense industry from its current “ailing industry” status into a competitive, responsive, national resource — essentially, restoring meaning to the phrase “The Arsenal of Democracy.”

Interestingly, the United States is the only nation in the world that does not explicitly treat its defense industry as a vital national resource. Fortunately, the need for US government action in connection with its defense industrial base is finally starting to be recognized on both sides of the so-called military-industrial complex. Congress has been pushing for changes, such as for more continuous competition. The Department of Defense has initiated a series of industrial preparedness actions intended to improve the health of the defense industry at all tiers as well as the surge responsiveness of the industry.

Finally, in a report of January 1984, the Aerospace Industries Association of America calls for “a new commitment and a new philosophy — characterized by a more cooperative relationship between government and industry… The government must take the lead in establishing policy, with input from industry.” For government to take advantage of industry’s strength, “[industry] must be supported by a stable framework of policies that allow and encourage most effective utilization of the resources.”

Clearly, there is much to be done before America’s defense industry makes the full transformation from its “ailing industry” status to the revitalized “arsenal of democracy,” but now is the time for these changes. The needed defense budget increases must result in corresponding increases in the amount of defense equipment supplied to our forces, and not simply in increased unit costs for the equipment. Additionally, the strategic responsiveness of our defense industry must be credibly perceived as valuable complement to our deterrent and warfighting posture. Thus, changes in the way defense does its business are clearly required — now.

Some of these changes will affect the way we select our systems and the way we acquire them. These changes fit into such categories as “JCS reform,” “budget reform,” and “procurement reforms.” But there is an additional major initiative required. That requirement is for government to gain visibility in and, where appropriate, to take corrective actions to strengthen the US defense industrial base.

None of these changes will come easily. But they must happen — our national security requires it, and the taxpayers deserve it.

Dr. Jacques S. Gansler is Vice President of The Analytic Sciences Corp. in Washington, D.C. A veteran of more than twenty-five years in government and industrial work, Dr. Gansler has served as Deputy Assistant Secretary of Defense and as Assistant Director of Defense for research and Engineering and has held senior management positions with ITT, Singer, and Raytheon. In addition to his degrees in electrical engineering and political economy, he holds a doctorate in economics from American University. Dr. Gansler is the author of the acclaimed The Defense Industry, a study of problems affecting military production in the US.