Academic Forum

and Europe:
A Time For
Unity, A Time
For Vision

21-22 Feb. '97

Panel Four: Sharing Hopes And Ambitions:
The Economic And Technological Base Of Western Security

"The Course of Defense Industrial Consolidation"

Cooperation or Consolidation?
Defense Industrial Dilemmas for NATO Governments

Executive Summary

Do the processes of defense industrial consolidation on both sides of the Atlantic threaten to undermine the political foundation of the transatlantic security relationship? The governments of Europe and the United States, faced with different economic pressures, have followed distinct policies toward defense industries that are dominated by economic and technological concerns. The United States has enjoyed a relatively rapid consolidation process that has created fewer, vertically integrated defense manufacturers. The process in Europe, by contrast, has been less tidy: governments have followed distinct paths to consolidation that reflect differences in the recent development of national industrial bases.

While national considerations are important, it is far from clear that these disparate processes will serve the long-term interests of the Atlantic alliance. Transatlantic disagreements over defense sales and reciprocal access to defense markets may have further harmed efforts to coordinate the industrial consolidation process. These disagreements may precipitate the emergence of separate and adversarial defense markets within the Atlantic alliance. The transatlantic security partners risk losing access to each other's industrial, technological and financial resources.

Governments need to undertake a new transatlantic dialogue on the economic and technological foundations of western security. While the economic imperatives of defense industrial consolidation are inescapable, governments need a better understanding of how their national industrial and technology policies will affect the security of the alliance. The economic factors which to date have dominated this dialogue have failed to account for the full costs of defense industrial dilemmas.

Without a common understanding of the ongoing defense industrial consolidation in Europe and the United States, governments on both sides of the Atlantic will find it more difficult in the long run to sustain the transatlantic security relationship. The technological and economic imperatives of a coordinated approach appear clear and unassailable. First, the increased tempo of joint U.S.-European military operations demonstrates that interoperability of allied armed forces is as important as ever. Second, U.S. and European governments have placed a high priority on maintaining a technological edge over potential adversaries; this may be even more important as governments look for technology to be a force multiplier during times of fiscal stringency. Third, no one government can be the best in all technologies at all levels, and complete autarky in the development and production of defense systems is no longer feasible. U.S. and European industry have tremendous technological expertise, productive capacity, and capital to offer governments on both sides of the Atlantic. To preserve money, technical expertise, and-most importantly-a capable joint military capability, the allied governments must devise a means of coordinating their approaches to the rationalization of their defense industries.

Defense industries on both sides of the Atlantic face tremendous economic pressures to consolidate and contract. What are the implications of the ongoing consolidation for the transatlantic security relationship? Is this process likely to undermine the political foundations of transatlantic security? Will consolidation weaken the West's defense industrial base? If the governments of Europe and the United States are to preserve their security relationship, they must address the diverse and often conflicting economic pressures that defense industries face on both sides of the Atlantic. So far American and European governments and industry have pursued these strategies in isolation of transatlantic considerations. It remains to be seen whether governments can devise strategies of consolidation that enhance the transatlantic security relationship.

This discussion paper addresses the pressures that European and American governments and industries face; their strategies for coping with these pressures; and the implications of industrial and national strategies for the broader transatlantic security relationship.

Pressures On Defense Industries

Despite five years of reduced defense spending and contraction within the industry, defense companies on both sides of the Atlantic face immense pressures to reduce excess capacity and eliminate redundant manufacturing and technological capabilities.

Pressures in Europe

While pursuing closer economic and political integration, the governments of the European Union have continued to recognize an exception for defense industries (Article 223 of the Treaty of Rome). National sovereignty over defense industries, however, has been overtaken by the pressures of the 1990s. Economics alone-spiraling R&D costs, declining defense budgets, and deteriorating national economies of scale-dictate the need to consolidate and cooperate. In addition, two other forces are impacting on European defense industries:

  • The common security and defense identity: A robust defense industrial base is a necessary foundation for the foreign policy flexibility that EU member states desire. Jacques Santer, president of the European Commission, has noted that "a strong industrial, scientific and technological component is at the root of this European defense identity." And Martin Bangemann stated that:

    . . . a European defense identity has three necessary components: a political component, which lies with the EU; a military component, which is the joint responsibility of NATO and the Western European Union since the option of a European defense within the NATO framework was chosen; [and] an industrial, scientific, and technological component without which this identity will have no substance. This means that an effective and competitive European armaments industry is so to speak a precondition for the existence of a credible European Defence Identity.

    Two parallel initiatives demonstrate the emerging industrial foundation of a common defense identity. First, the governments of France and Germany have agreed to establish a joint defense procurement agency to manage collaborative weapons programs; the United Kingdom, Italy, and the Netherlands are in the process of joining this agency. Second, in parallel to this initiative, the Western European Armaments Group has proposed a joint European Armaments Agency to oversee WEU members' weapons research.

  • Deficit reduction goals for monetary union: Monetary union creates an inescapable pressure that contributes to the economic rationale for coordinated procurement and research policies. As European governments approach monetary union in 1999, they face pressures to meet budget deficit and national debt goals. France, the United Kingdom, and Germany all have reduced government spending across the board and defense spending in particular, creating additional incentives for industry consolidation.

Given the persistently high levels of unemployment in continental Europe, however, privatization and downsizing are engendering increasingly verbal domestic constituencies that oppose the job cuts that are likely to accompany cross-border rationalization of the European defense industrial base. Notwithstanding, therefore, the long-term budgetary reasons for cross-border consolidation in Europe, European governments in France, the United Kingdom, and Germany are under great near-term political pressure to ensure that future cross-border consolidation still sustain as far as possible existing production and employment.

European Strategies of Consolidation

Despite these pressures, European defense consolidation inevitably is a slow process that is far more complex than in the United States. First, there are problems with the sequence of consolidation. After a round of restructuring at the national level in Britain and Germany in the late 1980s and early 1990s and the birth of some cross-border joint ventures, the transition to fully-fledged cross-border companies now awaits national consolidation in France. Different countries are at different stages of the consolidation process.

Second, even as they complete the process of national consolidation and look to formalize cross-border ventures (BAe-Matra), the main "producer" countries have not decided on the preferred model for a "European defense company." Should governments encourage vertical or horizontal integration? How will national governments preserve some control over government-funded technologies? How will they ensure that certain aspects of defense development and production remain part of the national economy for reasons of competitiveness and security? It is hard to see how European defense consolidation can escape the need for national holding companies acting as shareholders within combined defense companies and as the interface with national governments.

Third, though vertical and horizontal integration may offer European governments a rationalized defense industrial base, many policymakers argue that European industries still will be unable to compete with American industries unless European governments adopt a formal preference for European military hardware. The United States currently enjoys approximately a five-to-one advantage in defense trade with its NATO partners. When combined with the U.S. preference for self sufficiency in defense research and production, this imbalance in defense trade has encouraged some European leaders to consider adopting explicit preferences for European defense goods in government procurement decisions.

Finally, it is hard to see how European defense consolidation can proceed smoothly without real progress in opening up the defense market within the EU. Until defense industries know what the ultimate size of the European defense market will be, they will find it difficult to identify partners for rationalization that make economic sense. And yet, initiatives to open up European defense markets remain stymied by different national approaches towards export controls and towards the extent and form of residual levels of national protection.

Pressures in the United States

Even after 11 consecutive years of declining defense budgets, U.S. defense industries face a future of flat (if not declining) defense procurement spending. This is due in part to the high operational tempo that the U.S. armed forces continue to maintain: as the military spends more on operations, procurement spending has declined. These fiscal realities generate new demands on U.S. defense industries that in turn affect the consolidation of the industrial base:

  • The Demands of Private Ownership: Share-holder value has driven strategies of consolidation in the United States. Corporations like Northrop Grumman and Lockheed Martin, on the one hand, have maintained share-holder value by purchasing or merging with other defense companies to maintain revenues and amortizing overhead across a larger capital base. On the other hand, corporations like General Dynamics, Rockwell, Texas Instruments and currently General Motors have divested in part or in entirety their defense subsidiaries. While stock holders have been favorable to both strategies, it remains to be seen whether mergers and divestitures preserve critical national technological and industrial capabilities.

  • The Demands for Competitive Procurement: Industrial consolidation in the United States already has produced national champions in the development and manufacture of tanks and submarines, and threatens to create a sole supplier of combat aircraft. While the federal government has permitted this consolidation, it is unclear that it can protect both the value to taxpayers and the responsiveness to military requirements that competitive procurements provide.

    The federal government has several strategies to preserve competition in procurement decisions. The Pentagon already has diversified production even when there is a sole supplier of R&D expertise (as in the General Dynamics-Newport News competition to produce submarines). The Pentagon may also benefit from U.S. and foreign competition at the subsystems level since subsystems increasingly are the cost driver of major platforms like aircraft and ships. Finally, the Pentagon may choose to bring in foreign prime contractors to compete for bids, but it has yet to do so. Nonetheless, consolidation threatens to remove competition from many procurements: the Pentagon may have to purchase systems that are both more costly and less responsive to its specifications.

  • Strategies of Consolidation: Compared to European defense industries, U.S. firms are already highly integrated, both vertically and horizontally. Lockheed Martin, Northrop Grumman, Boeing-McDonnell Douglas and Hughes Aircraft all are integrated prime contractors with electronics manufacturing and other critical sub-tier capabilities. The defense industrial base has also consolidated horizontally. Today there are five manufacturers of aircraft and helicopters and five missile manufacturers; in Europe there are ten aircraft and eleven missile manufacturers.

While consolidation has proceeded faster in the United States than in Europe, the process may jeopardize important technological and industrial capabilities. These losses, on the one hand, may create demands for greater government oversight of the process of industrial consolidation. But conversely, the loss of technological and industrial capacity argues for greater access to European defense manufacturers as cost- and risk-sharing partners. European corporations also offer the U.S. government the potential benefits of competitive procurements. Although the consolidation process in the United States offers incentives for greater coordination with European governments, the Department of Defense has yet to look to European firms for expertise and productive capacity on a broad scale. Whether or not the Pentagon does turn to Europe depends in part on whether governments on both sides of the Atlantic can overcome obstacles to reciprocal access to defense markets.

Transatlantic Issues

There are several obstacles to a coordinated transatlantic approach to defense industry consolidation.

  • The Preference for Self Sufficiency: Both U.S. and European governments have an instinctive preference to go it alone in defense production for several reasons. These include channeling the tax payers' money back into the national economy; supporting national high-tech research and development; limiting dependence on foreign suppliers; and avoiding compromises on unique national military requirements.

    Widespread adoption of European preferences and continued formal U.S. preferences could precipitate the emergence of separate and adversarial defense markets within the Atlantic alliance. While this would undermine a transatlantic security relationship, the defense trade imbalance strengthens the hand of those who call for preferences given the political and economic pressures that European governments and industry face. Along with the economic pressures of Union, it may be impossible to develop a

    robust European defense industry to support a common European defense identity without more protection from American competitors.

  • The Imbalance Between U.S. and European Defense Markets: The mismatch between the unitary nature of the U.S. defense market and the fragmented nature of European defense markets creates different pressures on governments. While the U.S. government can set policies for consolidation of one pillar of the defense industrial base, a number of European governments must coordinate their differing approaches and often divergent interests to encourage consolidation in the other pillar. These market differences may exacerbate disparate time lines. European industry may be consolidating at a slower pace than American industry, but it is danger of falling farther behind unless European governments can coordinate their approaches quickly.

  • Continued Disputes Over Subsidies: U.S. and European governments are unlikely to coordinate their approaches to industrial consolidation unless each is confident of a "level playing field" in global defense markets. Subsidies to aerospace firms remain a source of tension. European governments remain dissatisfied with the U.S. government's funding of military R&D for private contractors, while the U.S. government objects to continued subsidies to state-owned defense industries in Europe. Because defense trade does not fall under any international tariff agreements, the Atlantic governments have yet to negotiate a settlement on subsidies that could facilitate the multilateral opening of defense markets.

  • Reciprocal Access to Defense Markets: Market access is an important complement to consolidation: just as mergers can offer greater economies-of-scale, so too can access to new or larger markets. But pressures for self-sufficiency and differing market characteristics impede reciprocal access to European and American defense markets. American firms face in Europe a wide array of differing and sometimes opaque national defense procurement requirements and practices, on the one hand, and explicit requirements for offsets on the other. European defense industries face formal barriers to the U.S. market like the Buy America Act. It remains to be seen whether a common European procurement agency will ease the barriers that American firms face, or whether offsets and the Buy American Act can (or should) be traded off to improve reciprocal market access.

While market opening measures can provide European and American defense industries with potentially larger production runs, governments have yet to negotiate reciprocal market opening measures. This may be particularly difficult during a period of consolidation, when strong domestic constituents already affected by defense downsizing will likely oppose any reduction of trade barriers. Until there is a more balanced relationship between the United States and Europe in terms of market integration and national industrial consolidation, there will be little legislative or corporate support for far-reaching coordination of national approaches to defense industry consolidation.

The Atlantic Security Relationship

Do the economic imperatives of defense industrial consolidation undermine the broader security relationship? While the answer to this question remains open, some disturbing trends have emerged. The different patterns and pace of industrial consolidation in Europe and the United States may undermine the European security identity embraced by policymakers on both sides of the Atlantic. While U.S. industries have consolidated fairly quickly, it is not at all clear what the end state of European industrial consolidation will be. The process of consolidating the European defense industrial base raises the risk in the near term of an increase in costs and stifled innovation. Even more troubling is the prospect of a European industrial base that continues to be fragmented. Can the governments of Europe share security responsibilities with the United States if they lack a strong defense industrial foundation?

Clearly, major defense procurement decisions by NATO governments now carry with them far greater implications for the industrial and technological base of the Atlantic alliance than they did during the cold war. Because the process of defense industry consolidation on both sides of the Atlantic will have a fundamental impact on the long-term strength of the Atlantic alliance, the Department of Defense should consider carefully the implications for the alliance of its procurement decisions and practices.

Moreover, European governments have become increasingly conscious over the past ten years of the strong underpinning that a more coordinated approach to defense procurements can provide to the political cohesion and, ultimately, the military effectiveness of EU member states either as partners in a European pillar of NATO or as a group pursuing their own, common security objectives. Similarly, the U.S. administration needs to make the case to U.S. legislators that maintaining an open approach to defense purchases from and cooperative programs with its European allies has a value that transcends the search for "best value" procurements. IT is an integral part of preserving a strong Atlantic alliance into the 21st century-an alliance in which all members are not only prepared but also capable of sharing in the burdens of a common defense.

Discussion Issues

  • What has European and American industry learned from the long process of consolidation? How have the experiences of American and European industry differed? What good has it produced? What would industry do over if it could do it again? If American and European industry have learned different lessons, why?

  • What are the implications of a failure of the NATO nations to arrive at a transatlantic understanding on defense industry consolidation? What are the prospects of "fortress Europe" confronting "fortress America"? What are the risks associated with greater competition between two sets of highly concentrated defense industrial bases on each side of the Atlantic?

  • Can the alliance maintain interoperable military forces if such competition emerges? Similarly, how will competition to equip new NATO members after expansion affect intergovernmental coordination of defense industrial practices?

  • How can governments assure that the process of downsizing on both sides of the Atlantic does not jeopardize critical technological capabilities? Have the partners of the Atlantic alliance already lost important technological or industrial expertise? Does the United States' free-market approach to consolidation fail to consider effectively the consequences for the alliance's technological resources?

  • Is a rationalized and integrated European defense industrial base a necessary precondition for the European Defense Identity? If so, can the governments of Europe proceed with consolidation without

    scrapping or modifying Article 223 of the Treaty of Rome and opening up the market within the European Union?

  • As industries consolidate, how can governments assure competition so that customers-including the U.S. Department of Defense-continue to receive the best value possible?

  • What model for cross-border consolidation is likely to emerge? Will national holding companies be necessary, or will pan-European companies emerge? Is there scope for transatlantic mergers?

  • As consolidation in the United States produces corporations with much broader technological capabilities, has U.S. industry lost its interest in cooperative arrangements with European industry?

  • Does the process of merging with other companies prevent U.S. corporate leaders from giving enough attention to transatlantic cooperative activities?

  • What role if any should formal European procurement preferences play in the rationalization and consolidation of the European defense industry? Can European defense industries consolidate and become effective partners to U.S. industry without a formal European preference? Or must European governments provide greater protection from U.S. competitors during the transition to a more consolidated European defense industrial base?

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