PRIVATIZATION IN NACC COUNTRIES Defence Industry Experiences and Policies and Related Experiences in Other Fields COLLOQUIUM 1994 ********* COLLOQUE 1994 PRIVATISATION DANS LES PAYS DU CCNA Experiences et politiques des industries de defense et experiences comparables dans d'autres secteurs Colloquium 29-30 June, 1 July 1994 Brussels --------------------------------------------------------- DEFENCE INDUSTRY PRIVATIZATION AND NATIONAL SECURITY REQUIREMENTS: THE UNITED STATES EXPERIENCE Robert Farrand The dilemma of how to beat swords into ploughshares in the wake of major armed conflicts has challenged humanity since the beginning of time. In describing the US defence industry privatization experience in the aftermath of war, Ambassador Robert W. Farrand and his colleagues explain that today's challenges for nations are to provide the level of national defence at a minimum cost. The question is not "should we privatize?" because the United States technical/industrial base is and has virtually always been in the hands of private industry, but rather "how can we continue to rely on our private sector defence industry in a time of war?". This paper was presented at the NATO Economics Colloquium by Ambassador Robert W. Farrand, International Affairs Advisor at the Industrial College of the Armed Forces (National Defense University), in Washington. It was written jointly by Ambassador Farrand and the following specialists from the Industrial College of the Armed Forces: Dr. Robert Scheina, Professor of History, Department of Strategy (co-drafter); Captain Fred L. Meyer, (USN, Ret.), Professor, Department of Resources Management (co-drafter); Mr. James R. Lecky, Research Fellow, Department of Resources Management (co-drafter); Commander Bernie Grover, Canadian Defence Force, Bernard M. Baruch Professor of Economic and National Strategy, Department of Resources Management (co-drafter); Dr. Clair Blong, Federal Emergency Management Agency, Professor of Industrial Relations, Department of Resources Management. Foreword -------- This paper presents a view of privatization as it pertains to U.S. national security in a post-Cold War world. In large measure, the future strength and prosperity of the American people will rest on the success of our Government and private industry working together to manage the process of converting industries heretofore dependent on weapons and defense-related production to the manufacture of civilian goods. We find ourselves at another decision point in history not unlike the end of the two world wars earlier in this century. The ICAF faculty members from diverse academic and career backgrounds who collaborated on this paper have sought to summarize the history of defense production and procurement in the United States, cull lessons learned from that history, and pose the strategic questions currently confronting U.S. decision-makers in both government and industry. The National Security Challenge ------------------------------- As a nation committed since its inception two centuries ago to the twin concepts of private property and free enterprise, the issue of privatization in the United States arises only in the context of governmental functions which the American people have decided must be performed by publicly owned, taxpayer-funded organizations and institutions. These functional areas have traditionally involved such sectors of the economy (and society) as government, education, municipal services, transportation infrastructure, and, most important, defense. By and large, all other sectors in American life, including manufacturing and services, have been left to the initiative of private commercial enterprise. Thus, with some variation in emphasis on the part of our political parties as to the proper role of government in the economy, the question of privatization in the American context has been largely sorted out. By far the largest source of strength, innovation, and investment capital in the U.S. economy derives from the financial and intellectual resources of individual entrepreneurs and corporate managers. The issue of privatization continues to be a vexing one, however, in the context of how a national economy based upon the free enterprise system where firms seek always to maximize profits can be relied upon to produce the materiel necessary for war. Brief Historical Overview ------------------------- The issue of how much national technical industrial base is adequate for security needs and how to guarantee that enough, but not too much, industrial base is preserved is a perennial challenge first confronted by the founding fathers of the United States in 1776. The United States has fought ten wars since its Independence. In each of these wars to a lesser or greater extent the Government struggled to insure that the defense industrial base was adequate and ready enough to provide our forces in the field with the weapons, ordnance, food, clothing, and other physical assets necessary to prosecute the war. In order to supply the Continental Army with enough cannons to fight the War for Independence, our early leaders found it necessary to establish a government arsenal in Massachusetts. To ensure the Army would be supplied with the necessary field pieces, therefore, the U.S. Government became an arms manufacturer at a very tender age. Alexander Hamilton, our first Secretary of the Treasury, however, did not consider the novel arsenal system adequate to meet the defense needs of the new nation. In his 1791 "Report on Manufactures," Hamilton called for a national industrial policy which through tariffs would protect industries critical to the national defense (such as sail cloth production, the 18th century equivalent to nuclear propulsion) and create defense industries for which there was no parallel commercial market, i.e., no "dual-use" in today's parlance. The Congress, then controlled by the opposition party, saw Hamilton's suggestion as government interference in the free market system and therefore a policy concept to be avoided. So throughout the first half of the 19th Century, the United States relied totally upon the yet-modest private sector to equip its small Army and Navy. During the U.S. Civil War, President Abraham Lincoln found it expedient for a variety of political reasons to rely on state governors and not the National Congress to raise the Union army to fight the war. To increase the influence of the governors, the Union chose to leave production of war materiel in private hands and to divide the procurement spoils among the states loyal to the Union based roughly upon each state's contribution of men. One historian estimates that as a consequence the Union probably paid twice as much as it should have for equipment and supplies, but that was an acceptable cost of victory. The military-industrial complex as we know it today first made its appearance in the United States in the late 19th century with the double birth of our new navy and a fledgling steel industry to support naval construction. The Government's boldest adventure was to the create an armor manufacturing plant with public funds. Long under debate and construction, however, the armor factory's completion, in an ironic twist of fate, coincided almost exactly with the signing of the Washington Naval Arms Limitation Treaty (1922) which placed a moratorium on the construction of battleships and, as a consequence, the taxpayer's investment in the armor factory was largely wasted. But this loss was pennies compared to the total cost of the logistics fiasco of World War I. American industry was caught in 1917 wholly unprepared to support the U.S. forces. We fought World War I using French and British weapons because our industrial base simply could not respond in time. Indeed, when our factories finally started producing weapons, our shipyards had not completed the ships necessary to get them or our troops to Europe. The few weapons we were finally able to manufacture virtually never got to our troops. Our inadequate defense industrial mobilization of World War I actually led to the formation of the Army Industrial College, the forerunner of ICAF, to help ensure that the nation never finds itself in the same unprepared condition again. The issue for the Government then became how to manage the build-down and how to be prepared the next time U.S. national security was threatened to build-up again in a timely manner. Thus, to address this double-edged challenge the following legislative and administrative initiatives were taken in the years following the Great War: First, the Bureau of the Budget was created in 1921 within the legislative branch, thereby setting up an auditing function outside the executive branch; Second, the Army Industrial College, now the Industrial College of the Armed Forces (ICAF), was established in 1924 so that the lessons learned during World War I would not be forgotten and the study of mobilization for war could be formalized; Third, the Government subsidized in 1926 the designing of aircraft as well as plant and production equipment to assure the survival of the aircraft industry; Fourth, the War Policies Commission was established in 1930 to give the government the capacity to regulate private property during war, thus eliminating the need for the Government to own a large number of production facilities. Fifth, a limit was placed in 1934 on the amount of profit that could be made by a private firm when selling ships and aircraft to the government. These measures and others adopted later in the 1930s were for the most part designed to reduce the need for the Government to own and operate costly, inefficient production facilities. The measures, taken as a whole, attempted to come to grips with the dilemma faced by a democratic government seeking to provide for defense without harming the system of free enterprise. World War II again severely challenged the ability of the United States to fight a global war. But by the conflict's end, the United States had manufactured almost half of all that had been produced in the world during the war years. For example, by early 1945 the U.S. industrial machine, in private hands but under close Government supervision (and contracts), had manufactured from a virtual standing-start five years earlier the following amounts of war materiel, by category: Aircraft 310,000 Tanks 88,000 Landing Craft 82,000 Rifles and Carbines 12,500,000 Trucks 2,400,000 To achieve this end, the Government had been required to enter into every conceivable ownership arrangement with the private sector in the United States. Although we conformed to our pattern of behavior following earlier wars by drastically reducing war production after 1945, the Korean War shocked us into facing the reality of an emerging Cold War. Recently abandoned manufacturing arrangements between the federal government and the private sector, based upon still existing legislation and agreements enacted during and before WWII, were renewed. Down-Sizing in the Post-Cold War Era ------------------------------------ The forty-year Cold War period which ensued saw as large a defense build-up and surge of technological research and weapons production as any comparable period in U.S. history. The Cold War's demise presents us all, the United States as well as other nations involved in the conflict, with a set of crucial decisions relating precisely to the topic of this colloquium. Since the vast bulk of U.S. defense industry remains in private hands, Government policy during the current "down-sizing" has been to leave the initiative on how to respond to reduced defense orders primarily in the hands of defense firms themselves. Government policy has had two primary aims, i.e., to attempt to: - Identify critical defense technologies and capabilities deemed essential to our long-term security requirements. We are doing this through continued orders or by paying firms to maintain idle capacity and essential tooling. For example, Congress has approved funding for another submarine, even though there is no immediate operational requirement for it. By building the submarine, however, we are able to maintain our technology base, our unique manufacturing processes, and our highly specialized labor skills. Each of these capabilities would have been lost had we allowed normal market forces to work, and they would have been extremely costly and difficult to replace at some future point. - Cushion the impact of reduced defense orders by creating a more favorable environment for defense plants and their workers. This initiative has taken several forms at the national and state levels, including: * Helping displaced workers find new employment through retraining, extended unemployment benefits, and employment information centers. * Assisting defense plants in finding civilian alternatives by providing consultation, information, and small-scale funding of studies on how to restructure or redesign a given facility for alternative production. * Providing tax advantages for new initiatives. * Providing small amounts of funding to underwrite partially the cost of highly selective dual-use projects which have commercial utility and value, as well as defense applicability. (We will discuss more about dual-use technologies later in this paper). As these changes are working through the economy, the U.S. Government continues to leave most of the initiative with individual firms and workers. In September 1993, then-Deputy Secretary of Defense William Perry said, "We've already lost hundreds of thousands of jobs (in the U.S. defense industry) and there are that many more ahead of us to lose. We clearly expect many defense companies to go out of business. And we will stand by and see that happen." In other words, the Government does not intend, under current post-Cold War conditions, to intervene in the market by centrally directing a detailed restructuring of defense production facilities from the national level. Instead, the Government is wrestling with the problems of identifying broad priorities and responding to strategic questions. That said, the Government has not lost sight of the need to preserve essential production capabilities. The current industrial policy vision, in simple terms, is one that hopes to minimize the size of "defense-only" capacity and maximize the size of "dual-use" capabilities which can only be sustained by a healthier, more robust civilian economy. International Competitiveness and Dual-Use Technology ----------------------------------------------------- The United States finds itself in the unique position of being a global power, while at the same time we are facing ever-increasing economic competition from the rest of the world, including significant competition from our traditional military allies. Our nation has strongly supported this increasingly open global trading system. The global trading system provided the basis for economic rebirth after World War II and increased opportunities for all, while increasing the standard of living for many. The key to America's defense in this new global economic environment is international competitiveness. Relative economic power is often the ultimate constraint on a nation's foreign and military power. For the nation to remain strong, it must remain globally competitive in economic terms. The Government is addressing the need to be strong militarily, within the context of greatly reduced post-Cold War defense budgets, with the concomitant need to be strong economically. One option the Government is pursuing is to concentrate on "dual-use" technology, e.g., technology that has both defense application and the potential significantly to contribute to America's international economic competitiveness. Exploiting dual-use technology is leading to a new form of defense privatization. In this new arrangement, the prime focus is on technologies - both product and process technologies - which will foster economic competitiveness, and thus will be of primary importance in the private sector. At the same time, the Government is concerned about maintaining a domestic technology capability, both to support current defense needs and to provide the weapons of the future. The Department of Defense (DoD), then, will work with private industry to foster, to nurture, chosen technologies in a way that supports both the military need and private sector competitiveness. In the process, both private sector firms and the military become winners. Technology Reinvestment Program ------------------------------- Yet another "privatization" initiative involves the privatization of defense technology. This is an initiative wherein technology developed for military-unique application is being adapted for commercial use. For example, technology that heretofore was used in nuclear weapons production is being adapted to medical equipment applications. Federal government funding is being used to assist in this transition of technology which has the dual benefit of creating commercial value from what had been purely defense investments. U.S. firms will thus benefit from unique new, technologically advanced products for the global marketplace. Strategic Issues of Industrial Organization ------------------------------------------- Once again the United States finds itself seeking answers to the following strategic questions: How should the U.S. change its national security strategy in the new era? What is the correct national defense strategy and related military force structure in the post-Cold War era? How should the nation optimally reallocate its resources between political, economic, military and psycho-social elements of national power? What are the desirable characteristics of the future national technology and industrial base (NTIB)? In response to the latter question, the U.S. Office of Technology Assessment concludes that the NTIB characteristics should include: * Advanced research and development capability * Ready access to civilian technology * Continuous design and prototyping capability * Limited, efficient peacetime engineering and production * capabilities in key defense sectors * Responsive production of ammunition, spares, and consumables for * theater conflict * Healthy, mobilizable civilian production capability * Robust maintenance and overhaul capability * Good, integrated management What is the correct mix of national investment in current versus future military capabilities? - To the extent that the U.S. faces an immediate military threat, the Department of Defense (DoD) will need to allocate resources for current capabilities. Current force structure must be maintained, obsolete systems replaced, and existing skills and facilities supported. Relevant policies would include: directly funding production over research and development (R&D);fostering weapons-specific manufacturing; and emphasizing weapon development over generic research and development. - If the immediate threat recedes, as it likely will continue to do, then the DoD can shift investment toward the development of future military capabilities. Related policies would include: shifting funding from production to R&D; emphasizing science and technology support; pursuing continuous prototyping; buying knowledge (as opposed to hardware); funding generic manufacturing advances; and emphasizing mobilization planning and the health of the broad national technical/industrial base. Should the Nation continue to depend upon a NTIB which supports military-unique (i.e., status quo) or dual-use technologies for both products and processes? - Military-unique technologies place performance first as the critical measure of effectiveness, require tight technology security, and generally have no civilian counterparts. To insure access to these technologies, the DoD would emphasize strict military design (rather than cost considerations), adopt commercial manufacturing practices which promote quality and efficiency, and fully fund R&D costs. - Dual-use technologies, on the other hand, enhance the desirable goal of civil-military technological and industrial integration while lowering costs, increasing production capacity and the economic dimension of national security. Thus, implementing this "dual-use privatization" approach would: increase commercial competition; increase the use of items not solely developed for defense purposes; emphasize performance as well as cost considerations; adopt commercial manufacturing practices, including quality control standards; streamline government oversight to remove unnecessary rigidities; and lead to an improvement in the training and quality of government acquisition personnel. In both the "military-unique" and "dual-use" technology approaches to maintaining current production and planning for future military capability, the Government must decide what level of public versus private national technology/industrial base (NTIB) is desirable; - A decision to retain strong private-sector "contractor-owned/contractor operated" (COCO) facilities involvement in the NTIB would require rule changes to enable industry to earn profits commensurate with risks. Under this option, the nation could retain its overall strategy of relying primarily on the private sector, while maintaining some critical military - unique technology and manufacturing capabilities in "government-owned/government operated" (GOGO) and "government-owned/contractor-operated" (GOCO) organizations. - If private-sector (COCO) industrial organizations are favored, some firms may have to be subsidized to main technology and manufacturing capabilities and profits must somehow be assured commensurate with risks to sustain the interest of public investors in the stock market. - If the decision is made for "military-unique" technologies to promote R&D and manufacture in government facilities, then the Government will inevitably assume a greater share of the financial and technological risk. During the Cold War era, the COCO/GOGO and GOCO industrial organizations were used in the U.S. with each one, singly or in combination, possessing unique advantages and disadvantages. - The GOGO organization provided for full government ownership and control of capital plant and equipment and public financing of operations. This form of organization meant greater bureaucratic controls, while insuring stability of services and production, and maintaining critical skills; - The GOCO organization permitted the Government to own the capital thus underwriting fixed costs of overhead while at the same time allowing "privatization" of the operations which increased reliance on market incentives to control variable costs of labor, materials, and the like; - The COCO organization preserved the full incentives and advantages of the market place, controlled costs and encouraged industrial efficiency. This approach, used very successfully during the Cold War, injected more innovation, creativity and efficiency into the R&D processes than either the GOGO or GOCO models. The added burdens of laws, regulation and government oversight made the latter two NTIB organizations less efficient than their COCO commercial-product-counterpart organizations even when under the same private sector management. - A key point to remember is that both the COCO and GOCO operations must provide the stimulus for adequate profit margins if these private sector enterprises are to stay healthy and viable. (Figure 1 presents the three options discussed above for public/private sector industrial organization in matrix form). The Office of Technology Assessment suggests that for reasons of cost, total capacity, and potential for innovation, the best options for post-Cold War industrial organization would be to increase the use of dual-use technologies, depend upon private ownership (COCO's) and competitive acquisitions. The next best option would be the GOCO-type operation providing for government ownership of overhead but private sector incentives to control direct, variable costs. Finally, for totally defense-unique manufacturing, and only as a last resort, the GOGO model option would be used. Which strategic commodities should the United States purchase from private versus government manufacturing sources? - The decision about the appropriate source from which to procure military products depends upon the item in question. Characteristics of products amenable to "privatized" sourcing would include: a unique military item nearly equivalent to a commercial item or which could be readily customized from a commercial item; a production process similar to the commercial process; an item from a lower manufacturing or technological tier (e.g., a commodity subcomponent). Examples of products which fit these characteristics are: commodities, foodstuffs, textiles, clothing, winches, laptop computers, satellites; global positioning systems, jet engines, cargo planes, food packaging. Examples of dual-use items include: helicopter airframes, heavy trucks, jam-proof radar/radios, automatic test equipment, and general maintenance services. Characteristics of defense goods or services which make them less amenable to integration with the commercial sector include those items where: - There is no related commercial variant, (e.g., weapons). - Production processes are highly specialized for performance or security reasons. - They emerge from a higher manufacturing tier, especially prime vendor-level integration. - They rely on cutting-edge technology having little or no commercial application. Examples of such items are: Large caliber ammunition; armored vehicles; specialty metals/composites; large gun barrels and their integration; nuclear weapons. Finally, we are left with the question of how Government should respond to this industry perspective on defense down-sizing and industrial conversion: "Defense private firms can transform themselves into competitive industries, given time, management persistence, and realistic expectations. Plant level conversion, however, is unlikely. Further, the implications for national security strategy of closing plants should not be minimized. Defense plants cannot be 'reconstituted' and once current defense production lines have been shut down, the time, political cost, and difficulties of restarting them will prove overwhelming." Richard T. Minnich in "Defense Downsizing and Economic Conversion: An Industry Perspective." (1993) The processes of "down-sizing," "right-sizing," defense conversion and privatization are complex and uncertain both in their implementation and in their outcomes. Even in the U.S., where the tradition of free market support of military security needs is centuries old, we continue to find the optimal solution to industrial organization for defense elusive. This paper has outlined U.S. industrial history and the flexible choices our system is pursuing to provide the industrial means to support the U.S. national security strategy. Senior Government, industry and academic leaders continue to evaluate and debate the issues of "privatization" versus government ownership and operations. We will continue to experiment, learn from unsuccessful approaches and eventually settle upon strategy. Sharing our experience could benefit other nations facing the challenge of reallocating resources and human talents to solve a range of national problems to improve the well-being of their citizens while maintaining an acceptable level of military security. Conclusion ---------- The dilemma of how to beat swords into plowshares in the wake of major armed conflicts has bedeviled humanity for millennia. The primal need of all peoples not to feel naked before their real or potential enemies is a powerful inhibitor to disarmament, even when levels of arms reach such proportions where they themselves pose a threat to the very security they were created to secure. The questions raised and partially addressed in this paper have enormous import not only for the U.S. but for other nations, as well. With the worldÕs population expanding with consequences for global security and standards of living, we must find a way of providing for our national defense at minimum cost. As experience has shown, wealth expended upon arms cannot simultaneously be applied to the amelioration of society's ills which, in the United States, are large and clamoring for attention. The challenge for U.S. policymakers and their counterparts throughout the democratic world is how to strike a just and workable balance between defense and social needs. The ICAF faculty members who contributed to this paper trust that in some small way they have been able to shed light on this question, one of the most pressing of our time. FIGURE 1 Three Options --------------------------------------------------------- | Option | Benefits | Cost | |-------------------------------------------------------| | Govt Owned & | Maximise Control | Lose Market | |Operated (GO/GO) | & Stability | Efficiency | |-------------------------------------------------------- | Contractor Owned | Maximise | Less Control, | | & Operated | Efficiency | Subsides | | (CO/CO) | | Necessary | |-------------------------------------------------------| | Govt Owned/ | Reduce Risk For | Less Control | | Contractor | Private Sector | Than GO/GO,Less| |Operated (GO/CO) | More Efficient | Efficient Than | | | Than GO/GO | CO/CO | --------------------------------------------------------- The analysis and opinions expressed or implied herein are those of the faculty members of the Industrial College of the Armed Forces who collaborated in this study and do not necessarily represent the views of the National Defense University or its constituent colleges, the Department of Defense, or any other U.S. Government agency. This material does not imply Department of Defense endorsement of factual accuracy or opinion. ---------------------------------------------------------- Copyright 1994 NATO All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means: electronic, electrostatic, magnetic tape, mechanical, photocopying, recording or otherwise, without permission in writing from the copyright holders. Authorization may be requested for redistribution of the text on a non commercial base by research and educational services. Requests should be addressed to the Economics Directorate, NATO, via e-mail 'scheurweghs@hq.nato.int'. First edition 1994 ISBN 92-845-0079-6 This is the latest in a series bringing together papers presented at the NATO colloquia organised by the NATO Economics Directorate and Office of Information and Press on economic issues in the former USSR and Central and East European countries. For further information please write to the Director, Office of Information and Press, 1110 Brussels, Belgium. The articles contained in this volume represent the views of the authors and do not necessarily reflect the official opinion or policy of member governments or NATO.