EVENTS

Date:	Friday, October 10, 2003
Time:	11:00 AM -- 1:00 PM
Location:	Wohlstetter Conference Center, Twelfth Floor, AEI 1150 Seventeenth Street, N.W., Washington, D.C. 20036

October 2003
Transforming the Military-Industrial Complex

What is the defense industry's vision for the "transformation" of the U.S. military, and how will transformation in turn shape the future of the defense industry? How is the post-Cold War, post-9/11 security environment changing the relationship between the private sector and U.S. national security, and what are the implications for defense policy?

In the first of a series of Supply-Side Briefings on the future of the defense industry, a panel of scholars considered these and other questions. This discussion was immediately followed by a keynote address by Northrop Grumman Chairman, President, and CEO Ronald Sugar.

The text of Dr. Sugar's speech is available at http://www.aei.org/news/newsID.19280/news_detail.asp.

Thomas Donnelly
AEI

Since the September 11 attacks and especially today, in the wake of Operation Iraqi Freedom, it is increasingly apparent that the military the United States has at its disposal may not be the military it needs. While it is comforting to think that Secretary Rumsfeld or President Bush can snap his fingers and effect the wholesale transformation of our armed forces, the reality is that the innovations and capabilities of our military are reliant on the creativity and expertise of the private sector.

Therefore, if the American way of war is to change, the defense industry is going to need to change with it. The question is how.

This is the question that the American Enterprise Institute intends to explore through its Supply Side Briefings. Over the coming months, the American Enterprise Institute will bring together distinguished academics, top defense industry analysts, and corporate leaders for a series of events that will consider the changing shape of what used to be called the "military-industrial complex."

Stan Crock
Business Week

The military-industry complex is dead as a political science concept, and no amount of money is likely to revive it.

Employment in the defense industry is shrinking precipitously. Between 2002 and 2008, nearly half of the industry's work force will be eligible for retirement. The satellite industry is in even worse shape. Although space-based systems are a critical component of Secretary Rumsfeld's vision for defense transformation, the United States is now a net importer of satellite technologies. Its share of global satellite manufacturing has shrunk from 64 percent in 1998 to 38 percent in 2002, and the number of orders is decreasing, largely due to satellite export control rules.

The budget picture is bleak as well. Most people believe that the defense budget is nearly $400 billion and that the industry is in good shape; they are ignoring where the money is flowing. Even the Bush administration's much touted boosts in defense spending are not increasing procurement. Procurement is at 50 percent of the level at the Reagan administration's high point. Since the first Bush administration, more than one hundred major weapons programs have stopped production.

The situation is unlikely to improve for three reasons. First, in the absence of a peer competitor that poses an existential threat, there is little political incentive for advocating huge increases in defense spending. The war on terrorism requires very different investments than the Cold War. The second reason is technological innovation. Because of precision-guided weapons, the question is no longer how many sorties are necessary to hit a target, but rather how many targets can be hit during a single sortie. As a result, the need for bomber and fighter jets has decreased. The third reason is budgetary. Defense spending is discretionary, like social security and Medicare. In a guns-versus-geezers debate, political considerations will not favor the Pentagon.

The question is what to do about this reality. First, it is critical to recognize that the defense industry is not a real market in any sense of the word; there are only a handful of sellers and only one true buyer-the government. As a result, the balance between risks and rewards is radically skewed. In order to correct the situation, the major defense industrial contractors should be treated as utilities, guaranteed a modest stream of revenue in return for their services. At the same time, because small companies provide a disproportionate share of innovation, it is important to continue to nurture them with research and development funding. One possibility is to foster a system in which there is a great deal of partnering of small companies with big defense companies that can navigate the Washington bureaucracy.

Byron Callan
Merrill Lynch

In considering the future of the defense industry, there are five points to take into account.

First, there is a need for a unique defense industry. The domain knowledge on what soldiers need and how the military works-not to mention, a reliable supply of military products-is vital for U.S. national security. There also needs to be excess capacity; just consider the surge capacity that has been required since the Iraq war.

Second, the defense industry does not operate in a vacuum isolated from the rest of economy. Increasingly, traditional defense companies are partnering with the powerhouses of the commercial technology world, such as Oracle and IBM. The absence of qualified engineers in the defense industry is not nearly so grave a problem as during the dot-com boom of the late 1990s.

Third, there is clearly an evolution in the competition of the defense sector, as the middle part of the market has been swallowed up in consolidation. There is also a smaller tier of companies that has been lost in this debate; this lower tier is equally important to the overall health of the sector. This has resulted from a range of things: budget constraints in the 1990s, reliance on joint programs, and the Department of Defense loss of some of its own internal capabilities to manage large contracts, forcing it to rely on the private sector more and more for systems integrations. There had been some progress toward the globalization of the defense industry, but the current political environment has worked against this.

Fourth, the structure of the industry will change, but this will be evolutionary rather than revolutionary. Vertically-integrated companies may give way to greater specialization of products. Compare IBM as a model for the computer sector ten or twenty years ago with Intel, Microsoft, and Dell today.

Fifth, capital goes where it earns attractive returns and growth. There has been some debate in the analyst community about the attractiveness of defense stocks. Contrary to the gloomsayers, the environment is still conducive to growth in defense spending, even as there may be disagreement about what exactly that growth rate will be. The stocks are simply not behaving as though this is an industry in distress.

Andrew Ross
U.S. Naval War College

The views expressed by Andrew Ross are his own, not those of the U.S. Naval War College or the U.S. government.

The U.S. Naval War College has led a study that examines explicitly what transformation means for the defense sector. The project began with the premise that what might be transformational or disruptive for the military might not be disruptive for industry; that a transformed military might not require a transformed defense sector. The project also asked who would provide the products necessary for transformation-traditional suppliers or startups. After all, transformation is supposed to bring the military into the information age.

The defense policy community is awash in visions of transformation. In order to narrow the scope of this study, it began with the Navy vision of transformation, or network-centric warfare, which has now become embedded in the visions of the other services as well. The study also focused on three industrial sectors: shipbuilding, unmanned vehicles, and systems integration. In examining these sectors, the study differentiated between disruptive and sustaining innovation. Sustaining innovation is likely to derive from existing, traditional firms; disruptive innovation, by contrast, may draw in new suppliers.

Fascinatingly, the study found the greatest potential for disruptive innovation, not in systems integration, but in shipbuilding, in part because of the new kinds of systems that the Navy hopes to acquire in the coming years, such as the Littoral Combat Ship (LCS). This has allowed nontraditional players to emerge, particularly in partnership with traditional defense contractors.
 
The unmanned aerial vehicle sector, by contrast, is likely to continue to be dominated by three traditional firms-Boeing, General Atomics, and Northrop Grumman. Although there have been several startups in the system, the most successful of them have adopted a business model in which they develop an innovative technology and are then bought out by traditional suppliers.

Traditional suppliers are likely to experience the least disruption in the systems integration sector. These suppliers have standing relationships with the military, while computer software firms like Microsoft have no interest in developing them. Startups may have a role to play, but again, as partners to the traditional firms, they are already putting special emphasis on systems integration skills. The defense sector is not going to be displaced by information technology firms.

The recommendations that came out of the U.S. Naval War College study were addressed more toward the defense sector's customers than its suppliers. The U.S. military needs to develop a coherent, consistent vision so that defense firms know what is expected of them. Unfortunately, many firms are still trying to grapple with new concepts like network-centric warfare, in part because they have not been adequately explained.

Richard Perle
AEI

The defense industry suffers from a glut of government regulation.  It is difficult to imagine any industry so heavily burdened by bureaucratic red tape. The proliferation of restrictions and controls on the export of many technologies, such as satellites, not only damages America's defense industry; it also harms the overall U.S economy.

It is especially important now, as the United States wages the war on terrorism, that the defense industry be strong. Prior to the September 11 attacks, the United States repeatedly, and wrongly, treated terrorism as a problem for law enforcement. As a result, states like Afghanistan were permitted to shield terrorist groups without threat of any serious punitive action. President Bush was correct to assert the United States will no longer distinguish between terrorists and the nations that harbor them. Unfortunately, the war on terrorism entails a greater degree of uncertainty than was inherent during the Cold War. Because it is unclear when and where the U.S. military may be called to fight, there is an incredible premium on speed, universality, flexibility, and precision in our weapons systems. It no longer makes sense to divide the defense budget into roughly equal thirds between land, sea, and air; rather, money should flow to systems that, on a cost-per-target-destroyed basis, are effective. This will require overcoming service parochialism, which often amounts to nothing more than turf wars between government bureaucracies.

Lastly, most of the defense budget does not go toward the research and development of new weapons systems or capital improvements. Rather, it goes toward manpower, which is treated as a free good, to be allocated communist-style and with extraordinary inefficiency. There is no way in the defense budget to trade off manpower against capital investment in technology that could accomplish the same task as a human being, but more effectively. Until it is possible to make those tradeoffs, the United States will unfortunately continue to spend a great deal of our defense money very wastefully.

This summary was prepared by AEI research assistant Vance Serchuk with AEI intern Sanem Ozbek.