The Defense Industrial Base: How Idiosyncratic and Historical Influences Dictate Its Future.


The Trump Administration's 2017 National Security Strategy (NSS) and 2018 National Defense Strategy (NDS) represent a major shift from a focus on counter-terror operations to great power competition. Since the end of the Cold War until the release of these new strategies, the Department of Defense (DoD) claimed to lack a near-peer--let alone peer--competitor able to exert influence globally. Coupled with the fact that the War on Terror directed the Department's strategic decision making and resource allocation since its inception, the United States has been focused on anything but great power competition for the last twenty-seven years. The defense industrial base (DIB), that collection of firms that supply the materials for the country's defense needs, is often a lagging indicator of these major strategic shifts. Currently, that lag is even greater than the historical norm.

Defense drawdowns after the Cold War caused a wave of change in this sector, which ultimately harmed its long-term effectiveness. The War on Terror gave the DIB a cash injection, but only in a specific set of capabilities, many of which would not be applicable or survivable in a great power war. Given the need for new capabilities to fulfill new objectives against new potential adversaries (a revisionist China and resurgent Russia), the DIB will be called upon in a way it has not been since the 1986 Reagan buildup. This paper will explore the health of the industrial base by examining market idiosyncrasies that impact how government and firm decisions are made; historical trends that explain how the sector got to where it is today and what lessons that may hold for the future; a check-up on specific capabilities and the acquisition process. Ultimately, despite difficulties in adapting the DIB to a new set of military needs, it is highly unlikely that industry would not be up to the task. Instead, this transition will present a political problem requiring exorbitant expense or serious tradeoffs. This paper shall offer this analysis without comment on whether this strategic shift is a sensible or harmful one for the United States--that analysis would require a whole other paper, if not book, to tackle. Market Uniqueness

There are a series of discrepancies between the defense market and other private markets, but most can be traced back to the defense market's unreliable monopsonist--the US federal government. A monopsony is a market in which there is a single buyer. This describes the market for US defense contractors as the federal government is the only buyer in the United States and there are a series of export restrictions that restrict these contractors from selling to foreign buyers, even allies. (1) Under the International Trafficking in Arms Regulation, the licensing process is burdensome and difficult to navigate. The labyrinthine paperwork process involved with selling to foreign buyers deters small companies from making the attempt, thus limiting their market. The strictness of the regulations can also chill informal cooperation between international academia and industry on emerging technologies, such as artificial intelligence and quantum computing, because both the universities and corporation fear censure or legal action from the DoD. (2) These factors combined incentivize more Foreign Military Sales (FMS, which are government-to-government) than Direct Commercial Sales (DCS, which are industry-to-government), meaning the government will often over-buy a project with the intent to export the excess. This practice exacerbates many of the market imperfections described below and can complicate the relationship between the DoD and DIB.

In the traditional monopsony model, the buyer would be able to perfectly price discriminate and the outcome would mirror a perfectly competitive market, but with the buyer capturing all available surplus. There are two reasons that this is not the outcome for the

American defense market: first, the federal government is an imperfect monopsonist and second, the supplier side of the market is insufficiently competitive to allow for effective price discrimination.

The DoD is unable to act as a perfectly price-discriminating monopsonist because its demands are often unpredictable and unreliable. The demands are unpredictable as they are based on the Department's strategic mission, which is liable to change considerably at any time. (3) This change can happen gradually over a long period (from World War II to the Cold War or from the wars in Iraq and Afghanistan to the current focus on great power competition) or quickly due to crises (Pearl Harbor or 9/11). The type of transition impacts the degree of strain on the industrial base, but the DIB is pulled by market "signals" more than any other industry. The word signals is in quotation marks because the defense market does not respond to signals so much as it does declarations. The mission is the market signal, meaning that the DoD has strong incentives to clearly describe the anticipated environment and its objectives (the foundations of any security strategy) both in public documents like the NDS and in private communications with contractors. (4)

This forceful and immediate market signal is both a blessing and a curse. During periods such as World War II, it meant that the industrial base mobilized on an epic scale. (5) In the case of the War on Terror, nearly the entire DIB shifted to produce the new, specific equipment required by the unfamiliar tactical environment, such as drones, which meant that many traditional industries, such as shipbuilding, began to atrophy. (6) Government regulation in many markets provides a level of institutional stability for buyers and sellers; when the buyer is the government, all bets are off and demand signals are both clear and volatile. (7) This problem applies to nearly all government contractors across a range of industries, but the DIB feels it most acutely. Many capabilities take years or even decades to develop, and by the time a project is complete, it may be obsolete.

There is often utility in market lag. In a typical industry, there are firms on the "cutting-edge," firms that stick to their traditional strengths, and boutique firms that fill niches. Although the DIB generally resembles this setup, the singular and clear nature of the demand signal pushes suppliers toward homogeneity, making future transitions more difficult and creating a thermostatic pattern of innovation. (8)

Congress produces the unreliability of DoD purchasing. The defense budgeting process is subject to both the complications that permeate the entire federal budgeting process and some unique convolutions. Continuing resolutions (CR) have plagued all of federal budgeting over the last several years. A continuing resolution is a temporary agreement that extends the last appropriations bill for some agreed upon period of time. Under a CR, agencies only fund projects that are already in progress. This has an outsized impact on the DIB because, as mentioned, projects take a long time to complete and the contracts that underlie those projects take time to negotiate--both of which are frozen under a CR. CRs also squeeze spending timelines.

The different titles in the defense budget (operation and maintenance (O&M); military personnel; procurement; research, development, test, and evaluation (RDT&E); revolving and management funds (RMF); military construction) have different timelines to spend the money appropriated for them. (9) For example, the operation and maintenance account has until the end of the fiscal year (September 30) in which appropriations are passed, whereas procurement has until the end of the following fiscal year (FY). The graphic on the next page demostrates the relative proportion of these timelines for 2018 appropriations.

CRs do not change the fiscal calendar, meaning that whenever a budget deal is reached, and appropriations subsequently delivered, the clock has already been running on the DoD for however many days the Department was operating under a CR. This issue is exacerbated by the notorious 80-20 rule (which became the 75-25 rule for the first time in 2018). The 75-25 rule states that no more than 25 percent of an agency's funds can be spent in the last two months of the fiscal year. (10) Any leftover money is lost to the Treasury. This rule, like many established by Congress, is a well-intentioned effort at fiscal responsibility, but ultimately incentivizes the Department to spend as quickly as possible, generating inefficiencies in the form of higher prices and haphazard contracting. (11) The graphic below demonstrates the impact of CRs and the rule. The operation and maintenance account must spend, on average, over a billion dollars per day until October 1, 2018 to clear its coffers. (12) If the appropriations process worked flawlessly and the Department was given from October 1, 2017 till September 30, 2018 without any additional rules, the amount spent per day would be cut about in half, as shown below.

A reform to allow even spending and carryover budgets would relieve pressure on lawmakers, Department officials, and contractors. It does not take a PhD in economics, government, or war studies to realize that there will be some years in which tax revenues will be higher or lower due to better or worse economic performance; some years in which the majority party will be more or less willing to fund the military; and some years in which military capabilities will be in greater or lesser demand. Allowing the DoD to manage its money for the long-term would partially insulate it from the changes in Congress and provide greater confidence to its contractors. The most recent government shutdown, the longest in American history at thirty-five days, (13) demonstrates the increasing riskiness of US budget politics. Although the DoD had already had its funding approved, defense contractors expressed...

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