In a previous post, I argued that corporate welfare is a function of Government restrictions on supply, which raises barriers to entry and lowers the risk of inefficient operations. In this post, I will begin to provide background for understanding corporate welfare in the defense industry.
An important aspect to national security is the fact that it is a joint venture between the DOD and private defense contractors. Industry’s role in the sector is largely to develop, produce, and maintain weapon systems. The systems are often large and complex. The firms often experience economies of scale. Interactions with the Government are tangled. This and more leads defense firms toward a particular organizational design.
Are defense industry giants economical?
The first thing to recognize when discussing corporate welfare is the efficient form of economic coordination. For the defense industry, the complexity of the task is often assumed to require the superior coordinating skills of large organizations which coordinate activities through lines of command. Market coordination, by contrast, requires lengthy negotiations to arrive at acceptable transactions.
The rise of large multi-unit enterprises in the latter half of the 19th century seemed to prove, using market-tested means, that planning was more efficient than prices. Inside firms, management coordinates the specialized activities, not the price mechanism of markets. For all the charges against anti-competitive monopolists, large enterprises simply out-competed the smaller businesses at the turn of the 20th century by rapidly driving down prices.
Managerial historian Alfred Chandler thought it was clear by 1977 that the invisible hand had been replaced by The Visible Hand of management. Similarly, in The New Industrial State, John Kenneth Galbraith recognized that:
The genius the industrial system lies in its organized use of capital and technology. This is made possible, as we have duly seen, by extensively replacing the market with planning.
The New Industrial State was published in 1967. Two years later, Galbraith wrote an op-ed in the New York Times arguing that defense firms were really public firms, and should be nationalized. He found competition to be excluded in defense more scrupulously than under socialist economies. Only one-tenth of defense contracts were subject to competitive bidding, meaning 90% of contracts were directly negotiated with an incumbent firm. The situation left no chance for new firm entry.
There was, indeed, no market between the firm and the Government. One public bureaucracy simply sat down and worked things out with another public bureaucracy.
Galbraith, however, found this to be an efficient solution. He assumed that industrial firms would continue maturing until their functioning merged with Government. Galbraith wrote:
The industrial system, in fact, is inextricably associated with the state. In notable respects the mature corporation is an arm of the state. And the state, in important matters, is an instrument of the industrial system. This runs strongly counter to the accepted doctrine that assumes and affirms a clear line between government and private business enterprise.
So the restriction of the number of defense suppliers, and the direct support provided from the DOD, was thought to be efficient. Galbraith thought that the defense contractor organization was optimal, but that they were an unaccountable part of the bureaucracy. To remove problems of regulatory capture, he recommended nationalization.
Organizational coordination.
Now, its interesting to think about why the US Government doesn’t develop and produce its own weapon systems. Instead, it uses the market mechanism to contract with private suppliers.
We may then ask: If organizational coordination were superior to market coordination, then why does the DOD contract out so much of its work? And if market coordination were superior to organizational coordination, then why are defense contractors so large?
Well, that is a good question. Herbert Simon believed in 2000 that organizational coordination was indeed surpassing market coordination. And he wondered the same thing:
… with the growing advantage that large organizations secured from advanced technology… we have enlarged greatly the area within which organizations are more effective than markets. This conclusion applies to governmental as well as to business organizations.
So the increasing tendency in recent decades for government agencies to contract out many of their activities evidently is not driven by considerations of efficiency — or, if it is, there is little solid empirical evidence for this preference.
Let’s leave that to the side. For now, we can just accept that the DOD contracts out most of its industrial work. Given the fact the DOD contracts out work on weapon systems, is it inefficient to provide support that grows defense firms until they dominate the industry?
Large defense firms have advantages of sharing information and balancing costs across a wide-range of technologies and contracts. The scale of these firms drives a focus on process control. It allows defense firms to tackle projects of the scale unimaginable to most commercial firms, and at the same time, provide significant transparency into business operations.
Organizational learning at large scales can create positive feedback effects. Different R&D projects produce outcomes with spillovers that can benefit other projects. Production line management can be shared across similar commodity types. Diversification allows the firm to keep the best performers on staff when there are DOD budget shortfalls.
It is by no means obvious that what people call corporate welfare in the DOD is really what they think it is. Perhaps corporate welfare just isn’t a useful way of thinking about the problem. Surely in some cases it is, but we must separate analytically the efficient coordination of organizations from instances that look like corporate welfare, or regulatory capture, or what can be summarized as the military-industrial complex.
The exceptional Mark Mandeles wrote:
It is not clear that the concept of military-industrial complex is useful for developing broader understanding about the history of relationships between public and private sectors in western democracies, and resulting implications for national security. President Eisenhower presented the concept as a rhetorical device to mobilize public awareness of a potential threat to democratic governance rather than as an analytical category describing a shift in the ratio of market-to-organizational coordination in the U.S.
We must disentangle these concepts before we can make progress on targeting corporate welfare.
But corporate welfare is real, right?
What about instances like when Lockheed was bailed out of its performance on the C-5A program in 1971. Here’s a clear case where the contractor bought-in on production, was demonstrably inefficient, covered up cost growth from the public, and when Lockheedran into severe financial problems, the US Congress bailed it out. It was an early example of too-big-to-fail. Here’s William Hartung:
The terms were generous. Lockheed was left to cover just $200 million of its massive overrun on the C-5A, and only half of that would come up front… Of the more than $1.3 billion in additional funds Lockheed was seeking, the government agreed to pick up nearly two-thirds of that, $757 million…
As it turned out, this wasn’t the end for Lockheed. Within a few months of the settlement, the company was citing the remaining $484 million in costs on mismanaged defense programs as a reason it should receive an additional subsidy — a $250 million loan guarantee to keep its troubled L-1011 Tristar airliner project going.
And yet the Government was culpable too, because the acquisition system incentivized this behavior. The C-5A was the first Total Package Procurement contract, which required costs and capabilities for a totally new system to be predicted over the course of a decade or more. The requirements set forth were strict and totaled 1,500 pages. In response, 5 contractors sent back proposals totaling 250,000 pages. The eventual contract included numerous oddities and loopholes which further confused responsibility down the road.
In this way, the Government absorbed the risk of Lockheed by giving them a pretext to dispute the contract and threaten default. The sheer size of the program, and the contractor it went to, made bankruptcy very costly to the defense industrial base and the American economy. This threat was explicitly used by Lockheed, that its failure could create systemic problems for the industry. The argument is similar to the one we heard during the financial crisis of 2007-2008. Here’s David Packard arguing on behalf of Lockheed:
[Lockheed’s] operations are so intertwined with other companies which contribute to our national defense that it was necessary to consider a chain reaction upon other companies as well.
If we accept the Lockheed bailout of 1971 as a sure sign of corporate welfare rather than organizational efficiency, then we run into another problem. If corporate welfare was such an awesome goodie in the DOD, then you’d expect the incumbents to work hard to maintain or grow their position. If defense firms were securing easy profits from the taxpayer, then the following statement from an industry executive in 1970 would sound strange:
… there isn’t a company in this country today whose board isn’t sitting up at night trying to think up ways to get out of the defense business.
Corporate welfare is pretty difficult to pin down.
The government doesn’t coordinate system developments itself like it did for the Fleet Ballistic Missile program in the 1950s and 60s. Program requirements for scale and complexity in the DOD have been coordinated through a prime contractor — a lead systems integrator. That means the contractors must be large themselves.
Large contractors with the capacity for massive programs will always be able to throw their weight around in terms of capability for defense officials and jobs for Congressmen. Corporate welfare is then intimately connected with the requirements demanded of industry by the Department of Defense.
And yet we can be sure that corporate welfare does exist in the defense industry. Unlike industrial era thinkers, we have evidence that disruptive innovation comes from small firms, who create new processes that out-competes the industrial giant despite the advantages of its size. We have built the tools to take advantage of open architecture, standard interfaces, and modular design.
There’s an importance for the acquisition system to be adaptive; to see firms grow, mature, die, and to see new ones born. The turn-over of dominant companies in the US economy is a testament to its dynamic underpinnings. You do not see the same kind of turn-over in many European firms, which usually maintain their market positions over long periods of time.
And so we must recognize that this consolidation of the defense industry, going along unbroken for more than 70 years now, is a reflection of high barriers to entry. And the lack of competition implied by those barriers means that defense firms are less innovative and less cost conscious then they would be under increased competition. Protection given to contractors only increases their ability to extract money from the taxpayer without delivering value.
this and more leads defense firms toward a particular organizational design.