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ECONOMIC INCENTIVES, CONVERSION, AND DUAL-USE TECHNOLOGIES: THE CASE OF RUSSIA

Clifford G. Gaddy

Research Associate

The Brookings Institution

The purpose of this paper is to present a framework for analyzing how policy regarding dual-use technologies in Russia may be affected by the present and future economic status of defense enterprises. What I am talking about includes what is loosely referred to as ''conversion.'' In the case of today's Russia it goes beyond that to embrace concepts such as "commercialization," "marketization," and "privatization." But for present purposes let me use the word conversion for all of this.

Much is unclear right now regarding the future of the Russian military industry. Certainly, straightforward prediction is impossible. However, I believe that simple economic reasoning can help define a range of possibilities, or scenarios, for the future of individual firms. My goal is to elaborate a set of such possibilities, with the hope that they can be usefully kept in mind as one examines how the dual-use issue relates to each.

I would also like to comment on two important economic policy issues relating to conversion that have recently been announced in Russia. These are a new law on conversion and the current official policy on arms exports. The exports issue in particular is a delicate one, and what I say may be controversial. But I believe that it is so critical to our main topic of dual-use policy that without an open discussion of it, everything else becomes academic.

THE ECONOMIC PROBLEM

What is the economic problem facing Russian enterprises? Fundamentally, it is the same as the problem potentially facing every other firm in the world: customers no longer want their products. Or, to be more precise, their current customers do not want the products they are currently producing. To survive, the Russian defense firm must somehow act to change this situation. This necessity is the same as for any firm in the world in the same situation.

What choices for action does such a firm have? Most of the world lies outside its control, of course. But generally it can at least control its own behavior: it can change



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Dual-Use Technologies and Export Administration in the Post-Cold War Era: Documents from a Joint Program of the National Academy of Sciences and the Russian Academy of Sciences ECONOMIC INCENTIVES, CONVERSION, AND DUAL-USE TECHNOLOGIES: THE CASE OF RUSSIA Clifford G. Gaddy Research Associate The Brookings Institution The purpose of this paper is to present a framework for analyzing how policy regarding dual-use technologies in Russia may be affected by the present and future economic status of defense enterprises. What I am talking about includes what is loosely referred to as ''conversion.'' In the case of today's Russia it goes beyond that to embrace concepts such as "commercialization," "marketization," and "privatization." But for present purposes let me use the word conversion for all of this. Much is unclear right now regarding the future of the Russian military industry. Certainly, straightforward prediction is impossible. However, I believe that simple economic reasoning can help define a range of possibilities, or scenarios, for the future of individual firms. My goal is to elaborate a set of such possibilities, with the hope that they can be usefully kept in mind as one examines how the dual-use issue relates to each. I would also like to comment on two important economic policy issues relating to conversion that have recently been announced in Russia. These are a new law on conversion and the current official policy on arms exports. The exports issue in particular is a delicate one, and what I say may be controversial. But I believe that it is so critical to our main topic of dual-use policy that without an open discussion of it, everything else becomes academic. THE ECONOMIC PROBLEM What is the economic problem facing Russian enterprises? Fundamentally, it is the same as the problem potentially facing every other firm in the world: customers no longer want their products. Or, to be more precise, their current customers do not want the products they are currently producing. To survive, the Russian defense firm must somehow act to change this situation. This necessity is the same as for any firm in the world in the same situation. What choices for action does such a firm have? Most of the world lies outside its control, of course. But generally it can at least control its own behavior: it can change

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Dual-Use Technologies and Export Administration in the Post-Cold War Era: Documents from a Joint Program of the National Academy of Sciences and the Russian Academy of Sciences itself. The changes can be of two kinds: it can change what it produces, or it can change to whom it sells. Or it can change both. The choices can be diagrammed something like the following: WHAT? TO WHOM? OLD PRODUCT OLD CUSTOMERS NEW PRODUCT NEW CUSTOMERS The diagram suggests four paths of adjustment. That is, either: the firm's old product continues to be sold to the same customers as before (which can be thought of as "zero adjustment"); the old product is sold to new customers; a new product is developed for the old customers; or a new product is developed and sold to a new group of customers. Now, of course, this is very simplistic. In reality, things are not so clear-cut. When does modification of an old product become a "new" product? When does narrowing or broadening of an existing market go so far as to define a new market? And so on. So far, this is a general scheme for a genetic firm. Does it—can it—apply to a Russian defense enterprise? There are certainly many differences between the situation of an American automaker, say, which is suffering a sales slump, no matter how severe, and a Russian tank manufacturer which sees its orders virtually disappear overnight. For one thing, the reduction in demand for the Western firm was probably gradual. This means that a firm has some time to adjust. This is clearly an advantage. An even bigger advantage for the Western firm is the existence of a competitive market. Suppose a capitalist firm experiences a rather sudden drop in demand for its product. How does it react? Unless demand for that product just vanished altogether, the drop in demand for the product of one firm shows up as increased demand for someone else's product. This means that the losing firm has a good chance to ascertain why the drop occurred. That winning firm's product was of better quality; it was less expensive; it was marketed better; there was better after-sales service. The losing firm can try to

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Dual-Use Technologies and Export Administration in the Post-Cold War Era: Documents from a Joint Program of the National Academy of Sciences and the Russian Academy of Sciences isolate the problem and adjust accordingly. This is usually the first approach: try to improve the product, make it more attractive, better marketed, modify it, reduce its price by cutting costs, specialize more in the target consumer groups, etc. Only if these relatively marginal changes seem to fall does a firm resort to more radical steps, such as re-directing the product line. There is a fundamental principle involved. It is basically a kind of "Least Action Principle"—if you can accomplish your goal in several different ways, you will rationally try to do it in the way that involves least effort. For economists, this is an axiom. For a given payoff, firms—like all other economic agents—will make choices which minimize their costs (where costs are defined broadly to include not only the monetary costs of production and marketing, but also other so-called transaction costs, including even psychological costs). THE RUSSIAN CASE How does this apply to a Russian defense firm? The collapse in demand in defense industry here may seem to be so different in nature and in extent as to defy meaningful comparison with anything in the West. This is not a question of a "product" suffering from flaws, or a competing supplier who is doing things better. The product itself is wrong. Russia is not looking for a better missile or a better nuclear submarine. It does not want any more missiles or submarines at all. Hence, there is no chance of adjustment of the product to suit the former customer. But this is jumping to conclusions. Let us rather test the relevance of the scheme by looking at each of the four possible options for adjustment in the case of a Russian defense firm: Old Product—Old Customer This would mean continuing to produce (roughly) the same kind of arms for the state (admittedly, now the Russian state rather than the Soviet state...). Is this a viable option? Yes, arms will be needed. With a population of 150 million, and armed forces of 1.5-2 million men for the rest of this decade, Russia will need arms. Even without the more advanced systems "based on new physical principles" called for by defense minister Grachev, merely maintaining these forces will provide orders for many Russian firms for years to come. Old Product—New Customer Military procurement inside Russia is being slashed, but some of that lost market might be replaced by the foreign market. I will say more later about the possibility of

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Dual-Use Technologies and Export Administration in the Post-Cold War Era: Documents from a Joint Program of the National Academy of Sciences and the Russian Academy of Sciences arms exports. Suffice it to say here that the option of selling the old product on a new market is very much alive for many Russian defense enterprises. (Someone might object to my referring to foreign customers as "new." The export market is hardly a new one for Russia—the former Soviet Union was a massive arms exporter. I would counter with the recent comments of Mikhail Bazhanov, head of the Russian State Committee on Conversion: yes, the USSR exported arms. But the customers were chosen on ideological, not commercial grounds. The Soviet state sold the weapons on credit, and provided this credit itself—long-term, interest-free loans. In effect, says Bazhanov, "our state was buying weapons from itself' and giving them to client states.) New Product—Old Customer Could a defense plant convert to producing civilian goods, but still count on the Russian state as its buyer? As a matter of fact, this is the case right now for virtually all the civilian goods produced by defense plants in Russia, since very few wholesale and large retail firms have been formally privatized. I am thinking of a different arrangement, however. Even with full-scale privatization of Russian industry and trade, the state may remain a major customer for the former defense plants. The best example of how this could happen is the type of large-scale infrastructure contracts espoused by some people. This is, for instance, the gist of the new "industrial policy" advocated by deputy defense minister Andrey Kokoshin. New Product—New Customer This is what I would like to call "full conversion"—i.e., former military plants producing civilian goods for private households and firms. This is the most obvious thing we think of when we think of "conversion," and it is certainly possible. Thus, Russian defense firms have good reason to consider all four options. Which choice will they make? The enterprises are very different; they have different preconditions. The relative attractiveness of each option will vary from firm to firm. Hence, their choices will differ, depending on how their prerequisites match up with opportunities. So we should expect to see a mix. But even for the individual firm, the choice is not a choice among a set of static options. We must also realize that the relative attractiveness is itself a variable that firms can influence, by influencing policy. That means that actions taken, and effort (and money) expended to influence policy will be very important. Economists will tell you that any time there is a potential economic payoff to an action, then it becomes included in the range of possible options. It may, to put it bluntly, be more worthwhile to invest some resources in lobbying than in actually producing.

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Dual-Use Technologies and Export Administration in the Post-Cold War Era: Documents from a Joint Program of the National Academy of Sciences and the Russian Academy of Sciences INFORMAL MECHANISMS A second complicating element in predicting a firm's behavior is the possibility that it—or, more correctly, its managers—might choose to go outside the recognized choices, and creme their own opportunities. Such actions fall into the realm of the illegal, although I prefer to use the term "informal" activities because of the unclarity about what is and is not illegal. Let me give a couple of examples of such informal mechanisms. These happen to apply not only to defense enterprises, but to all categories of firms in Russia today. One common activity has been to sell (at home on free markets or abroad) raw materials or intermediate goods which have been purchased at lower-than-market state prices inside Russia. Officially, the goods were to have been used as inputs in production. Instead, they are sold for profit. In the past, defense firms have had privileged access to shortage goods and were thus in an excellent position to behave in this way. This type of operation only works in an environment of non-market (distorted) prices. The 1992 price reforms make this behavior less likely in the future. Beginning in 1991 and into this year, a wave of so-called spontaneous privatization has swept Russia. One form of such spontaneous privatization resembles a crude form of asset-stripping. In a "reorganization" of the firm, a firm's assets are distributed among enterprise personnel at a nominal valuation and then capitalized at full market price in any of several different schemes. A third, related, practice is that of spinning off small private enterprises from a large state enterprise. Assets, sometimes including valuable intellectual property, are transferred to the spin-off company, where all proceeds are considered the private property of those who founded the company. This practice of "picking the raisins from the pudding" can make a few former managers and employees quite well off, but the majority of the work force are left to fend for themselves inside an increasingly worthless shell of an enterprise. The list of informal mechanisms could be continued, and probably could never be made exhaustive for the simple reason that as soon as one loophole is plugged, another will be found. The important thing is to recognize that although such behavior as I have described may seem reprehensible in many ways, it is natural. It is the natural inclination of an economic agent—in this case, the enterprise director—to follow the path of least resistance. And in the case of the defense enterprise, adaptation to the market in the sense of producing civilian goods for private customers on an open market is not the "path of least resistance," even in the face of initial commitment by the government to a policy of no subsidies and no bailouts. Full conversion is a tough path, perhaps the toughest, and there are lots of ways firms have available to try to avoid it.

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Dual-Use Technologies and Export Administration in the Post-Cold War Era: Documents from a Joint Program of the National Academy of Sciences and the Russian Academy of Sciences Recognizing the real options that firms and their managers face is important for any policy which relates to economic behavior. Economic policies are chosen to induce certain types of results by providing specific incentives and disincentives. The policies always assume a range of choices on the part of agents. You want to encourage some paths and discourage others. But if you fail to recognize that agents see other choices than you, your policies may produce the wrong results. RESEARCH TASKS The conclusion we must draw is that there are potentially many ways for defense enterprises to react to the drastic cut in defense orders. In particular, there are many ways to avoid a "productive" conversion to market-oriented civil production. We are already seeing firms act in some of these ways. There are undoubtedly others that we do not know of, that haven't even been invented yet. The research task is to follow these. I am convinced that one indispensable component in this research is case studies—very detailed on-the-ground studies. Simply put, we need to identify who is doing what, and why? This is a general research task for those interested in conversion (and economic reform in general). For the specific issue of dual-use technology policy, we begin with the knowledge above, and then ask how does each type of behavior affect the dual-use issue. We should raise questions such as: What are the types of enterprises that will continue to be defense contractors selling to the Russian government? What is an appropriate dual-use policy towards them? What sort of former defense firms can be engaged in various infrastructure projects that serve only civilian ends? What role does dual-use play for them? Then the sensitive issue: Which firms will export? What will they export? To whom? And so on. The point I am making is that without this "map" of the former military-industrial complex, it is rather meaningless to state policy. Finally, we should not forget the possibility of informal behavior—the choices not listed in the formal scheme. Part of this is the issue of evasion of rules and agreements—certainly an issue of relevance to dual-use technology transfers. From the economist's point of view, the task is to find out who is likely to evade regulations, and why? RECENT POLICY ON CONVERSION Two important policy measures relating to conversion have recently been adopted in Russia. One is the new law on conversion. The other concerns arms exports. Both of these policy measures directly affect the choices defense enterprises will face as they decide how to adapt for survival.

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Dual-Use Technologies and Export Administration in the Post-Cold War Era: Documents from a Joint Program of the National Academy of Sciences and the Russian Academy of Sciences LAW ON CONVERSION President Yeltsin signed the new "Law on Conversion of the Defense Industry in the Russian Federation" on March 20 (although it was not made public until April 27). The law has many flaws: it is contradictory, vague, and simply avoids all too many key points by saying that "details will be provided later" or that things will be subject, in an as-yet-unspecified manner, to the provisions of other legislation, existing or future. Perhaps the biggest problem with the conversion law, however, is that it is not really a law on conversion. It is a law providing the framework, and the first steps, for a comprehensive defense-economic policy. The real conversion law is yet to come. Ideally, one would like to have, first, a clear military doctrine, which implies which weapons the country needs. That would then be followed by a clear definition of how those weapons are to be obtained. In the Russian case, this means delineating the spheres of continued active military production and resolving the issue of "mobilization capacity," as well as deciding on public versus private ownership. The final step would be provisions relating to conversion of those plants eligible for conversion. Realistically, we have what we have: a conversion law that came before it has been decided what to convert. In fact, the conversion law is a mixture of all these steps, with timetables for the others. As usual, we can expect policy to be formulated as we move along. But these criticisms aside, it is worthwhile looking at what the law does say in light of the possible choices for defense firms outlined above. The Russian conversion law in fact confirms that the individual enterprise will be faced with all four options for its continued existence: Continued Arms Production Article 3 of the law discusses the state defense order, which will, of course, continue to exist. The law also stipulates [Art. 2, para. 4] that enterprises may contract with the government to maintain, at government expense, "mobilization capacity." Enabling legislation accompanying the conversion law specifies [point 5] that the basic principles of Russian military doctrine and a "list of directions of activity in the military-industrial complex which will not be subject to reduction" shall be submitted by March 31. Arms Exports An entire section [Arts. 9 and 10] of the law is devoted to foreign economic activity by defense enterprises. Full allowance is made for arms exports.

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Dual-Use Technologies and Export Administration in the Post-Cold War Era: Documents from a Joint Program of the National Academy of Sciences and the Russian Academy of Sciences Industrial Policy Contracts. Article 2, paragraph 3 of the law speaks of plans to enlist former defense firms in "priority targeted state programs for socioeconomic development" [prioritetnye gosudarstvennye tselevye programmy sotsial'no-ekonomicheskogo razvitiya]. The enabling legislation calls for such programs (which it calls "top-priority state conversion programs" [pervoocherednye gosudarstvennye programmy konversii]) to be submitted for approval by June 30. Production for the Commercial Civilian Market This option is given the least attention in the law. A very modest tax break will be granted to enterprises undergoing conversion on their own [Art. 5, para. 5]. ARMS EXPORTS Clearly, there is a big incentive for Russian arms manufacturers to try to sell their products on the international market for hard currency. It is truly the "path of least resistance" for many firms. One of the most outspoken advocates of Russian arms exports has been Mikhail Maley, Yeltsin's counselor on conversion issues. Unlike many others who have in the past criticized the Gorbachev conversion programs for their failure to demilitarize the economy, Maley criticizes those programs for the fact that they destroyed Russia's military potential. The preferred approach, says Maley, is to expand production of (at least some) Russian arms and to export them (for at least a "transitional" period). To that end, he is urging Yeltsin and other Russian leaders to work to eliminate all "unfair" quotas and restrictions on the Russian arms trade. Maley calls his approach "economic conversion"—a meaning that has nothing to do with military conversion, but rather conversion to the market. "Economic conversion means turning the military-industrial complex into an export sector for a transitional period," said Maley in Nezavisimaya gazeta [February 28, 1992, pp. 1-2]. Defense firms will no longer be subsidized—they will be "self-financing," as in the old Soviet jargon. They should follow their own economic self-interests, which Maley believes (probably correctly) is to export as much as possible at as low a price as is necessary to sell. Maley projects revenues of $5 billion a year from arms sales. This then is to be used for "military conversion," although many observers have pointed out that it is highly unlikely that firms which have been successful in earning dollars in a particular activity will be eager to abandon it.

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Dual-Use Technologies and Export Administration in the Post-Cold War Era: Documents from a Joint Program of the National Academy of Sciences and the Russian Academy of Sciences Maley is being allowed to use one republic, Udmurtiya, as his test bed for this policy. The republic is all behind him, for understandable reasons: no less than 86 percent of its industry is defense-related! Maley has invited Arab nations and others to invest in Udmurtiya to help implement his policy. Much could—and should—be said about the consequences of Russian defense industry staking its hopes on the international arms trade. Not least among these consequences is what it implies for policies regarding transfer of dual-use technologies from the West. In my remarks in this paper, I have tried to look at the economic incentives for military conversion facing the individual firm. However, what makes sense for the individual firm may not make sense for the nation as a whole, or even for other firms. One of the social (as opposed to firm-level) costs of a policy of large-scale arms exports will be political restrictions, including restrictions on the transfer of dual-use technologies, to the Russian economy. A clear statement of what those costs might be, and who would bear them, would be useful in the current Russian policy debate.

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Dual-Use Technologies and Export Administration in the Post-Cold War Era: Documents from a Joint Program of the National Academy of Sciences and the Russian Academy of Sciences This page in the original is blank.