The Policy Context for Military Aerospace Offsets

Kenneth Flamm

Brookings Institution

With the end of the Cold War, military establishments around the world have been decreasing their force structures and spending by significant amounts. This decline in defense spending has made the linkages between the economics of the maintenance of national defense establishments and political-military security issues clearly visible as never before. One issue that is much debated, and highlights the linkages between the economics of international trade in armaments and U.S. national security interests, is the question of American policy toward so-called "offsets."

In this paper I examine the larger context in which the offsets issue is embedded. I argue that offsets are just one dimension—and not necessarily the most important one—of a much larger issue facing U.S. policy makers. Put most starkly, the United States might choose to vigorously promote its armaments exports through active export promotion policies (that match or even exceed what is done by other exporting nations) so as to further strengthen its defense industrial base and lower the acquisition costs of its defense systems. The United States can do this without paying a great deal of attention to the increasingly competitive atmosphere for exports of advanced military capabilities that it will be reinforcing. Or, the United States might instead try to work with its allies' competitive armaments industries to work out some regime that restrains at least some elements in international competition for sales of advanced weapons systems so as to reduce the proliferation of the most advanced capabilities and reduce the urgency (and resource requirements) of development programs for new and ever more sophisticated systems. The United States, in many respects, supplies resources used by both itself and its allies in fielding the most advanced systems competing in the international marketplace. Offsets are both an element in arms



The National Academies | 500 Fifth St. N.W. | Washington, D.C. 20001
Copyright © National Academy of Sciences. All rights reserved.
Terms of Use and Privacy Statement



Below are the first 10 and last 10 pages of uncorrected machine-read text (when available) of this chapter, followed by the top 30 algorithmically extracted key phrases from the chapter as a whole.
Intended to provide our own search engines and external engines with highly rich, chapter-representative searchable text on the opening pages of each chapter. Because it is UNCORRECTED material, please consider the following text as a useful but insufficient proxy for the authoritative book pages.

Do not use for reproduction, copying, pasting, or reading; exclusively for search engines.

OCR for page 115
--> The Policy Context for Military Aerospace Offsets Kenneth Flamm Brookings Institution With the end of the Cold War, military establishments around the world have been decreasing their force structures and spending by significant amounts. This decline in defense spending has made the linkages between the economics of the maintenance of national defense establishments and political-military security issues clearly visible as never before. One issue that is much debated, and highlights the linkages between the economics of international trade in armaments and U.S. national security interests, is the question of American policy toward so-called "offsets." In this paper I examine the larger context in which the offsets issue is embedded. I argue that offsets are just one dimension—and not necessarily the most important one—of a much larger issue facing U.S. policy makers. Put most starkly, the United States might choose to vigorously promote its armaments exports through active export promotion policies (that match or even exceed what is done by other exporting nations) so as to further strengthen its defense industrial base and lower the acquisition costs of its defense systems. The United States can do this without paying a great deal of attention to the increasingly competitive atmosphere for exports of advanced military capabilities that it will be reinforcing. Or, the United States might instead try to work with its allies' competitive armaments industries to work out some regime that restrains at least some elements in international competition for sales of advanced weapons systems so as to reduce the proliferation of the most advanced capabilities and reduce the urgency (and resource requirements) of development programs for new and ever more sophisticated systems. The United States, in many respects, supplies resources used by both itself and its allies in fielding the most advanced systems competing in the international marketplace. Offsets are both an element in arms

OCR for page 115
--> deals through which American firms compete against others in global markets and an instrument through which the United States ultimately ends up supporting both U.S. companies and their current and future international competitors. From a policy perspective, there are two big questions surrounding the use of offsets in defense trade. First, should the U.S. government attempt to unilaterally "countervail" foreign government policies (such as offset requirements) designed to improve the bargaining power of their firms against American suppliers? Or should the United States instead (or in addition) work toward a common international "rules of the game" for competition among potential suppliers of advanced military technology that might both create a ''level playing field" for competition and reduce economic pressures to sell ever more advanced technology to ever more dubious customers? Second, how can taxpayer and national interests in maximizing returns on defense technology investments be better aligned with private returns from technology transfer in situations in which the economic impact of the technology transfer may be felt well beyond the boundaries of the firm negotiating the transfer? In this paper I first examine the current economic environment for defense industries around the world. I then characterize the "big picture" that is stimulating more intensive competition among the major defense suppliers selling the most advanced systems into international markets, and I identify the major regions competing in this global market. Next, I discuss the government policy instruments affecting this competition and analyze the particular role of offsets and offset policy as a dimension of international competition. In the final section I identify policy issues tied to the use of offsets in global defense trade. The Current Economics of the Defense Industry A key economic fact is that the cost structure in many key high-technology defense industries is dominated by various flavors of economies of scale—in assembling and sustaining essential design capabilities, in systems research and development (R&D), in start-up costs, in production capacity, and in learning curves. The price of entry into development and production of the most advanced weapons systems is a large fixed investment, with unit costs declining sharply as the scale of production increases. A fundamental element of the national security policy of many nations (including most U.S. allies) is the creation and maintenance of their own independent, autonomous capabilities to produce at least some advanced weapons systems. During the 40 or so years of the Cold War, defense spending was large enough in most countries with pretensions to producing advanced weapons to enable production of these systems in sufficient volumes to at least approach affordability. With the widespread decline in national defense budgets, however, the only way in which many nations will be able to maintain a viable industry is by exporting a much larger portion of their output to overseas customers. This is

OCR for page 115
--> true in Western Europe, where despite trans-European defense industrial consolidation and halting steps toward a single European defense market, tremendous economic pressures to export leading-edge systems outside the North Atlantic Treaty Organization (NATO) alliance remain in force. It is equally true in Japan, where, with the active support of the Ministry of International Trade and Industry (MITI), Japan's defense industry is currently mounting a campaign to relax current policies prohibiting defense exports. It is even true in the United States, where, since 1995, formal conventional arms transfer policy for the first time has explicitly recognized the economic impact on the domestic industrial base as a considerable factor in decisions on arms exports. The Big Picture In even the medium run, lessened inhibitions on the export of advanced weapons—and increased competition for these sales among the United States and its allies—may have significant impacts on the political and military balance in many regions. In the long run, because retention of a significant technological advantage over adversaries is critical to U.S. military strategy, proliferation of advanced capabilities through the export of weapons by U.S. allies may ultimately be the threat forcing the United States to once again increase its own defense spending and accelerate the development of new generations of systems at a time when budget realities allow little margin for doing so without sacrificing other national priorities. One excellent example of this phenomenon is use of the so-called "gray threat" (as a recent RAND Corporation study described it) to justify the rapid development of the F-22 fighter. With the imminent production of European fighters (e.g., Eurofighter, Rafale, Gripen) that are beginning to approach the quality of current U.S. front-line fighters and the necessity for the Europeans to export these aircraft to reduce their unit cost, it is likely that U.S. forces will need to deploy even more-advanced fighters in the not too distant future so as to guarantee the assumed substantial margin of superiority over aircraft in the hands of conceivable adversaries. Indeed, once it seems likely that U.S. allies will be willing to sell a relatively potent system to a foreign buyer, there is a considerable argument for instead supporting the sale of an equivalent U.S. system on the grounds that the United States might as well reap the political and economic benefit—and the advantages of a closer military relationship—for itself. In effect, given sufficient competition from U.S. allies, there is a perverse but compelling logic for the United States becoming its own "gray threat." Thus, there is a complex, self-reinforcing dynamic at work. With declining defense spending, exports have become critical to the very survival of most defense industries outside the United States. Retention (or creation in some cases) of economically viable, indigenous defense systems capabilities is viewed as fundamental to national security in many nations, leading to aggressive economic

OCR for page 115
--> competition for defense export opportunities. The increasing economic pressure to export ever-more-advanced capabilities, in turn, may alter delicate strategic balances in sensitive regions. Changes in the strategic balance may trigger even greater or wider interest in acquiring advanced systems, and ultimately, create more pressure to accelerate the pace of development of new systems by the most advanced military powers. One can dimly imagine two possible new equilibria: a regime with much higher levels of defense spending in which the economic pressure to export the most advanced capabilities has subsided to more manageable levels, or, alternatively, the construction of a more cooperative regime for arms sales in which a handful of military powers with any realistic potential to develop the most advanced military systems agree to some degree of mutual restraint on exports to third parties, perhaps in exchange for some program of industrial and technological cooperation that assures the survival of core defense industrial capabilities deemed essential to national security. This last idea has gone by various names—a suppliers' cartel, an "inner circle," etc.—and is probably best viewed as an experiment to be pursued rather than a crystal clear vision of a particular endpoint. The current market for defense exports provides excellent illustrations of the fundamental linkages and tensions between U.S. security policies and U.S. policies that promote defense exports. In the discussion below I focus on process and organizational issues as well as the particular policies that are pursued. The Competitors To begin, there are basically three countries that sell advanced weapons systems worldwide: the United States, Europe (which in practical industrial terms is beginning to move toward a single European conglomerate in some, though not all, defense sectors), and Russia. Japan has capabilities in defense systems that are highly advanced, but at least until now, has enforced a self-imposed ban on exports. China does not produce the most sophisticated systems, but is an important exporter of middle- and low-end equipment. U.S. industry is the 600-pound gorilla, accounting for about one-half of worldwide arms transfer deliveries.1 At least one reason for this is very simple: The United States spends far more on developing new technology and systems. Figure 1 shows the distribution of defense R&D spending between the United States, its NATO allies, and Japan in 1994. The United States accounted for over 70 percent of the total. The United States enjoys a similar advantage in the size of its internal market 1   Arms Control and Disarmament Agency figures show almost exactly a 50 percent U.S. share of arms deliveries over the 1992-1994 period.

OCR for page 115
--> Figure 1 Distribution of alliance R&D. Figure 2 Distribution of alliance procurement.

OCR for page 115
--> (i.e., its defense procurement budget). Figure 2 compares U.S. procurement with the remainder of its NATO allies and Japan. The United States was slightly less than half of the total; the runner-up was Japan, with about 16 percent of the pie. (This suggests, incidentally, that if Japan were ever to seriously enter the global armaments markets, its domestic output makes it an immediate contender to be the second most efficient producer of military systems.) Indeed, the real question is—with over 70 percent of allied R&D, how is it that the United States has only a 50 percent share of the global defense trade? Is the United States that inefficient? Are the performance advantages of American systems that much more costly at the margin? Casual observation suggests that the United States is not grossly less efficient than its allies, and whereas the squeezing out of marginal performance advantages on the bleeding edge of the technological frontier may be disproportionately costly, this too seems unlikely to explain the bulk of this gap. Rather, it seems likely that the United States, through a variety of policy choices, has in effect subsidized the development of high-technology weapons systems by its closest allies. The mechanisms have included a deliberate policy of liberal transfer of technology, on the cheap, to allies through co-production, licensed production, and co-development programs and a variety of policies (such as waiver of recoupment of R&D charges on export sales of components and systems, intellectual property policies, etc.) that make it possible for foreign competitors to acquire some of the key components of high-technology weapons systems at prices that may approach their marginal cost of production. Buying a U.S.-built radar design at only a modest premium over production cost and inserting it in a European fighter, for example, allows the European systems integrator to market a state-of-the-art platform without investing in an enormously costly development effort on the radar subsystem. Having an American defense contractor work as a joint venture partner on air-to-air missiles may provide access to technologies developed at great U.S. taxpayer expense for a much more modest cost. This is not to say that doing this was irrational from the U.S. perspective. Strengthening U.S. allies militarily (including their industrial capabilities) was a security interest of the United States that was given priority over possible implications for longer-term economic competition during the Cold War. Often, U.S. allies built protective walls around their defense markets, and giving them access to U.S. technology was one of the prices for slipping over the walls. The decision was an economic one—selling them something, with some return, was better than selling them nothing, and earning no return on technology that in any event had already been paid for. The decision reflected a political judgment—industrial cooperation strengthened U.S. alliances. And the decision was a military one—given that the United States would fight alongside its allies, why not give them the same equipment to use and build a greater operational military coherence? The structure of incentives within the U.S. acquisition system was another

OCR for page 115
--> factor promoting bargain basement technology transfer to U.S. allies. U.S. defense contractors were, after all, contractors. The costs of technology development were funded primarily by the taxpayer (although the property rights to the technology, when not used by the U.S. government, generally went to the contractor). Unlike the situation in commercial high technology, a company did not have to define a pricing structure for its output that allowed for a reasonable return on technology investments to be recovered so as to remain viable. Furthermore, because often there were competing U.S. contractors able to offer competitive solutions, foreign governments—with considerable monopoly power—were able to play the contractors off against one another so as to negotiate the most favorable possible terms in acquiring U.S. technology. U.S. policy, because the government was forbidden from favoring one contractor over another in competing for foreign sales, did nothing to improve the bargaining position of U.S. firms and the increased economic rent earned on taxpayer-funded military technology investments. U.S. contractors, of course, always had their own economic self-interest to guide their decision making. If a company decided, for example, to transfer technology representing a taxpayer investment of $4 billion to Japan for $800 million in licensing fees, it presumably was making the judgment that, in the long run, its potential returns on sales lost to future Japanese competition making use of those technologies was valued at less than $800 million. But if government investments in similar technologies were also earning returns for other U.S. companies, it is easy to see how the company's calculation of a floor on what it would be willing to accept for use of the technology, and a national calculation, might logically diverge. I return to this point below. In short, both the data and the structure of the U.S. acquisition system naturally lend themselves to speculation that what Figures 1 and 2 really depict is the United States shouldering much of the burden of development cost for systems procured and built by its allies. That is, U.S. policy, in addition to underwriting the cost of sustaining the most formidable and effective defense industry in the world—its own—also in effect underwrote its own industry's principal competitors. U.S. policies supporting defense exports are at least a part of this story. Government Policy U.S. policy supports defense exports through three principal avenues: 1. Granting of export licenses. Weapons systems and major system components are all subject to export control. In principle, licenses are only granted when it is in the security interest of the United States; an explicit recognition of the role of arms exports in strengthening the U.S. industrial base was added by the 1995 Clinton administration conventional arms transfer policy. There are no broad criteria or principles that guide decision making on license applications—the meth-

OCR for page 115
--> odology is explicitly case by case, with a regional focus and with no guarantee of logical consistency within or across regions. The concept of "benchmarking"—producing general guidelines detailing under what circumstances differing levels of advanced technology could be released as a tool to improve the consistency and coherence of the licensing process—has been the subject of some discussions, but never broadly implemented. In practice, the de facto process by which licenses are granted boils down to a nation requesting a license to learn about or actually buy something (which not infrequently follows informal contracts with a U.S. contractor wishing to sell something), followed by an interagency review process in which the U.S. departments of Defense (DoD), State, Commerce, Energy, the Arms Control and Disarmament Agency, the intelligence community, and possibly the National Security Council can play significant roles. The agencies not infrequently have different views—economic and trade interests versus security considerations versus proliferation concerns versus diplomatic issues—and as the Nolan Commission recently observed, "Bureaucratic warfare rather than analysis, tends to be the modus operandi in what is often a protracted process of plea bargaining and political compromise that may not reflect long-term national objectives." The administration of the system is also very far from space age. Needless to say, the significant potential for uncertainty and delay built into this process—albeit now much improved from a business perspective—can remain an obstacle to exports. Congressional prohibitions have placed further restrictions on policy makers in specific cases of regional arms transfers. On the other hand, one can argue that, with the increased recognition of economic benefit as a legitimate arms export policy objective, the system has been gradually tipping toward a presumption that—excepting particularly disreputable would-be customers—if someone else is able and willing to sell a particular capability to a buyer, then it might as well be the United States. 2. Diplomatic and administrative support. As the U.S. foreign diplomatic infrastructure became aware that encouraging U.S. exports was a priority for current government policy, a greater involvement in even-handed support to U.S. contractors in winning competitions for military exports developed over the past few years. The support took the form of sharing unclassified insights on what is going on within often opaque budget planning in foreign governments, embassy lobbying with local government officials, U.S. military lobbying with foreign militaries, and senior political appointees lobbying hard for U.S. solutions with their foreign counterparts. In my experience, this has been perhaps the most important and effective element of U.S. policy support for military systems exports. On the other hand, I have also observed questionable excesses. One example—an East Asian one—was that of an ambitious young ambassador, who with minimal interaction with local U.S. military staff (but presumably greater contact with the U.S. contractor eager to make the sale), was pressing local defense officials hard to buy an advanced military helicopter. Behind the scenes,

OCR for page 115
--> senior military staff from the DoD's Pacific Command were scratching their heads in befuddlement, observing that the local military had not yet absorbed the tons of recently acquired equipment they were already struggling to master. Furthermore, what was the country's neighbor—also a U.S. ally—going to think of this proposal? Ultimately, once again the calculus ended up boiling down to the fact that if some enterprising salesman—official or unofficial—convinced the locals that they wanted something, then it might as well be the U.S. that does the selling. 3. Financial subsidies to exports. U.S. defense contractors have lobbied successfully for some new financial supports for defense exports by arguing for a "level playing field."2 The two principal subsidy proposals that have attracted attention in recent years are a waiver of R&D recoupment charges on exports sales and an export loan guarantee facility similar to Exim Bank programs for non-defense exports. The leveling argument has both a domestic component—armaments should receive the same type of treatment that other goods receive—and a foreign component—foreign governments give their firms financial support in exporting, and therefore the United States should too. This logic is attractive at first glance, but it has two problems. The first one is the implicit assumption that defense exports are—putting aside the special nature of their customers and application—like other traded goods. The second problem is the assumption that broadly focused export subsidies are likely to be a cost-effective tool for increasing export sales. Generally, weapons systems are not like other traded goods in that a national security exemption has exempted them from the subsidy and antidumping disciplines of the General Agreement on Tariffs and Trade (GATT). Thus, although it is true that producers of industrial goods making use of R&D that is funded by other government agencies are not forced to pay a R&D recoupment charge (charges to foreign customers covering a portion of the government's investment in R&D), the extent to which those export sales of goods can be subsidized by government are severely limited by the ability of foreign competitors to seek countervailing duties and antidumping orders. No such restraints apply to weapons systems, which are presumed to be covered by the national security exemptions in the GATT. In fact, one could reasonably argue that "dumping" (pricing exports below full average cost of development and production) is normal practice in international competition in defense systems, unlike virtually any other class of traded goods facing the disciplines of the GATT. The waiver of R&D recoupment charges (charges to foreign customers covering a portion of DoD's development costs for a system) has some particularly important economic implications in calculating the economic benefit to DoD from 2   Another form of support for DoD exports that periodically has been the subject of discussion is DoD payment of the costs for its participation in air shows and trade expositions where weapons systems are exhibited to potential customers. Current policy is to pay for such participation in the most important such shows.

OCR for page 115
--> defense exports. First, it means that the benefits will be felt mainly through cost declines derived from production-scale economies and learning curves (and possibly through avoidance of shut-down and start-up costs when exports keep lines "warm"), and not through spreading of R&D costs over a larger output. Second, as already stated, it means that foreign users of defense components have potential access to U.S. technology at marginal cost, enabling them to be competitive in systems where they might otherwise be unable to compete against U.S. producers. R&D recoupment charges have been waived since 1992 for commercial sales. For foreign military sales made on a government-to-government basis, DoD has long had the discretion to waive R&D recoupment charges on sales to NATO, Japan, Australia, and New Zealand and has routinely done so. Since 1996, congressional authorization to do so in other cases has existed. In 1996, Congress also authorized a system of loan guarantees for defense exports that could support up to $15 billion in sales. This system is required to be " self-financed" through fees charged to the buyers (cynics argue that the Office of Management and Budget "scoring" system used to assess the probability of default in fixing these fees introduces some element of subsidy vis-à-vis market rates, whereas others argue that the paperwork required by the system should be counted as a cost). To date, after about a year of operation, not a single export sale has actually made use of this self-financed program. Doubts about the efficiency of general subsidies as a tool to promote defense exports are raised by an analysis of actual markets for defense systems. DoD's 1994 forecast of arms exports3 divided arms deliveries into two categories—goods already under contract for future delivery and products not yet under contract. The global split for worldwide arms trade for 1994-2000 was about 50-50 in these two categories. Within the "not yet under contract" category, foreign purchases were divided into three categories: (1) the U.S. was the only source for the system the customer was likely to specify, (2) the U.S. was not in competition (it did not produce a cost-effective or competitive system, or the United States did not sell to a particular customer as a matter of foreign policy), and (3) the United States was in competition against other foreign arms producers. Of deliveries during 1994-2000, only 11 percent were in this last category (see Figure 3). The inference was that U.S. arms exports would be at least 48 percent of world sales over this period, and at most 59 percent. Therefore, absent any policy changes, no more than about 10 percent of a 50-60 percent market share was in play when changes in export policy are being discussed (see Figure 4). The conclusion was that an 3   Requirements-based forecasts by the intelligence community were aggregated into an unclassified format and published as Worldwide Conventional Arms Trade (1994-2000), A Forecast and Analysis, Office of the Undersecretary of Defense (Acquisition and Technology), U.S. Department of Defense, December 1994.

OCR for page 115
--> Figure 3 Supplier market share of total worldwide arms deliveries (1994-2000). Figure 4 Bounds on U.S. arms exports (1994-2000).

OCR for page 115
--> efficient export subsidy policy should be selective—picking customers and sectors in which real competition was in evidence and in which it was likely to have a significant impact on DoD's industrial base. Offset Policy? One policy instrument that did not make the list above is U.S. offsets policy. This is because, officially, the United States has no offsets policy. To understand why, first I define exactly what an offset is. Most simply put, an offset is a transfer of goods, services, or other commitments by a vendor and customer that are bundled with the sale of a good or service, but are not required to effectively support the original sale. Offsets may typically include such things as transfers of technology, agreements by the seller to purchase from local suppliers with some connection to the buyer, agreements to invest in production or other facilities in geographical proximity to the buyers, or agreements by the seller to meet certain performance targets (e.g., export requirements) or undertake other unrelated activities (e.g., countertrade) on behalf of the buyer. One can even point to certain transactions that might be regarded as ''reverse offsets," with the vendor reducing the price or providing additional services in exchange for commitments by the buyer that would not normally be part of a "straight" sale (e.g., agreement by aircraft vendors to reduce prices in exchange for buyer agreements to exclusively purchase their product over some future period). Offsets, if defined merely as the activities listed above, are not uncommon in purely private arrangements between private companies operating in today's global markets. Many agreements associated with the rapid growth of so-called "strategic alliances" among multinational companies tie other commitments and activities in with the sale of goods and services to strategic partners. This "barter" of rights to technologies, or other goods and services, transferred between companies, tied to an agreement in which cash may also flow between companies, is common among high-technology companies. It might be argued that this is a reasonable way of dealing with the high degrees of risk and uncertainty in valuation of the future economic impacts of technology. It is therefore not difficult to see why there is no official U.S. offsets policy. Officially, offsets are a purely private matter between two companies, and there is no reason for the government to intervene. In fact, if it did intervene officially, the government might find itself enmeshed in the details of a competition that might involve two different American firms. Although government officials would have no problem supporting a proposal by an American firm over foreign competitors, favoring one U.S. company's proposal over another's is absolutely forbidden. But at another level, the U.S. government vaguely disapproves of offsets, which it sees as a distortion introduced into international trade that it would pre-

OCR for page 115
--> fer to end. What really makes an offset a matter for official government displeasure is the overt or covert intervention by another government into the terms of what otherwise might be a purely private transaction. At a still deeper level, the U.S. government is a practical and enthusiastic supporter of offsets used to promote defense sales. If there are going to be offsets, goes the logic, the United States should be able to provide offset packages that will allow the United States to win in competitions with others. Pragmatic U.S. defense officials in recent years have often lobbied for U.S. solutions in foreign defense markets (for both economic and national security reasons), and part of that lobbying has been to assure foreign customers that U.S. suppliers would be allowed to provide "competitive" offset packages. This highlights the fact that at the deepest level, there is a de facto offset policy when the offsets involve (as they usually do) technology transfer. Such military sales (and many commercial aerospace sales that bundle an offset involving sensitive dual-use technology transfer to a foreign producer) must be approved through the export control process. Approval in this process typically has (at least in recent years) considered the availability of similar technology through offsets provided by foreign firms competing against the American companies seeking export licenses. Thus, the official policy leverage over privately negotiated offset packages has been, and continues to be, approval of export licenses. Issues for Offset Policy Government-mandated offsets in military aerospace connect three economic issues. First, foreign offset requirements can be used to affect the terms of private transactions in ways that improve deals from the perspective of foreign purchasers of U.S. products and technologies, or further other foreign government objectives. Second, because offset requirements in defense often involve the transfer of U.S. technologies funded by public budgets, the incentives of a firm selling such a technology to a foreign buyer can diverge from a more inclusive national calculation of the costs and benefits of a particular deal. Third, offsets can be viewed as a potential backdoor around disciplines imposed on trade and investment by the GATT and the World Trade Organization (WTO). Bargaining Power and the Terms of Transactions Offset requirements are imposed by foreign governments as a bargaining tool to influence the terms of transactions involving export sales of American defense technology and products. One objective may be to increase the bargaining power of domestic firms in negotiations with U.S. defense suppliers. By pairing a national preference in defense procurement with government-mandated offset requirements on imports of foreign products or technologies, governments

OCR for page 115
--> can improve the terms of deals struck between local firms and American partners. Where local firms might otherwise be competing against one another by offering ever more favorable deals to potential American partners, offset requirements can set a minimum floor on the types of deals with local firms that are acceptable to the government, increasing the bargaining power of local firms vis-à-vis possible American vendors. A minimum set of requirements can be designed to improve the terms on which foreign goods and services are purchased by local firms. Obviously, in "commodity" markets with many vendors and a price that approximates long-run costs of production, there is little scope for such policies to accomplish much. In imperfectly competitive markets—such as defense—with small numbers of sellers or buyers, however, such policies can significantly effect the terms on which deals are cut. Government-mandated offset requirements may also serve other political and economic agendas: In economies where government has an explicitly developmentalist view of its role in promoting industrial growth, offsets can be an element of a national industrial policy. In economies where government has a major influence on the behavior of certain non-defense sectors (because of public ownership or regulation), governments are frequently tempted to impose formal or informal offset requirements on procurement from abroad that are linked to politically popular (though economically debatable) goals such as jobs or export creation. The same objectives can motivate offsets in defense as well. In all countries, defense purchases (closely linked to the aerospace sector) are undertaken by a single customer (the government) with a non-economic goal (the national security). Transactions involving domestic and foreign defense firms (and non-defense goods and services with defense applications) are scrutinized and shaped by all governments to reflect their perceived national security interests. The latter may have an explicitly economic component (protecting or stimulating the defense industrial base). The policy issue for the United States is that it is apparently acceptable for a foreign government to organize foreign buyers in a way designed to increase its monopsony power (i.e., imposing offset requirements) vis-à-vis sellers seeking to penetrate that national market (or to exert that monopsony power directly, if the foreign government is the sole potential buyer) so as to increase some measure of national benefit. Would it also be desirable for the U.S. government to help organize U.S. sellers in ways that increase their bargaining power—and U.S. national benefit—to countervail foreign buyers organized in monopsony-enhancing ways? Some such forms of monopoly-power-enhancing organization are already permitted. Voluntary private export cartels (domestic international sales corporations) are legal if certain requirements are met. Government-led efforts are un-

OCR for page 115
--> likely to be successful, unless the government is funding much of the product development or technology export is regulated directly by the government. Both of these conditions, however, are met in the U.S. defense industry. Of course, if there are foreign providers of the same systems that are not part of a U.S.-organized supplier's club or are not subject to U.S. government-imposed export restrictions, there is a good chance that a U.S.-only effort to impose limits on exports would fail, and the United States would simply give the business to foreign suppliers. On the other hand, in high-end military systems, there are a relatively small number of countries with advanced capabilities, most of whom are U.S. allies, and it is not impossible to envision some grand agreement on limits on technology transfer to support common security objectives, if some part of that agreement also addresses the ability of all parties to maintain needed defense-related industrial capabilities. This was the idea behind the "inner circle" concept mentioned above. In commercial industries with limited numbers of international players, it is also possible to conceive of international arrangements that might benefit vendors facing buyer offset demands. Boeing and Airbus, for example, might in theory be sanctioned by their respective national antitrust authorities to set common maximal limits on co-production or technology transfer conditions attached to commercial sales deals to complement Euro-American national controls on defense aerospace technology exports. Public Investments and Private Profits One bright line separating defense offsets from commercial offsets is the role of governments in funding R&D. Although private firms are probably best equipped to secure the deals that capture the maximum return on private investments in new technology, the same may not hold true when it comes to securing the maximum national return on public investments in new technology. For example, if $15 billion is invested in developing a new engine technology, a firm may logically consider its direct return from licensing the technology and $3 billion in lost profits on possible future sales won by its now more competitive foreign licensee and decide that $4 billion in licensing fees is a good deal. If the company alone invested in the technology, that would be the end of the discussion. If the government funded the $15 billion, however, and made the resulting know-how available to multiple U.S. companies, it might reasonably want a U.S. company to consider the possible costs of future competition to other U.S. firms as well. If this future loss from the new competition to all U.S. firms were, say, $6 billion, the $4 billion licensing deal would be considerably less attractive from a national perspective. This is a calculation that a U.S. company would not normally make in evaluating the deal from its own purely private perspective, but it might be the appropriate one in considering the transfer of know-how based on publicly funded R&D.

OCR for page 115
--> Although the solution to this problem is far from clear, it is equally certain that the terms on which publicly funded technologies are transferred or sold to foreign buyers by their private developers will continue to be the subject of vigorous public debate when those technologies draw from a common pool of knowledge extending beyond the boundaries of the seller. The government, as the custodian of the public interest in taxpayer-funded R&D, will continue to be called on to make decisions and defend them when export of technology is considered. We should also accept that the bright line between military and commercial investments is often much fuzzier than is commonly acknowledged. Most commercial jet engines developed over the past 20 or 30 years, for example, were largely based on cores and other technologies originally developed for military platforms. Indeed, the jet engine business remains highly dependent on military-funded R&D for much of the continuing advance in its technology base, despite the fact that only one-fourth of the value of U.S. shipments today comes from military units. The Trading Regime Offsets might be regarded as a form of subsidy to exports (because other goods, services, and commitments with some economic value are being bundled into a sales transaction). There are restrictions on subsidies and pricing behavior in international trade that discipline the use of such subsidies, and governments therefore are interested in offsets as a trade issue in sectors where they may be used to promote exports by national companies. The defense sector (including much of aerospace) is unique in this regard in that the national defense "escape" clause written into the GATT exempts defense goods and services from some of the effects of these disciplines. The limits on "greenlighting" of R&D subsidies to product development in commercial sectors, for example, arguably do not apply to defense articles. Indeed, one might even argue that what might be labeled as "dumping" (sales of products at prices that do not cover the fully loaded—including R&D—cost of production) is routine practice in international sales of defense articles. There is a real danger that offsets can be used as a backdoor around GATT trade disciplines. One example is the apocryphal (but generally accepted) account that has the Japanese government agreeing to use its good offices (and regulatory powers) to encourage Japanese airlines to purchase Boeing aircraft in exchange for Boeing's increased use of components made by Japanese aerospace suppliers. (Japan Air Systems reportedly defied the government pressure and purchased Airbus jetliners at a very good price, at the cost of a considerable negative campaign in the press and elsewhere against it.) In essence, the European supplier of Airbus became a "less favored nation" when selling into the Japanese market. In a similar view, a Boeing executive publicly acknowledged at a National Academy of Sciences forum in the early 1990s that Japan's MITI had cut a deal that

OCR for page 115
--> involved assuring Boeing that Japanese aerospace companies would not team with Airbus to produce a new aircraft competitive with Boeing's line in exchange for work guarantees in producing components for Boeing aircraft. Both agreements could be interpreted as offset arrangements, although these agreements also have a certain "informal" quality that make them less transparent than examples normally raised in discussions of offsets. The challenge to the spirit, if not the letter, of the GATT is obviously much more relevant to offsets in commercial sales because defense is given a wide berth by WTO disciplines. In the long run, the solution to this problem may well be an explicit definition of "informal" trade barriers covered by GATT principles that includes offsets and further agreements on transparency of procurement procedures in government-owned, regulated, or subsidized industries that ultimately defines government offset requirements as an explicit trade barrier. But as noted above, the dividing line between defense and commercial products is not always sharp. Some might even argue that this line is growing ever wider and fuzzier as more and more industries historically dominated by military procurement (such as space) increasingly turn to commercial customers and financially strapped defense ministries turn to low-cost commercial alternatives for specialized defense components historically purchased from a captive military supplier base. Conclusion With defense downsizing in full swing around the globe, all major producers of high-technology armaments other than the United States face virtual economic crisis in their defense industries. Unless they are willing to give up maintenance of a national capability to produce advanced military systems as a national security objective (exceedingly unlikely), this means that they will be pushed to (1) close off their national markets to foreign-built systems and (2) dramatically increase exports. In the long run, this is likely to raise significant problems for the United States. Offsets are a competitive tool used by both buyers and sellers in an increasingly cutthroat global market for defense equipment. The United States is alone in being able to sustain a viable, broad-based defense industry solely on the strength of its large domestic market; other countries with advanced arms industries must export substantial volumes of defense goods into a shrinking global market just to keep their industrial base economically sustainable. Offsets create policy challenges in three ways. They offer a way for governments to insert themselves into private transactions to increase the bargaining power of domestic firms in international agreements or advance other government objectives. If successful, however, offset requirements may invite retaliation through a countervailing policy of organization of private or public cartels among suppliers. (This might even work in industries with small numbers of

OCR for page 115
--> suppliers, such as defense and aerospace.) Second, their use as leverage to force technology transfer from private suppliers raises difficult policy questions about the extent to which private interest fully captures the public interest in technologies funded out of public coffers. Third, use of offset requirements is a backdoor challenge to the GATT vision of open global markets. The obvious alternative in military aerospace that addresses both the big issue of unrestrained exports of advanced military capabilities and the smaller issue of offsets (one tool used to pry open greater technology transfer) is to work through some sort of system of industrial and technical cooperation with major U.S. allies (Europe and Japan). Some arrangement would be needed that would maintain access by U.S. defense producers to these important markets while permitting U.S. allies to maintain core defense systems capabilities and restrain the unchecked proliferation of advanced military exports. The United States—as the only nation that can maintain an economically affordable advanced defense sector without relying on exports—must play a leadership role in constructing such a system. The massive investment by the United States in military technology—which in effect underwrote the development of allied industrial capabilities in the first place—continues to provide us with enormous leverage that can be utilized for this purpose.