Panel 1
Offsets in Commercial and Military Aerospace: An Overview

David C. Mowery

University of California, Berkeley

Dr. Mowery explained that his paper provides some background and an overview on aviation offsets. Defining offsets is a tricky issue, especially finding a definition that spans both military and commercial sales. On the military side, the classic definition of an offset is that it is a requirement for a transaction associated with a weapons system sale that goes beyond what is "normally" required to make the sale. Such a requirement may be a co-production arrangement under a government-to-government agreement, licensed production offshore negotiated between the company and a foreign government, or purchase of components by the company for inclusion in the weapons system. Indirect offsets include the purchase of components, technology transfer, technical assistance, or other forms of assistance provided to the purchaser. That assistance could extend well beyond the aerospace industry. On the commercial side, the blurriness of the definition is even more pronounced, often involving some form of strategic outsourcing such as technology transfer, or purchasing of components that goes beyond what would normally be assumed to be commercially necessary. Given these definitional difficulties, it is subsequently hard to collect data on trends, magnitude, and content of offsets on the commercial side. It is also important to keep in mind the difference between direct and indirect offsets, especially because the impact of indirect offsets is likely to be more diffuse.

Military Offsets

The origins of military offsets go back to policies to support the rearmament and reconstruction of the defense industrial base and the development of interoperable weapons systems between the United States and the allies. Over time, a



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--> Panel 1 Offsets in Commercial and Military Aerospace: An Overview David C. Mowery University of California, Berkeley Dr. Mowery explained that his paper provides some background and an overview on aviation offsets. Defining offsets is a tricky issue, especially finding a definition that spans both military and commercial sales. On the military side, the classic definition of an offset is that it is a requirement for a transaction associated with a weapons system sale that goes beyond what is "normally" required to make the sale. Such a requirement may be a co-production arrangement under a government-to-government agreement, licensed production offshore negotiated between the company and a foreign government, or purchase of components by the company for inclusion in the weapons system. Indirect offsets include the purchase of components, technology transfer, technical assistance, or other forms of assistance provided to the purchaser. That assistance could extend well beyond the aerospace industry. On the commercial side, the blurriness of the definition is even more pronounced, often involving some form of strategic outsourcing such as technology transfer, or purchasing of components that goes beyond what would normally be assumed to be commercially necessary. Given these definitional difficulties, it is subsequently hard to collect data on trends, magnitude, and content of offsets on the commercial side. It is also important to keep in mind the difference between direct and indirect offsets, especially because the impact of indirect offsets is likely to be more diffuse. Military Offsets The origins of military offsets go back to policies to support the rearmament and reconstruction of the defense industrial base and the development of interoperable weapons systems between the United States and the allies. Over time, a

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--> series of co-production agreements evolved into initiatives by allies to become more involved in development, as well as licensed manufacturers. Data collected between 1980 and 1995 show no clear trend in the percentage of weapons systems sales accounted for by offsets, with a bump up to 80 percent in 1995 but long-term fluctuations around an average of 45-55 percent. There is a clearer trend, however, in the increase in the proportion of indirect to direct offsets. Only half of these indirect offsets involve aerospace; thus, an increasing number of military offsets affects companies outside the aerospace industry. This is especially true with respect to military exports to Pacific Rim countries. There are complex interactions between commercial and military offsets. The many military co-production and licensing agreements allowed the reconstruction of significant manufacturing capacity, employment bases, and aerospace infrastructures in countries allied with the United States. This in turn created a demand for offsets, much of which was sought in the form of civil or commercial business. Demand for commercial offsets began in a significant way in the 1960s and 1970s, a few decades after the beginning of military offsets. Motives for Commercial Offsets There are three motives driving commercial outsourcing: market access; a desire to spread risk and gain access to capital, including financing from governments interested in building their domestic aerospace industries; and access to product and process technological skills that are equal to or superior to that of U.S. domestic suppliers. It is important to remember that these motives are reactions to both purely technical and commercial forces, and to trade-distorting government interventions. Separating these two factors, market forces and government intervention, is very difficult. Dr. Mowery also noted that the U.S. firm that was the least successful in managing this international outsourcing and strategic alliance building was McDonnell Douglas. This inability to manage effectively these relationships, especially the inability to tap into funding sources to expand and maintain its product line, reduced McDonnell Douglas' share of business. Thus, there is a question as to whether aerospace companies can remain viable without maintaining these complex strategic alliance networks. Impact of Offsets Dr. Mowery observed that the effects of offsets are difficult to assess for three reasons:

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--> the lack of clear demarcations among the different categories; the long time required for effects to reveal themselves; and the difficulty in specifying the counterfactual (i.e., what would have happened in the absence of the offset). Thus, a key analytical issue is whether U.S. firms could succeed in making substantial international sales without employing offsets. Answering this counterfactual is very difficult. However, it is clear that, absent some level of offsets, foreign sales are not likely to be made. A second issue is the impact of indirect versus direct offsets on technology transfer and employment in the aerospace industry. The impact of indirect offsets, which are the more rapidly growing portion of offsets, is much more difficult to trace. A third question on the commercial side concerns our ability to tease out what portion of the offsets are in response to government pressure. Another issue concerns the outsourcing activities of non-U.S. companies. Dr. Mowery suggested that there may be a broader pattern of increased intraindustry trade in components and subassemblies, which may result in increased exports by U.S. suppliers. He noted that his paper shows that the trade surplus in U.S. aircraft parts has, in fact, increased in the past eight years. These questions are especially relevant when looking at the employment impact, particularly the comparison of the impact from indirect and direct offsets. This type of analysis requires a complex set of distinctions between the wages and the relative labor content of the non-aerospace industries affected by indirect offsets versus the aerospace industry affected by direct offsets and the export sale. Impact of Technology Transfer Concerning the impact of technology transfer, Dr. Mowery noted that there is little evidence that technology transfer through military offsets has had a major impact on building up the civilian aerospace production and design capabilities of non-U.S. firms. Technology transfer has expanded the capacity and manufacturing capabilities of non-U.S. aerospace industries. However, if we take into account that, particularly in Western Europe, there was an aerospace industry that began the post-World War II period at a high-level of technological capability, it is not clear that the offset transactions, per se, have had a major effect on building up the prime contractor tier of non-U.S. aerospace industries. Still, it remains difficult to trace the impact of these technology transfer agreements for long periods of time. Certainly the generic capabilities, such as production capacity, tooling, and the maintenance of a skilled work force, have been strengthened by some of these agreements. Nevertheless, entry to the prime contractor tier, especially in the commercial sector, remains difficult. The trend in the industry has been the exit of prime contractors, not entry.

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--> Consequently, Dr. Mowery suggested that the most likely impacts of offsets will be on the supplier tier. Because of the many influences affecting this sector of the industry, it is difficult to analyze the impacts of offsets. It is a large segment of the industry with many small firms and has not been very well tracked by public data. The Industry Outlook Concerning the trends and outlook for the industry, the most rapidly growing markets for commercial aircraft are outside the United States. However, the largest single market will continue to be North America, where demands for offsets are more manageable. Over a longer period, continued bilateral competition between Boeing and Airbus, and trilateral competition among Rolls-Royce, Pratt & Whitney, and General Electric, will continue the pressure for offset agreements. On the military side, substantial excess capacity means that competition in weapons systems is likely continue to intensify. A Limited Role for Offsets Dr. Mowery stressed that the contribution of offsets to employment shifts, compared with the broader trends of internationalization in the aerospace industry, is quite modest. The overall technological and employment impact of offsets on the aerospace industry is small when compared with the impacts of rationalization and defense downsizing. Thus, although not a trivial issue, the employment impacts of offsets per se are not the most important problem. Nonetheless, there remains a legitimate basis for developing a policy response to displacement and employment loss in this industry because of increased internationalization-as there is to respond to trade-related displacement in any industry. Any response to offsets and broader trends of aerospace restructuring needs to deal with the trade-distorting policies of other governments, combined with ways of dealing with the adjustment issue domestically. Policy Tools The United States has a number of international tools to deal with trade-distorting behavior of other governments in both the commercial and the military sectors. These include international codes of conduct for military sales; various trade agreements under the General Agreement on Tariffs and Trade (GATT) such as government procurement and trade-related investment measures, although national security exemptions generally preclude their applicability to military offsets;

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--> various agreements on trade on large civil aircraft, such as the United States-European Union agreement; prohibitions on offsets in U.S. military sales financed under the foreign military sales funds program; and bringing Pacific Rim nations into negotiations over codes of conduct for military sales and elevating the offsets issue in the negotiations with the People's Republic of China on GATT accession. However, it is important not to let offsets dominate discussion over the very real costs and adjustment issues associated with increased internationalization in the aerospace industry. The costs of offsets, both economically and politically, are very real. But analysts and policy makers must keep a sense of proportion in addressing the different causes and fashion the tools to deal with what are different sets of problems. Discussants Sally Bath U.S. Department of Commerce Although agreeing with Dr. Mowery's description of the growing internationalization of the commercial aerospace industry, Ms. Bath observed that, at the same time, there are continuing efforts toward greater internalization now under way in Europe. The appearance of new European government subsidies, specifically designed to displace U.S. supplier firms from the European market, is particularly disconcerting. These targeted subsidies may have a larger impact on U.S. employment than offset agreements and may represent a first salvo against the U.S. subcontractor industry. She suggested that this is especially worrisome coming at a time, as Dr. Mowery's paper points out, when U.S. parts exports are increasing. Dealing with this emerging threat will require concentrated negotiations and discussions with our European aerospace colleagues. Consequently, in Ms. Bath's view, the two trends of internationalization and an increased threat from European subsidies must be carefully watched. Although internationalization presumably cannot be stopped, it has not had that much of an impact on employment. The worldwide defense decline has been a greater factor. Changing production technology, which requires new skills and, in some cases, fewer people in the production process, is also a major factor. These changes in technology and production processes have not been looked at adequately. If we cannot maintain the flexibility to address quickly and adequately the requirements of technology change, we are damaging our long-term competitive position. The industry must retain the flexibility to adopt new processes, regardless of the impact on employment, and have the ability to quickly apply new technologies, which will often require new skills.

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--> Steve Beckman United Auto Workers Mr. Beckman began by pointing out that the United Auto Workers (UAW) interest in this issue is both from the standpoint of a union that directly represents workers in the industry and from a concern over broader trade policy, especially given the previous internationalization of the auto industry. Although the experience of internationalization in the auto industry is no way identical to that of the aerospace industry, there are some common themes. With respect to the policy portion of Dr. Mowery's paper, there appear to be three main sections: corporate policies, trade and international policies, and adjustment policies. In the sections on corporate policies and trade policies, the paper seems to say that the status quo is fine. To Mr. Beckman, the status quo is a serious problem for workers in the industry, and for the national interest. He disagrees with the proposition that there is no need for a business-labor-government debate or discussion on internationalization because the government has no role to play. On the contrary, in light of the industry's military connections and the fact that many countries have targeted aerospace as a lead economic development priority, there is an appropriate government role. National security and economic development concerns, including technology, jobs, and incomes, are huge issues of national interest. National Decision Making at the Firm Level Mr. Beckman remarked that the status quo is to allow companies to decide what form of internationalization will take place, what the response will be to foreign governments' policies, and how the development of the U.S. industry will proceed. However, there is necessarily a national interest in these questions, not just a corporate interest. This raises the issue of the identity between what is in a company's best interest and what is in a nation's best interest. It is both necessary and useful to have consultation and information from the involved companies, to provide advice, counsel, and guidance on how the government should consider the national interest. As has been mentioned several times, the information needed to encourage rigorous analysis and thoughtful decision making is absent. There needs to be a mechanism for the exchange of information. Without such, we will continue with the status quo, with companies continuing to make decisions on behalf of the national interest and the government unable to assess adequately the consequences. International Negotiations: Modest Accomplishments Concerning trade and international policies, Mr. Beckman noted that there are numerous ongoing or potential negotiations. However, the accomplishments

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--> to date are incredibly modest. The U.S. government is able to negotiate agreements reducing trade barriers; yet the ability of those agreements to actually accomplish anything in the marketplace is not very well demonstrated. Our history of negotiations with Japan underscores this problem, as it appears will be the case with our negotiations with China. As mentioned in Dr. Mowery's paper, China's entry into the World Trade Organization will likely allow a 10-15-year period of transition. Much can be accomplished by China during this time, creating a major enforcement problem later on. Adjustment Policy This leaves adjustment policy. Mr. Beckman said that, although most people agree in principle concerning the importance of adjustment assistance, resources for such programs remain scarce. Companies are unwilling to fund adjustment assistance themselves; nor are they willing to pay higher taxes to fund government programs. In addition to a lack of funds, procedures for workers to qualify have always been onerous. Taking issue with the central premise of adjustment, that overall the economy will benefit from the displacement, Mr. Beckman argued that, in the case of aerospace, this is an industry that generates high value-added. Moving employment and production out of such a high value-added industry may not benefit the economy, especially if the movement is to lower value-added industries. He points out that Dr. Mowery's paper discusses imports of avionics from Canada displacing imports of potash. In his view, moving workers from the aerospace sector to potash does not appear to be a net benefit to the U.S. economy. The key question is why adjustment is always left up to the individual worker. Beckman asked whether a European Commission employee would ever say that societies and workers must adjust to the technology, regardless of the impact on employment. The European attitude, and the attitude of much of the rest of the world, is very different than that of the United States regarding trade and employment. This is something that neither our trade negotiators nor the public appreciates. The potash example brings to line the famous comment that there is no difference for the U.S. economy between potato chips and computer chips. That comment implies that it does not matter what the United States produces. Mr. Beckman stated that the view of the UAW is that, what is produced in United States matters very much-both for current employment and future economic development. This viewpoint is shared by policy makers around the world.1 1   For a discussion of these perspectives, and the programs that result, see Conflict and Cooperation in National Competition for High-Technology Industry (National Academy Press, Washington, D.C. 1998, pp. 12-40). See especially Box A, ''Why Are Countries Concerned about Their High-Technology Industries," pp. 33-35 and Box H, "The Stakes in Aerospace Competition," pp. 88-90.

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--> Assessing both Exports and Imports Mr. Beckman closed by remarking that both Dr. Mowery and Ms. Bath had commented on the exports of aerospace parts to Europe as an indicator of how well the industry was doing. Mr. Beckman argued that only looking at exports does not give a clear picture as to the employment impacts of trade. The effect of imports must also be taken into consideration. The overall balance of trade must be looked at when assessing employment effects. Ms. Bath objected, arguing that she is one of the few analysts in the U.S. government who looks at both imports and exports. Dr. Mowery also pointed to the use of both export and import data in the paper. General Discussion Alan Wm. Wolff, Dewey Ballantine and STEP Board: Ambassador Wolff opened the general discussion by commenting on the lack of information with respect to foreign governments' industrial policy plans. He cited his recent experience trying to gain information on China's five-year plan for industry. He agreed that other forces may swamp the impact of foreign government plans on the U.S. aerospace industry. But without access to the information, it is very difficult to make that determination. Steve Sleigh, International Association of Machinists and Aerospace Workers: Mr. Sleigh raised the question as to Dr. Robyn's comment in the opening remarks that there is no alternative to strategic outsourcing, and to Dr. Mowery's assertion that McDonnell Douglas failed because of its lack of strategic outsourcing. He pointed out that McDonnell Douglas planes contained more outsourced parts than either Boeing or Airbus. Kirk Bozdogan, Massachusetts Institute of Technology: Dr. Bozdogan also questioned the comment that McDonnell Douglas' demise was due to the failure to establish strategic alliances. On the commercial side, McDonnell Douglas did a good job in integrating its suppliers into its production, design, and development process. He then raised the question about exports of aerospace parts and components. Because much of the worldwide installed base of aircraft is U.S. made—either Boeing or McDonnell Douglas—most of the spare parts to sustain these aircraft must naturally come from the United States. However, the U.S. aerospace industry cannot survive by simply selling spare parts. John Sandford, Rolls-Royce, N.A.: Noting that his perspective is that of the CEO of an aerospace company, Mr. Sandford pointed out that in the commercial sector there has been a massive shift in the reason for outsourcing. It is no longer simply for market access. Access to capital is now the major reason behind strategic outsourcing. Cash flow considerations are very important, and margins within the industry are very poor. Risk sharing and a steady stream of payments made for

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--> work done in-country are important considerations in placing production. The investment made by foreign companies, through their governments, in the development of U.S. products is very large. That trend will continue in the future. Corporate versus Government Balance Sheets Mr. Sandford emphasized that one of the challenges we face is that decision makers in this process are using the balance sheet of corporations rather than the balance sheet of governments. Thus, European governments can afford to invest in their own products and in their industry to gain a share of the U.S. defense business. He urged analysts to "follow the money." Randy Barber, Center for Economic Organizing: Mr. Barber had a question concerning Dr. Robyn's comments. He asked if she was describing a return to the competitive situation in commercial aircraft similar to that in the 1970s. At that time, there was fierce competition with high-level government intervention on the European side. In addition, he thought that Dr. Robyn stated that it was inconceivable that strategic outsourcing would not be part of Boeing's response. This assumes that direct government assistance, similar to that of the Europeans, is not an option in the United States. This situation would suggest that Boeing has become the U.S. national champion, but without a corresponding national responsibility. Dorothy Robyn, White House National Economic Council: Dr. Robyn clarified that she was simply referring to the fact that Boeing and Airbus are now competing directly for market share. Whereas in the past Airbus took market share away from McDonnell Douglas, any increase in Airbus's market share will now come directly at the expense of Boeing. She added that there is a debate as to whether and to what extent government actions such as procurement and research and development (R&D) support are actually helpful to the industry. The United States has never provided direct aid to Boeing. The Europeans argue that U.S. defense procurement and R&D provide much more benefit than the United States believes. In fact, the U.S. Defense Department (DoD) now believes the reverse, that defense benefits more from expertise gained in the commercial sector. Dr. Robyn noted that her point is simply that Boeing must compete with a company that is still in the position to receive large direct subsidies. She also pointed out, as is discussed in Dr. Scott's paper, that Airbus also does a great deal of strategic outsourcing. This has made them more competitive. In this environment of heightened competition, it seems naive to think that Boeing will do less strategic outsourcing. David Welch, Defense Industry Offset Association and Lockheed Martin: Mr. Welch clarified some details regarding one of the examples of an offset deal in

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--> Dr. Mowery's paper and pointed out the positive employment benefits of that deal. He urged participants to be very careful about advocating any legislation that could end up hurting export sales. Adjustment Assistance Owen Herrnstadt, International Association of Machinists and Aerospace Workers: Mr. Herrnstadt agreed with Dr. Mowery about the confusion over direct and indirect offsets and about the lack of data. Given these difficulties, he questioned the conclusion in Dr. Mowery's paper that the employment impact of offsets is negligible. Without adequate data, such a conclusion is both hard to reach and hard to accept. Mr. Herrnstadt also pointed out that, although the paper called for improved adjustment assistance, one of the difficulties in receiving assistance is proving the cause of the displacement. This also points out the need for better information and data to inform the policy debate. David Mowery, University of California, Berkeley: Responding to a number of comments made during the discussion, Dr. Mowery emphasized that the employment effects of offsets are only negligible with respect to other forces affecting the industry. This finding is broadly consistent with findings of others, including those in Dr. Scott's paper that will be discussed later in the day. With respect to adjustment assistance, Dr. Mowery offered that he has always believed that adjustment assistance should be made available, regardless of the cause of the displacement. Creation of separate programs based on the cause of displacement is poor policy design and needlessly adds administrative costs. He reiterated his belief that the decline and fall of McDonnell Douglas was due to its inability to develop new products, which was due, in part, to its inability to get risk-sharing partners on the commercial side of the business. Although there may not be a direct causal effect, there is a connection. He also pointed out that any discussion on offsets should not be dominated by the Boeing-Airbus competition. Internationalization and subsidies are still an important part of the aircraft engine sector, with the British government still providing launch funding to Rolls-Royce.