Trends and Challenges in Aerospace Offsets (1999)

Kenneth Flamm

The Brookings Institution

Dr. Flamm presented an overview of the policy issues regarding offsets in military aerospace. Cautioning that his paper was a deliberate attempt to be provocative with the hope of stimulating discussion, he added that he agreed with Dr. Mowery's conclusion that, with respect to the military sector, offsets are not necessarily the most important piece of the story. In fact, there is a much more interesting and complex story.

It is important to begin with an understanding of the cost economics of the military aerospace sector. The industry is driven by economies of scale, particularly because of the large development costs that characterize weapons systems. Fixed production and tooling costs add to economies of scale, as does the dynamics of learning economies. The more you produce, the cheaper the production process because you learn how to do it better. Thus, economies of scale are very important. The higher the volume, the more fixed development costs and production costs can be spread across the entire production run and the greater the learning effects.

As a result, with the worldwide defense downsizing, exports have become critical. This is especially true for non-U.S. producers. U.S. companies still enjoy a large domestic market, with U.S. industry accounting for roughly half of world sales. Everyone else competes for the other half of the market. That puts non-U.S. producers at a distinct disadvantage—basically they need exports to maintain essential economies of scale, or they die.

During the Cold War, production volumes were high enough to maintain economies of scale for almost all countries. Now procurement budgets in European countries have fallen even further than in the United States. This means

that the critical mass of volume needed for a new weapons system must rely on export sales.

In the United States, exports continue to play an important role in lowering the cost of weapons systems. However, the U.S. volume of R&D and procurement is large enough to maintain a strong defense industry without exports. This gives the United States the luxury of contemplating policy without having to deal with the immediate short-term requirement of exporting to maintain production. The Europeans, on the other hand, find themselves in a very different situation, with a driving need to export.

One consequence of this need to export is a tendency by our competitors to export more-advanced capabilities as a way of competing with U.S. industry. The result is a vicious cycle. The response to this higher-capability competition by U.S. producers is to also export more military capabilities. At the firm level, the logic is straightforward: If the United States does not give the buyers this capability, they will still be able to acquire it from a competing producer. The United States may as well make the sale and gain the economic benefit.

Complicating matters is the close technological cooperation between the United States and its allies. Historically, the United States has, to some extent, subsidized the development of the very capabilities that are driving the competition in foreign markets. The United States makes up a little less than half of total Allied procurement. However, the United States provides about 72 percent of total R&D. Either the United States is incredibly inefficient in its R&D, or it is subsidizing the rest of the world. During the Cold War, this was a perfectly reasonable policy for building up the defense industrial base of U.S. allies. From the point of view of economics, it also makes sense to sell off components or technology to our allies to recoup some of the money already spent to develop the technology.

All of this strengthens alliance ties by creating a world of close cooperation. The subsidies to Allied defense industries have been both direct (through licensed production, co-production, technology licensing, and participation by U.S. companies in product development teams in Europe) and indirect by providing components for European weapons systems so that they do not need to develop a particular technology embodied in the component themselves. The United States has thus created a system in which it cooperates technologically while competing for sales.

The above is a consequence of a logical set of actions by the individual actors that has significant negative impacts for the system. The intensified competition

for sales has led to increased transfer of higher levels of technology. This has a negative feedback on the United States in terms of increasing the technological capability of foreign threats. As a result, it becomes more important for the United States to maintain its technological lead by building even more-advanced weapons systems domestically. Thus, the United States has a system whereby it cooperates technologically to create its own competitors. The intensified competition increases the transfer of advanced capabilities overseas, resulting in a heightened threat that then requires higher levels of domestic R&D to maintain a technological lead.

There are two possible scenarios for the outcome of this dilemma: a much higher level of defense spending or a more unsafe world for the United States. The preferable third alternative is to find some way of creating a new system with our allies. Such a system would preserve the desirable elements of cooperation but moderate the unhealthy competition to make sales to questionable customers and markets.

Dr. Flamm noted that he is confining his analysis to military sales. These sales, however, constitute 50-60 percent of total aerospace industry sales—even though this year may constitute a turning point in which commercial sales are greater. Even in the aerospace engine sector, military R&D continues to play a very important role in developing new jet engines. Thus, military sales continue to be a major part of the aerospace industry.

Turning to policy issues, Dr. Flamm outlined three important ways in which the U.S. government supports foreign exports of defense systems—which do not include offsets as they are not a critical factor. First, export licensing is where the government has the most leverage over export sales. As explored in greater detail in the paper, the export licensing system remains a hodgepodge of bureaucratic warfare in need of reform. Export licensing is key for military exports. Number two on the list is diplomatic and administration support for exports. Government officials spend a great deal of time arguing on behalf of U.S. weapons systems with foreign buyers. Although this form of government marketing support is not talked about a lot, it is a more important factor in military sales than many other forms of government support.

The third form of government support is financial subsidies. Ironically, the way in which some of the subsidies are structured tends to defeat the purpose of exports sales. For example, R&D recoupment costs are routinely waived for exports. But the purpose of exports from a defense-industrial perspective is to maintain economies of scale to overcome high development costs. Waiving the re-

coupment costs means that you are selling to foreign buyers at marginal cost and not charging them for the costs of development. Any economic return to the DoD from spreading these development costs over a larger volume of sales is immediately lost. But the United States does this because its competitors do it. There is an additional, similar benefit to foreign companies when the United States sells them components without charging R&D costs, which they then use in selling their own weapons system in competition with a U.S. weapons system.

Another issue, in terms of financial subsidies, is loan guarantees for military sales. As is argued further in the paper, these broad-based subsidies for exports do not seem to do much to generate U.S. overseas sales.

Offsets are very far down on the list of ways in which governments support exports. The U.S. government has no official policy on offsets. Each part of the government has its own view. Unofficially, the policy of the DoD seems to be that the United States will grant whatever offsets it takes to win the deal.

Technology transfer through U.S. cooperative programs, licensed production, co-production, and co-development programs are significantly more important than most offsets in diffusing technology. Citing a National Academy of Sciences' report on Japan², Dr. Flamm disagreed with Dr. Mowery, in that he believes there are a number of examples in which military technology transfer has had an impact on commercial aerospace technology. Western Europe started out with a high commercial aviation base and therefore was not as strongly impacted by military technology transfers. But it is hard not to conclude that military programs have had a positive impact on the Japanese aerospace industry.

In conclusion, there are two fundamental issues concerning offsets. The first is technology transfer through offsets. If the technology being transferred was funded by the company, then it is a purely private transaction with the company best able to make the decision. However, in the case of government-funded technology, the government must play a broader role as the custodian of the public interest. It is quite possible for a company to make a rational decision on the transfer of technology that might be detrimental to the entire industry, especially when the technology transfer impacts the competitive position of other parts of the industry. Thus, there is a serious potential mismatch between private and public interests when considering technology transfer of government-funded technology.

The other fundamental issue concerning offsets is the impact on the trading regime. For example, dumping is a way of life in the defense industry. No one ever sells for the fully loaded average cost of production of a system. Systems are sold at marginal cost; thus, in this sense, everybody dumps. Given this, aerospace has a trade regime that is different from all other goods. Moving to a more open trading system will require reinventing the rules for aerospace. Industry often complains that it wants a level playing field. There are two ways to get a level playing field: Either reach agreement with the major exporters in the area or use countervailing duties. Countervailing would lead to a competitive spiral, because European governments and European industry cannot simply give up attempting to maintain their own domestic production. Therefore, a more complicated solution for the trading regime is needed.

Page Hoeper

U.S. Department of Defense

Mr. Hoeper stressed his agreement with an earlier speaker, Mr. Beckman, as to the difference between economics and policy. It is important to note that economics is a tool for measuring the impact of policy; it is not policy. He also pointed out that underlining the discussion is the distinction between a free market economy and a planned economy. Globalization is essentially the peace dividend—the thing that has given us economic growth, productivity growth, and low inflation even as it has resulted in unwelcome income disparities. As a result, the United States is always looking over its shoulder at how other countries are operating. Specifically, questions continue to be raised as to whether more-directed economies, such as Japan and China, will do better. Even with the end of the Cold War and the current Asian meltdown, these countries are not yet willing to change.

Mr. Hoeper stressed that the role of the DoD is national security. The DoD view of how military operations will be conducted in the future, as outlined in Vision 2010, is one of joint operations among the services and coalition operations with U.S. allies. Given the importance of information technologies, coalition operations will require interoperability and common systems. The key question from the security point of view is how does the United States get those common systems without economic distortions?

In the past, the United States had a unifying threat that encouraged our allies to buy our systems and not to sell to bad actors around world. Now, we are in a situation of intense competition in which each national industry needs to be sup-

ported by foreign sales. This leads to what economists call a "prisoners' dilemma" in which one of our competitors would sell an advance system to a country to whom we would not normally sell. But, because our competitors are going to do it, we feel forced to do it as well. The result is a downward spiral of increased proliferation of more-capable weapons at lower and lower prices.

The only solution to a prisoners' dilemma is cooperation or collusion. Dr. Flamm, in his paper, makes reference to the need for some form of "inner-circle" approach to solve this problem. Mr. Hoeper expressed his concern that this might result in a decline in competition. However, it is important to have some mechanism of cooperation to get out of this prisoners' dilemma without driving values to the bottom and continuing to proliferate weapons. A solution for future weapons systems may be to develop competing transatlantic teams in which we agreed in advance on the military needs for the alliance and on the percentage of the production that the United States and Europe will each buy. The United States and Europe could then split the work, including development, in order to capture the economies of scale.

This only works for future systems. For systems that are already developed, there is already a rush to the bottom. But it is time to compete at least two transatlantic consortia to satisfy the needs for coalition operations in the future.

Frank Parker

ITT Defense and Electronics

Mr. Parker noted that the industry is very concerned about the issue of offsets. The demand for offsets has increased rapidly over the past few years to a point where approximately 110 countries now impose offset requirements. Fifteen years ago, the number would have been 20 countries, with much lower levels of offset demands. Given the range of the various types of offset requirements used by these countries, it is very difficult to define what these offset programs are. Although the focus is often on prime contractors, offsets also have a considerable impact on the sub-tier. A pass-through to a subcontractor imposes a tremendous burden, especially if that subcontractor does not have the infrastructure in place to meet that offset requirement.

The issue of technological transfer, as addressed in Dr. Flamm's paper, is of special interest. No company wants to give away its technology and create another competitor. However, there is great strength within the U.S. industrial base, and companies have developed a number of tactics to meet offset requirements. In each case, companies must devise a unique way of how best to handle the particular requirement depending on the country.

Technology transfer may not be as serious a problem as outlined in Dr. Flamm's paper. Companies do everything they possibly can to mitigate the

amount of technology that is transferred. In contrast to Dr. Flamm's comment, Mr. Parker believes that the U.S. State Department does a reasonably good job in trying to curb some of these technology transfers in its export licensing process. The problem is lessened because of the fact that most of the products sold internationally are mature, sometimes to the point that they may almost be obsolete.

Mr. Parker also disagreed with Dr. Flamm's comment that there is no official offsets policy. The Defense Production Act of 1992 originated from a 1990 presidential statement of policy. The law states that the policy of the U.S. government is to not interfere in the issues of offsets. This is a position that industry supports. Industry recognizes that offsets can be an important competitive weapon. However, Mr. Parker suggested that it would be appropriate to restrict the use of government money to support offsets in the foreign military sales (FMS) program.

Mr. Parker closed by stating his support for the broader argument in Dr. Flamm's paper that there are more overriding issues affecting the industry than offsets.

Albert Kelley, Massachusetts Institute of Technology: Dr. Kelley stressed the importance of separating the military and commercial sectors of aerospace industry, as was done in Dr. Flamm's paper. As was pointed out earlier, venture capital is especially important in commercial aerospace, whereas government procurement is key to military aerospace. Military aerospace is a less risky business, but more subject to government regulation. Regarding one portion of Dr. Flamm's paper, Dr. Kelley asked whether the issues raised in the paper concerned the FMS program or concerned offsets. Many of the issues are raised as part of a FMS package. But such packages often include offsets, thereby confusing the analysis.

Kenneth Flamm, The Brookings Institution: Dr. Flamm replied that he agreed with Mr. Hoeper's remarks concerning the need for a new way to jointly develop future weapons systems with U.S. allies. Such a transatlantic or transatlantic-transpacific mechanism could be constructed in a way so as to increase competition. His suggestion in the paper for an ''inner circle" was one form this new mechanism might take. Creating such an open market in defense procurement with U.S. allies would create a larger volume. Enabling easier construction of multinational teams to compete on some systems is an appealing idea. This would ease the worry of our European allies about the disappearance of their industrial base while at the same time encouraging competition.

Dr. Flamm disagreed with Mr. Parker's comment that the State Department does a good job on export licensing, or even has a good understanding of technology issues in general. He reiterated his belief that export licensing is a process in need of improvement, particularly in terms of its coherence and in the need to articulate broad objectives for technology transfer policy.

Technology transfer is clearly an area for potential mismatches between public and private incentives. Specifically, technology largely funded by the government can be part of private deals, which may not take into account some of the objectives of the government when it funds the development of technology. He also stressed that the defense industry can in no way be considered a truly free market—DoD has direct control through a number of ways over the configuration of the industry.

Dr. Flamm agreed with Dr. Kelley's comment that, in discussing FMS, he barely mentioned offsets. Dr. Flamm stressed that the reason for this was his belief that offsets are not the most important dimension of the issue. In addition, FMS is less and less important in military sales.

John Sandford, Rolls-Royce, N.A.: Mr. Sandford reminded participants that FMS financing deals take much more than a year, even though there is an example of Lockheed putting together a deal very quickly.

Joel Johnson, Aerospace Industries Association: Mr. Johnson pointed out that, whereas export licensing is an important government export policy instrument, it is a case of easing a negative barrier on the industry rather than actively helping. In addition to the policy concerned, there is also an administrative problem with export licensing. In the commercial business, it is required to get parts to customers within 48 hours. Export licenses can take from 11 to 90 days. This is a competitive disadvantage for U.S. exporters.

Concerning the issue of recoupment, Mr. Johnson argued that, by the time a product is being exported, it is old enough that it is no longer possible to load development costs into the price. In a commercial business, sunk costs are loaded up front when you think you have market advantage; you do not average the costs over the life of the product. The DoD insists on trying to do that, and industry only asked for common sense. The system of collecting R&D recoupment made no sense in the commercial world, and the DoD never benefited because the funds went directly back into general revenue.

General Discussion of Dumping: A number of participants commented on Dr. Flamm's statement about dumping. Gordon Healey stated that aerospace companies are not aware that they are dumping; companies do not remain in business by failing to make a profit. Dr. Flamm responded that failing to make a profit was not the definition of dumping. Dumping is selling below the fully loaded average cost of production. The term selling below "fair market value" was also used in the discussion. Mr. Beckman noted that the issue raised an important question as to what is the market—there is not a free market in defense products but one where there is only one buyer. Dr. Flamm commented that there are mechanisms for calculating dumping where markets are thin. Mr. Johnson suggested that the issue was more one of a countervailing subsidy case under U.S. trade law rather than dumping. Companies are not selling below their costs. The issue is how to

deal with government subsidies. Seventy percent of sales are sold government to government with the price constructed by the government. The revenue to the companies would be the same whether or not there was R&D recoupment. The difference between waiving R&D recoupment and not is the difference between making the sale or not. Thus, the issue is not a defense industry issue, but a government policy issue.

Dr. Flamm agreed with this last observation, noting that the important point is that the normal practice in FMS is to sell below the average cost being charged to the U.S. government—the average product-cycle costs of the system. Mr. Healey disagreed with Dr. Flamm's last point. Dr. Flamm reiterated that he is not criticizing the industry, merely pointing out the rules of the game over which industry has no control. Dr. Wessner noted that the discussion on dumping is recurrent and controversial. It was explored in some depth by a previous National Academy of Sciences' study on trade in technology, although no consensus was reached on the issue. The STEP report, Conflict and Cooperation in National Competition for High-Technology Industry, summarizes the competing views and provides useful source material.³ A companion volume, International Friction and Cooperation in High-Technology Development and Trade has two relevant papers. The paper by Thomas Howell is especially relevant. It describes the dumping of steel products at the turn of the century by producers in the United States and Imperial Germany (and the subsequent security consequences for the United Kingdom during World War I) and draws parallels with the more recent cases of dumping in semiconductors.⁴

John Shaw, Cambridge Consulting Group: Mr. Shaw agreed with Dr. Wessner's emphasis on the need for historical perspective. He suggested that much of the discussion assumes a continuum on the issue of military export sales. He stressed, however, that over the past 20 years there have been a number of different preoccupations, such as "merchants of death," foreign corrupt practices, and the end of the Cold War. Much of the moral posturing on the issue has subsided, but the overall problem remains: There is no overall policy. Policy keeps changing and various parts of the government get involved on an ad hoc basis. He noted that the current preoccupation is national economic security, with the central issue being the coordination of government activities with various private sector initiatives. This preoccupation has taken central stage in part because of the lack of other issues. Mr. Shaw cautioned that, based on the history of this topic, the industry is likely to be challenged by some new concern in the future.