Panel 4
Offsets in the International Marketplace: An Aerospace Industry View

Joel Johnson

Aerospace Industries Association

Mr. Johnson agreed with earlier comments that, from an economic perspective, offsets are not very important relative to other factors in the aerospace industry and the economy. Offsets are, however, politically important, which is the reason for the attention.

International and Domestic Offsets

Because the customers in the defense sector are governments, they want more out of their procurements than simply price and performance; they also want jobs. The industry faces these pressures even domestically in the form of a number of ''domestic offsets," such as minority business set-asides and informal requirements for a large geographical distribution of production. The industry is skilled in meeting these domestic offsets demands of its customers, which gives it a competitive advantage when faced with similar requirements overseas.

Buoyant Sales

As noted in Mr. Johnson's paper, sales in the industry have increased over the past year from $112 billion to $130 billion, employment has increased by approximately 40,000-50,000 workers, exports are at an all-time record of $50 billion, and the sector's trade balance hit an all-time record of $34 billion. This is not a picture of an industry in decline.

More important, more than half of annual sales in 1997 were to non-U.S. government buyers—something that has happened only once before in the history the industry, in the 1930s. Of those sales that did not go to the U.S. govern-



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--> Panel 4 Offsets in the International Marketplace: An Aerospace Industry View Joel Johnson Aerospace Industries Association Mr. Johnson agreed with earlier comments that, from an economic perspective, offsets are not very important relative to other factors in the aerospace industry and the economy. Offsets are, however, politically important, which is the reason for the attention. International and Domestic Offsets Because the customers in the defense sector are governments, they want more out of their procurements than simply price and performance; they also want jobs. The industry faces these pressures even domestically in the form of a number of ''domestic offsets," such as minority business set-asides and informal requirements for a large geographical distribution of production. The industry is skilled in meeting these domestic offsets demands of its customers, which gives it a competitive advantage when faced with similar requirements overseas. Buoyant Sales As noted in Mr. Johnson's paper, sales in the industry have increased over the past year from $112 billion to $130 billion, employment has increased by approximately 40,000-50,000 workers, exports are at an all-time record of $50 billion, and the sector's trade balance hit an all-time record of $34 billion. This is not a picture of an industry in decline. More important, more than half of annual sales in 1997 were to non-U.S. government buyers—something that has happened only once before in the history the industry, in the 1930s. Of those sales that did not go to the U.S. govern-

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--> ment, 75 percent were exports. In the future, it is clear that the U.S. government share of sales is not going to go up. The only expansion will be to non-U.S. government buyers, most of which will be international. Given that U.S. government procurement is essentially protected, competition will be concentrated in this growing international market. Two Trends The industry has had to cope with two major trends over the past few years. The first has been the decline of the defense and airline markets. The airline market is recovering, but defense spending is unlikely to increase to previous levels. The second trend is the major restructuring within aerospace industry. The industry has dramatically increased productivity as customers have become more cost conscious. Of particular interest was the earlier analysis presented here showing that productivity gains accounted for twice as much employment loss as offsets. Extrapolating these losses forward, the industry will have a negative 100,000 workers by 2013—which makes one suspicious of such projections! Mr. Johnson has seen little evidence of increased foreign penetration in aerospace parts. Imports over the past few years have held relatively constant at 5.5-6 percent of production. Problems facing the supplier base seem to be more the result of a decline in business and a rationalization of the supplier base rather then increased foreign penetration. He reminded participants that the United States essentially has a 100 percent offsets requirement. Contracts for almost every major weapons systems require 75-100 percent production in the United States. The question becomes what the United States would be willing to lay on the table in negotiations with its allies on offsets. He suggested that negotiations limiting the United States' ability to demand production here would be politically unpopular. Concerning the data, Mr. Johnson commented that the three sectors in the Commerce Department report on offsets—gears, machine tools, and shipbuilding—have all been either government subsidized or protected by Section 301 trade actions. In those sectors, offset performance was less than 1 percent. Another concern was that the Commerce Department data did not show the degree to which one foreign supplier was being substituted for another. Given that in these three sectors there is a lot of substitution of one foreign supplier for another to gain offset credits, the 1 percent is probably an exaggeration. Thus, he argued, there is no "smoking gun" as to the negative effects of offsets. He suggested that a better way to conduct the analysis would be to look at the problems facing the subsectors, rather than start with offsets. Offset managers tend to circle around the subsectors in trouble—those subsectors that are not providing performance, are not cost competitive, do not provide quality, have not taken care of the customer, and have sought government protection in the past. In many cases, the offset is not the sector's problem; the sector has problems that

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--> attract offset managers. Offsets may simply be a scapegoat for these underlying structural problems. Anecdotal data about problems caused by offsets may be suspect unless the analysis asks questions about the deeper structural problems. No Unilateral Action The industry has a number of recommendations for dealing with offsets. At the top of the list is a plea for no unilateral action. Also important is reform of the export licensing system. Mr. Johnson stated that the single greatest impediment to industry exports remains the U.S. government—because of the problems with export licensing and the tendency to impose unilateral trade sanctions. He agreed that government funds (through FMS programs) should not be used to support direct offsets. However, there are only two countries that currently use U.S. funds for military procurement: Israel and Egypt. Congress already gives a half billion dollar subsidy to the Israeli defense industry and is therefore unlikely to do anything about offsets in this area. With the FMS program down to $3 billion, FMS-supported offsets are no longer a significant problem. Negotiations? The industry remains supportive, but skeptical, of multilateral negotiations on offsets. Mr. Johnson argued that the Europeans would be very happy to agree to no longer offering offsets in third-country markets. The U.S. industry has a competitive advantage in its ability to place work offshore. The Europeans do not necessarily need to make a profit, but find it difficult to place work offshore. If we propose an agreement to limit our ability to place work offshore—and therefore remove a U.S. competitive advantage—the Europeans may well accept it. The situation is different when it comes to transatlantic offsets where there is considerable political pressure on the Europeans to require domestic production. For example, statements from American labor unions concerning protecting American jobs are similar to those made by British labor unions concerning protecting British jobs. Mr. Johnson urged that the issue be kept in context. He also expressed concern as to the assumption that indirect offsets are worse than direct offsets. The more one moves toward indirect offsets, the closer one comes to real trade. Direct offsets require bilateral sectoral and country balance; indirect offsets move toward only requiring bilateral country balance. The more the offsets are spread around the economy, the less damage is done to the aerospace sector and the more the transaction looks like real trade, because for every import there has to be an export in the economy sooner or later. The question becomes the extent to which governments, U.S. and foreign, get involved in determining what makes up the imports and exports, as opposed to letting the marketplace decide.

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--> Mr. Johnson closed with the admonition to be careful about data. He stated that there is nothing but downside risk to further publication of the data. The better it looks to the industry's foreign customers, the worse it looks to Congress, and vice versa. Data published by the Commerce Department is used by foreign governments to determine how high of an offset requirement they can impose. He argued for a better way of handling the data so it does not make the problem worse. Discussants Steve Clemons Economic Strategy Institute Mr. Clemons stated that he would focus on the political issues revolving around offsets. The offsets issue has thrived in obscurity and ambiguity. As a result, the industry seems to have a strategy that "doing nothing is best." Mr. Johnson's paper offers prescriptions that would be very tough to implement, while discounting all other possible solutions. There is a general agreement that any unilateral action is probably not possible. There is also a generally held view that offsets are a necessary evil as part of the business of doing defense trade. However, Mr. Clemons stressed that, because of the mix of national security concerns and tax dollars, offsets are not purely a commercial matter. Offsets meddle in market behavior. They reflect the industrial policy objectives of other countries who are trying to use a sale process to create a high-wage aerospace industry. This calls out for a policy response by the U.S. government. For too long, industry has played the role of saying "do nothing." It appears that the DoD, starting with the June 1997 workshop by this group, has taken a much more pro-offsets position—to the concern of some in Congress. Because labor unions have brought this issue more to the forefront, there is an increased perception of job dislocation and of a problem that is going to increase. Industry, therefore, must become more of a partner in figuring out what to do about the perceived problem. The political volatility of the issue will only increase. Mr. Clemons gave the example of companies seeking to work with the national laboratories as part of offsets agreements. This raises politically dangerous questions, including the use of tax dollars and national security research by private companies for parochial deals abroad. Over the next few years, politicians are likely to look more carefully at these issues of the use of tax dollars under the mantra of "corporate welfare." This is very worrisome to those who believe there is a government role in the development of the technology. Just allowing the system to go forward without any kind of constructive thinking about the involvement of industry, the use of national resources such as the laboratories, and parochial defense sales may be reckless.

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--> Use of indirect offsets is also politically volatile, as shown by the recent case cited by Senator Feingold. Commerce Department data show that indirect offsets are rising. Thus, somewhere, someone in some industry or company will feel that they have been hurt by a subsidized effort to gain a defense sale. The defense industry should be worried about the impacts of indirect offsets because of the political consequences of those impacts outside of the defense sector. There need to be some principles of self-restraint established, which industry seems to be reluctant to do. Without such action, the issue of indirect offsets is likely to attract higher political attention. Mr. Clemons concluded by reminding participants that this is non-market behavior. It is not simply a question of letting markets operate. The situation is parallel to that of the state-versus-state competition for new businesses. States have come up with all types of innovative incentives for companies to locate plants within their borders. An entire industry has grown up around providing these incentives. There is the concern in the political world that this same type of innovation is occurring with respect to offsets, which is not very healthy. That is the perception, and industry must therefore be much more actively involved in helping to craft a solution than it has been thus far. Randy Barber Center for Economic Organizing Mr. Barber commented on the need to be clear on a number of points. The first is the difference between defense offsets and commercial sales. Although perhaps there are no such things as voluntary offsets on the defense side, it is important to keep definitions in mind. Earlier speakers drew a clear distinction between offsets as a government requirement and strategic alliances. Measuring these offsets due to specific government requirements is much easier than obtaining data on commercial strategic alliances. Yet there are clearly decisions that companies make voluntarily from a marketing perspective to enter into certain types of relationships. Mr. Barber agreed with Mr. Johnson in that U.S. industry developed its ability to offer offsets into a competitive marketing tool. It is clear that parts of the industry, such as Boeing, believe that they have a major competitive advantage because they can offer parts of the production process to the potential customer. Mr. Johnson's suggestion for negotiating a standstill on offsets with Europe is based on the fact that the Europeans are now using offsets as a competitive tool as well. Referring to Figure 4 of Dr. Scott's paper, Mr. Barber disagreed with Mr. Johnson's data. He argued that imports of engines and parts have increased from 8 to 16 percent from 1988 to 1995 rather than staying flat. Mr. Johnson responded that the import-export data mix engines and aircraft. Rolls-Royce engines are counted as an import; Pratt & Whitney engines end up as part of the aircraft export numbers. Thus, the data are incompatible.

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--> John Sandford, Rolls-Royce, N.A., stated that Rolls-Royce holds roughly 20 percent of the market, but added that company claims as to market share are often suspect. Data on the import or export of engines is often suspect as well because the trade data reflect the full value of the product, whereas much of the production takes place in another country. He cited the example of a popular General Electric engine for which more manufacturing occurs in Europe than in the United States. He also expressed concern that it is unclear how the data account for cases such as Rolls-Royce engines sold to Boeing for aircraft sold outside of the United States. Mr. Johnson added that this means that figures on engine imports will increase as Boeing increases market share and exports more. Mr. Barber reiterated that part of the problem is a lack of reporting requirements on the commercial side. Beyond the fact that there is a fuzzy line between a true "required" offset, a preemptive offset, a strategic marketing initiative, and a technology licensing agreement, there is no data as to what is happening on the commercial side. We really do not know. This lack of data has been used by a number of earlier speakers to argue that we cannot prove the impact of offsets. Mr. Barber can understand the industry's argument as to why they have been very leery of the collection, analysis, and distribution of this information. However, it is important to get past arguing over numbers that fundamentally have not been collected. There may be a risk of disseminating the information, but it is likely that the industry's customers share this information among themselves anyway. Mr. Barber closed with his agreement with Mr. Clemons' comment on the importance of perception. He personally believes that the problems of offsets and globalization are real. But the perception is that companies are voluntarily trading production and technology for sales—an undertaking that a generation ago would have been considered crazy. Although this may have become an acceptable idea within business, it is very unsettling to workers. Workers do not have the mobility of capital and the ability to cope with these changes. This mind-set is a dramatic shift in what one would expect in the behavior of an industry that is so closely linked to national defense and is considered to be a premier example of U.S. manufacturing prowess. General Discussion Greg Martin, Lockheed Martin: Mr. Martin noted that the discussion has moved away from a focus on trade-distorting requirements by governments to attention on voluntary activities that companies might engage in as part of good business practices. He expressed the hope that we were not moving toward legislating what U.S. businesses can do in international business practices. Randy Barber, Center for Economic Organizing: Mr. Barber responded by noting that many speakers have pointed out that the issue is not one of simply offsets. The issue involves trade policy, employment policy, and capital markets policies,

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--> to name a few. To the extent that companies' interests diverge from the interest of their workers or the country, these issues must be addressed. Clearly, the issue is broader than simply government-mandated deals, but includes the various ways in which technology and production are traded for sales. Mr. Martin responded that this is a greatly expanded definition of offsets. Steve Clemons, Economic Strategy Institute: Mr. Clemons stated that a parallel can be drawn to the question of international codes of conduct. Two years ago there was a great deal of concern that Congress might move recklessly and legislate on the issue by trying to, for example, tie the tax code to corporate behavior. With respect to policies on offsets, very little has changed in the past ten years. Most have simply hoped that the issue would not receive a lot of attention. Efforts were confined to reporting requirements with the mantra of "take no unilateral action." Although there is a concern about Congress doing something, the corporate community has not initiated anything that might work multilaterally or might respond to the major concerns. Industry seems to be waiting for things to happen while hoping nothing happens and refusing to take the lead to define what might be a positive outcome. Now the situation has come down to labor versus industry, because labor and others believe that offsets are having a negative impact and that they are eroding the American technology base. Industry needs to move away from its passive position and get behind a workable multilateral solution—which would greatly raise the probability of success. Mr. Martin argued that the industry is working on the problem, but is doing so on its own with its foreign customers. The industry is trying to move away from traditional offsets toward good business practices that do not count credits and look toward long-term business relationships. In these types of relationships, U.S. companies might gain access to markets, whereas customers might gain access to financing and complementarities of technology. Mr. Clemons noted, and Mr. Martin agreed, that this is being done on an individual company basis. Mr. Clemons stressed, and Mr. Martin again agreed, that individual companies have no incentive to defect in this prisoners' dilemma game because if they do so they are left out. Mr. Clemons then noted the situation therefore is one of "market failure." In such a situation, it may benefit industry to come together as a group with unions and government to develop something that no single company could initiate on its own. Mr. Martin stated that the industry is willing to do this and share as much information as possible without giving up competitively sensitive data. The industry is also willing to work with others on a multilateral basis. However, there is still concern about legislation that, in the name of restricting offsets, would restrict what the industry believes are good business practices that open markets and share risks. Joe Evans, General Dynamics: Mr. Evans commented that foreign customers are making offsets much more difficult and expensive to implement, adding to the

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--> costs of a program. If U.S. legislation were to restrict the ability of American companies to do what they think is necessary, then the response from industry will simply be to walk away from the business. That, as Dr. Wessner pointed out, would have its own consequences for employment and national security. Steve Beckman, United Auto Workers: Mr. Beckman noted the importance of the distinction between the military and the commercial sectors. What is being discussed as "sound business practices" are not sound practices by the standard of American economics. Economic theory would predict that the United States should be dominant in the aerospace industry because it has the most efficient production. The problem is that the market does not work that way. It is difficult for business to accept that a different mechanism is needed because the market is not working the way it should. In essence, business is making a necessity into a virtue by saying that these agreements are the only way to get access to markets. The traditional way to gain access to markets is for governments to negotiate access agreements and enforce those agreements through trade mechanisms. If the argument is that trade mechanisms and trade policy do not work, then the discussion needs to be enlarged. The fundamental problem with offsets is the imperfections of the market that are being, in many respects, exacerbated by these "good business practices." Such practices do not move toward a common way of dealing with the problem in a manner beneficial to the U.S. national interest as well as the commercial interest of the companies. Mr. Martin responded by saying that he was focused on market access in terms of what the customer wants, not in terms of what governments will allow. For the same reason that there is a reluctance on the part of some U.S. companies to buy from a foreign source, there is a reluctance on the part of European companies to buy from American sources. This reluctance stems from that fact that suppliers are not located in-country. You have to be there to support your customer. These strategic alliance arrangements allow U.S. producers to be there without having to open up a new company in each customer country. Charles Wessner, National Research Council: In closing this part of the discussion, Dr. Wessner noted that Mr. Beckman's point appeared to be not that there are market imperfections through lack of information, but rather that the issue is one of how to respond to government interventions designed to achieve a particular goal.