In This Issue
Celebrating Manufacturing Technology
March 1, 2005 Volume 35 Issue 1

Post-Cold War Policy and the U.S. Defense Industrial Base

Tuesday, March 1, 2005

Author: Kenneth Flamm

The author traces the evolution of defense industrial and technology policies since the end of the Cold War.

Technology development in the United States has historically been closely related to defense industrial policies. At times, new defense-related technologies led to the development of products that fueled growth in a broad spectrum of commercial industries. At other times, the U.S. military establishment has focused its resources on specialized technologies with little if any applicability to other markets. This essay traces the evolution of defense industrial and technology policies from the end of the Cold War to the post-9/11 world.

The rise of modern high-technology industries (e.g., semiconductors, computers, key elements of modern communications systems, aircraft and space technology, and biotechnology) was stimulated by post-World War II government investment in (1) research and development (R&D) to strengthen national defense and (2) the education of skilled scientists, engineers, and technical staff to work in these new industries. However, in these industries sales of dazzling new commercial products soon eclipsed sales of high-technology products to military customers. During the Cold War, roughly two-thirds of U.S. R&D was funded by the federal government, primarily for defense. Today, that percentage has been reversed, with two-thirds of U.S. R&D funded by private industry.

The Defense Industrial Base
Only a handful of U.S. industries are now dominated by defense spending (so-called defense industries), and most of them produce “defense-unique” products (e.g., ammunition and ordnance, tanks and armored vehicles, ships, aerospace vehicles and technologies, search and navigation electronics, and some kinds of optical instruments) for which the military is the primary customer. The largest defense sector is military-related electronics, which accounts for almost 50 percent more in sales than aircraft. The relationship between the defense establishment and these industries is symbiotic—the military depends on them for its technical advantage, which is at the heart of U.S. security doctrine, and the industries depend on the U.S. armed forces as their primary customer.

Despite the military origins of computers and microelectronics, these industries are not on the list of defense industries. Even though the military is still an important funder of specific, leading-edge technologies in these fields (e.g., supercomputers and microelectromechanical systems [MEMS] devices), commercial demand for these products has far outstripped the requirements of the military.

U.S. defense suppliers turned
to exports to take up the slack
in the domestic military market.

The aircraft industry is an exception. For almost a century, demand shifted back and forth between military and commercial customers. The aerospace industry, which never “graduated” from its symbiotic relationship with the military, is still highly leveraged with military technology investments. Recently, however, as commercial space launch has become more important in telecommunications, the trend has shifted toward more commercial sales.

Shipbuilding, besieged by inexpensive foreign competitors, has become increasingly dependent on selling high-priced, specialized systems to the military. Today, the U.S. shipbuilding industry is virtually a captive supplier to the U.S. Navy.
The end of the Cold War had surprisingly little effect on defense industries, partly because U.S. defense suppliers turned to exports to take up the slack in the domestic military market. As a result, the dollar volume of sales over time remained relatively stable. The only large declines were in sales of ammunition and tanks and space vehicle equipment (the latter is probably attributable to the vertical integration that accompanied consolidation).

The Post-Cold War Conundrum
The relative stability of U.S. defense industrial output contradicted the prevailing forecasts as the Cold War wound down. U.S. defense spending was expected to fall sharply, with procurement budgets forecast to fall by as much as 70 percent. In the 1980s and 1990s, adjusting the defense industrial structure to predicted post-Cold War budgets was a central theme, based on clear, deceptively simple logic. The U.S. defense procurement system, which had evolved from a structure dating back to World War II, operated largely in a cost-plus-markup contracting framework. Contractors were encouraged to invest in substantial fixed facilities and capabilities and then recoup their overhead costs through charges added to U.S. Department of Defense (DOD) contracts. If procurement budgets shrank, as expected, and the number of contractors remained stable, a company would have to set aside an increasing portion of its contracts to recouping its unchanged overhead costs. Thus, funds available for new systems would inevitably diminish sharply.

This argument for restructuring defense industries was made by William Perry, who became deputy secretary of defense when the Clinton administration took office in 1992 and was appointed secretary of defense shortly thereafter. As secretary of defense, Perry put forward a three-part strategy. First, shrinking funds would be stretched by instituting more economically efficient purchasing processes. Reform of the acquisition process had been urged by a succession of bipartisan commissions, and there seemed to be a political consensus supporting it. Perry proposed that the acquisition of defense systems be retooled to be more like the competitive, price-conscious practices used in commercial industry. Greater competition, it was argued, would also stimulate innovation among defense suppliers.

Second, efforts would be made to procure systems and technologies from outside DOD’s traditional circle of suppliers, that is, from firms selling mainly to commercial customers. In semiconductors and computers, for example, commercial industry was investing vastly larger sums in new technology development than DOD, and commercial markets had greater technological momentum. Thus, DOD could both save money and encourage the rapid incorporation of new technologies into its systems by tapping into burgeoning innovation in the commercial arena.

The logic behind this “dual-use” strategy seemed unimpeachable. The military would turn to commercial suppliers for leading-edge technologies in fields where commercial markets were driving technological change and, at the same time, stimulate the transfer of DOD-funded technologies with commercial potential to firms willing to adapt them to commercial markets. It was argued that this would ultimately lower the cost of new technologies to DOD because of economies of scale and greater investment from private sources.

The dual-use strategy was not popular, however, with traditional defense suppliers who feared they would be facing new competitors in a time of falling budgets. Resistance also arose from the uniformed services, the ultimate customers, who anticipated additional strains on their budgets with little promise of receiving qualitatively better hardware in the near future. The benefits, they believed, might only be realized in the medium to long term.

The third element of the Perry prescription involved reducing the defense industry’s fixed overhead costs. For government-operated or government-owned facilities, a new base realignment and closure (BRAC) process (begun in 1991 under the previous administration) would be charged with eliminating unneeded facilities. The situation for private industry, however, was more complex. In July 1993, Secretary Perry urged the top defense companies to merge and consolidate to reduce overhead as procurement declined. At a Pentagon dinner (dubbed the “Last Supper”), Perry pledged to support efforts by the defense industry to undertake its own consolidation. In marked contrast to earlier policies, he said DOD would adopt measures to facilitate consolidation by assuming a more active role in government approval of mergers and acquisitions among its suppliers and implementing cost-reduction incentives for mergers and acquisitions (e.g., projected cost savings from mergers would be shared by DOD and its suppliers).

The International Dimension
At the same time, equally difficult issues were becoming apparent globally. Post-Cold War downsizing was also under way overseas. Major U.S. allies, who also had substantially smaller procurement budgets, faced difficult choices, sometimes between sustaining a single, very high-overhead, very high-cost supplier and losing the capability of producing a particular type of defense system entirely. Thus, to keep key systems from becoming unaffordable, there were substantial economic pressures to export defense systems, perhaps even to less-than-savory customers.


The logic behind the
“dual-use” strategy
seemed unimpeachable.

To reduce pressures for exporting technologies with potential proliferation implications, DOD proposed offering more technology cooperation with close allies. The idea was to offer an explicit quid pro quo on proliferation. Access to U.S. defense technology investments would be exchanged for prior agreements restricting exports of systems that used the technology. The most trusted allies (dubbed the “Inner Circle”) would be offered the greatest access in exchange for the greatest restraint; agreements with less intimate friends might be negotiated later for less access, and, perhaps, less restraint. Ultimately, it was hoped, this policy would lead to some institutional structure that would reduce economic pressures for the proliferation of advanced military technologies.

The flip side of this initiative was DOD opposition to increasing U.S. subsidies or increasing exports by American arms makers. Detailed internal studies showed that, except in a few specific cases, export subsidies were likely to have a small impact on overall U.S. market share. Broad subsidies and promotions might increase U.S. share globally by, perhaps, 10 percentage points; but they might also trigger countermeasures by strapped foreign competitors that would increase the risks of proliferation. DOD argued that it would be better to promote U.S. exports through cooperative arrangements with allies linked to restraints on their exports.

Finally, DOD opposed increasing waivers for R&D recoupment charges, which essentially freed U.S. arms exporters from having to levy a charge to repay DOD for a portion of its R&D investment in exported military systems. R&D recoupment charges on exports had been a significant factor in reducing the cost to DOD of developing some new systems, thereby stretching U.S. procurement funds. Waivers of these charges significantly lowered the price of exported systems, but raised the ultimate total cost to DOD of developing systems.

The international initiatives had mixed results. DOD succeeded in reviving moribund international programs with U.S. allies, and, despite current political tensions, increased cooperation with allies in NATO and with Japan continues to this day. However, DOD either lost interagency battles or bowed to political realities on most other issues. As a result of heavy industry lobbying, a policy directive made the untargeted promotion of military exports (using diplomatic, political, and economic leverage) on economic grounds the default government position. Congress passed a “self-financing” export promotion scheme (with defense industry support) that had little if any real effect and did not evolve into the costly subsidy its proponents had hoped for.

The Inner Circle idea was attacked from both ends of the policy spectrum. Nonproliferation activists opposed the idea of sharing U.S. technology, even with trusted allies. Proponents of arms exports did not like the idea of restraints on exports as an institutionalized feature of cooperative arrangements and worried about allied industrial competitors getting access to U.S. technology. Although the general policy was rejected, remnants of the idea survive today on a program-by-program basis. In the Joint Strike Fighter (JSF) Program, for example, allied industrial participation was invited, linked to a review of exports that included JSF technology. The controversies also survive, and the struggle continues.

The policy changes and the mathematics of global procurement budgets undoubtedly resulted in greatly expanded exports of military systems. U.S. arms exports increased from about 20 percent of domestic military procurement in the late 1980s to almost 70 percent of domestic procurement outlays in 1999 (see Figure 1). Concerns about the proliferation of militarily signi-ficant capabilities by increasingly strapped foreign competitors remain.

From Endgame to “N-Game”
Domestically, the policy initiatives of the 1990s also had mixed results. The verdict on acquisition reform is still out. In an inversion of previous policy, a new directive made unique military specifications for components and parts (as an alternative to commercial products) acceptable only if they could be explicitly justified and defended. By most accounts, this change has been successful.

Changes were made to the Federal Acquisition Regulations (FAR) to encourage commercial acquisition processes whenever possible. Campaigns were mounted to encourage acquisition executives and program managers to consider price in acquisition policy, and policy directives encouraged bottom-line price justifications for acquisitions, in lieu of the traditional cost-based approach with its extensive documentation requirements. “Cost as an independent variable” became a shorthand description of the new approach. However, the effects of changes to FAR and the attempted reengineering of the procurement culture have yet to be persuasively demonstrated.

The promotion of consolidation in the defense industry was motivated by concerns about fixed costs, particularly investments in physical facilities. Clearly, having fewer producers would lower fixed costs per unit on any given volume of output because of the economies of scale created by the fixed costs. But with fewer producers, there would also be less competition and a greater likelihood that producers would increase profit margins and prices. With fewer producers, there might also be less pressure for them to innovate technologically to win DOD contracts. Clearly, there was a trade-off between economies of scale and competition, but when the policy was first articulated, attention was focused primarily on the cost issues. The competition trade-off only belatedly became a central concern as consolidation proceeded.

Table 1 shows that the numbers of prime contractors for major systems dropped from 25 to 70 percent from 1990 to 1997. Estimates of capacity based on U.S. Census Bureau data also showed significant reductions in physical production capacity in most defense industries through 1997.

After 1997, however, there was little further consolidation among primes—the result of a rethinking of the policy. From 1992 to 1997, acquisition policy was conceived as an “endgame” for the Cold War defense industry infrastructure; restructuring of the industrial legacy was the primary issue on the table. As the numbers in Table 1 show, however, by 1997 the number of primes had dropped to very low single digits in many sectors, raising concerns that consolidation might have gone too far. At that point, DOD discussions of defense mergers began to focus on the effects of consolidation on competition and how low the number of producers (the “N-game”) could go before DOD ought to become really concerned.

The change in policy was signaled in 1998 when DOD opposed mergers of Lockheed Martin and Northrop and the acquisition of Newport News Shipbuilding by General Dynamics. At about the same time, because of congressional concerns about “payoffs for layoffs,” the overhead savings-sharing incentives were ended. Although mergers continued among subcontractors, the great wave of mergers among large primes ended in 1997. Statistics also show that physical plant capacity began growing steadily again in most sectors after 1997, as savings-sharing was discontinued.

Ironically, the sharp declines in procurement that led Perry and others to propose cost-saving consolidations in the 1990s seem likely to be completely reversed in the next five years. Recent defense budgets show R&D and procurement reaching their Cold War peak in 2009—only there will now be far fewer defense firms competing for many more contract dollars. Needless to say, this was not the desired outcome of the policies of the 1990s.

To some extent, procurement officials, in their zeal to promote consolidation, overstated their case. Although procurement in constant dollars did decline by almost 70 percent in the 1990s from its Cold War peak, outlays (the amount DOD actually spends in a year, a more relevant number for an industry dependent on defense spending) declined only by about 55 percent. This is because lags in spending for different types of items have the effect of smoothing out zigs and zags in budget appropriations. If we consider only arms investments (what DOD actually buys from the defense industry, excluding the substantial spending on non-defense-unique items like paper clips and personal computers), spending was cut by only 40 percent. Coupled with the surge in arms exports discussed earlier, overall defense industry sales declined only slightly, despite forecasts of impending doom.

Procurement in constant dollars, which fell to the level of the mid-1970s at its low point in the 1990s, is now almost back to its Cold War peak. And there will soon be greater output produced by substantially fewer players than there ever were during the Cold War. This was not the anticipated result of the original restructuring, but the current leadership of DOD (understandably distracted with other issues) shows no sign of considering the long-term consequences.

In retrospect, the defense industrial policy initiatives of the 1990s effectively responded to the realities of the moment. The impulse to reform the acquisition system was sound, although long-term results should be monitored. The financial incentives to reduce overhead seem to have worked during their lifetime, but their effects were quickly reversed when they were ended. Thoughtful proposals on export policies and technology cooperation were only partly successful, although the underlying ideas still have some limited impact. Most important, DOD’s development of a framework for sorting out policy choices affecting the size and configuration of its industrial base was a laudable first step toward rationalizing its interactions with industry. Perhaps the most significant defect was that not enough consideration was given to framing the underlying trade-off between competition and economies of scale, which ultimately halted the consolidation initiatives.

Should we intervene
to improve the
performance of producers
in commercial markets?

Long-Term Concerns
We now face a rising tide of procurement spending with substantially fewer defense industries. One immediate concern is competitiveness in the aerospace sector. In contrast to computers and semiconductors, this industry never significantly decreased its reliance on DOD support for the development of new technologies. However, aerospace is as important to the strategic advantages of U.S. military forces today as it was decades ago. Like electronics and IT, aerospace is a dual-use technology with many important commercial applications. Unlike IT, however, the relative sizes of the commercial and military aerospace markets have remained in rough parity. This has created unique strategic considerations that complicate economic policy (e.g., trade and technology policy).

Many indicators suggest that the U.S. aerospace industry today is in trouble in commercial markets. However, it is inconceivable that the U.S. military will let its suppliers fail. This raises the specter of a military-only aerospace industry, analogous to the military-only U.S. shipbuilding industry. Can a military-only aerospace industry remain a viable and technologically dynamic sector? Must we intervene to improve the performance of our producers in commercial markets? This is a difficult policy question that we seemed destined to address in the next few years.

IT is transforming the military as it has transformed the rest of our society. Electronics, software, and “other” defense equipment now dominate investment in defense equipment (Figure 2). These technologies, which are primarily driven by commercial suppliers in an increasingly globalized industry, raise some difficult long-term questions. Will the qualitative technological advantage of U.S. systems that we have relied on in the past become less sustainable? Will the export controls we have relied on to deny potential adversaries access to our most advanced technologies become increasingly inadequate and outdated?

Innovation in IT and biotechnology continues to accelerate, and new industries are springing up to commercialize products based on these technologies. Even by the standard of U.S. military procurement budgets, very large sums are being invested in R&D in these areas; however, U.S. defense contractors are barely involved. Given the threat of chemical and biological weapons and the rise of information warfare, this situation must be changed. However, ensuring that the producers of our defense systems are in close contact with technology development in IT and biotech will require that we change the procurement system we inherited from the last century.

Despite the reforms of the 1990s, the procurement system is still basically a World War II-era regulatory system based on administered prices derived from costs. The system was designed to deliver specialized products to a single customer, the government, produced by suppliers with significant monopoly power. Monitoring and audits were necessary to ensure that outcomes were reasonable, but post-Cold War downsizing of the military included downsizing of the government workforce that monitors procurement.

Thus, while procurement is once again increasing rapidly, the monitoring and audit function is not. Indeed, recent well publicized scandals suggest that instances of malfeasance on a spectacularly large scale, which occurred from time to time in the past in the defense sector, may be on the upswing. Consolidation and less competition in the defense industry may aggravate the problem.

This raises the issue of whether it is time to revisit the fundamental design and operation of the procurement system. The last major examination of this system, conducted in the 1980s, two decades ago, led to only marginal changes. Given the significant changes that have occurred in the technological, industrial, and geopolitical environment since then, it would seem appropriate that we reexamine how the government goes about the business of maintaining a technological advantage for U.S. national security.

The globalized production systems currently producing IT, semiconductor, and biotechnology innovations raise serious questions about national advantage in both the military and economic arenas. Private-sector R&D investments in these areas continue to dwarf technology investments by the military. The issue for the military is how to tap into commercial developments while securing closely held technological differentiators for military systems that incorporate commercial technologies.

Specialized software and systems-integration know-how may be the keys to transforming widely understood technology building blocks into closely held military systems. However, the defense industrial base must not be cut off from commercial developments. To make effective use of new commercially developed technologies, defense industries must be part of the commercial world. One solution may be to reengineer the procurement system so military markets will be more attractive to commercially oriented companies and to reduce differences between military and commercial products wherever possible. This would also help alleviate the problems of increasing concentration and decreasing competition in defense industries.

Thus we have come full circle, back to a central theme of the defense industrial policies of the 1990s—commercial-military integration and dual use. In cases where DOD has unique technology requirements and product niches, it must be prepared to bear the full cost of maintaining a separate and unique industrial base. In other cases, however, many problems can be solved by revamping the procurement system to make it easier for commercial companies to sell solutions to military problems using commercial technology. Dual use is back—or at least it should be!

Table 1 Declining Number of Primes,

Number of Contractors
Tactical missiles
Fixed-wing aircraft
Expendable launch vehicles
Surface ships
Tactical wheels vehicles
Tracked combat vehicles
Strategic missiles
Rotary-wing aircraft

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About the Author:Kenneth Flamm is a professor and the Dean Rusk Chair in International Affairs in the Lyndon B. Johnson School of Public Affairs at the University of Texas at Austin. He was Principal Deputy Assistant Secretary of Defense for Dual Use Technology Policy and International Programs from 1993 to 1995.