War Will Change Industrial Priorities, Says Policy Chief.

Defense spending in the United States is likely to grow in the long term, officials said, regardless of the length or the outcome of the war in Afghanistan. The expected boost in Pentagon budgets is good news for the defense industry even though experts believe that companies will have to adapt to a new way of doing business.

The surge in requirements for new equipment and weapons that ensued from the terrorist attacks of September 11, on the one hand, will result in significant new business for many companies. On the other hand, the nature of the conflict in Afghanistan is driving Defense Department officials to rethink buying priorities. The so-called "transformation" of the U.S. military, officials said, means that increases in spending will nor necessarily be allocated to traditional military hardware, but rather to "transformational" technologies.

Deputy Undersecretary of Defense for Industrial Policy Suzanne Patrick recently told National Defense that she is confident that the defense industry will be able to adjust to the changing environment, which is "a natural by-product of the transformation we find ourselves in."

Recent developments in the world, she said, show that "we are veritably at the watershed between the more known, conventional forms of warfare and new ways of pursuing warfare that will undoubtedly be less platform and more network-centric.

"So it should not be surprising that as we advance this new kind of warfare, we will have a dwindling supplier base of the old-style platforms and systems." At the same time, Patrick said, "it is important to adequately fund the futuristic systems that will rake us to this new form of warfare without exposing ourselves to imprudent risks relative to current requirements."

Patrick said that specific programs would benefit as a result of the current conflict. The Pentagon, she said, will "accelerate into production a number of the transformational technologies so important to Secretary Rumsfeld as he took office."

Defense contractors, she said, should be flexible, "in order to pursue new opportunities as they continue to produce current platforms." A case in point is an initiative by Boeing to pursue future contracts for unmanned aircraft. "We were particularly pleased to see Boeing stand up its Unmanned Vehicles business unit in order to go after some of these new opportunities with many members of the fine team they assembled to compete for the Joint Strike Fighter program.

Operation Enduring Freedom and homeland defense efforts will result in the infusion of significant funding for "key programs in the defense industry," Patrick said. "And even after the current conflict ends, there should be considerable additional funding allocated for the replenishment of defense hardware and consumables expended."

In the United States, she said, "We are very fortunate ... to have a strong, resilient and responsive industrial base."

Patrick's office is part of a newly-established Defense Department task force aimed to ensure that the industry can produce the needed equipment and that the available funds are prioritized to meet the most urgent needs. Patrick is working with the Joint Staff, the Defense Contracting and Management Agency, and the services, in a group called the Priority Allocation of Industrial Resources Task Force. The task force, she said, "will ensure the smooth and equitable allocation of key warfare requirements among multiple programs."

This organization will monitor the industrial capabilities and assign "production priority to key systems and subsystems," she said. "These measures should allow for the most efficient and expedient provision of needed hardware to the war fighter."

One important consideration for the Defense Department is whether is the industry is robust enough to meet changing requirements, said Jeffrey Bialos, senior fellow at the John F. Kennedy school of government at Harvard University and former deputy undersecretary of defense for industrial policy. "The nature of warfare has changed," he said in an interview. "The concept of surge capacity is fairly outmoded." The Defense Department should ask: "do we have sufficiently robust defense companies to meet our national security needs?"

A short-term boost in defense spending surely will benefit defense companies, said Bialos, "Some $20 billion of the $40 billion emergency funding already appropriated by Congress will go to defense for such things as increased operations, upgrades to electronic reconnaissance aircraft, situational awareness, acceleration of unmanned air vehicle (UAV) programs such as the RQ-4A Global Hawk and munitions purchases," said Bialos.

"Most people agree that what we cant scrimp on right now is defense," said Andrew Krepinevich, president of the Center for Strategic and Budgetary Assessments. This makes the defense industry "recession-proof," he stressed.

Despite significant boosts in defense spending, a skittish stock market and an uncertain U.S. civilian economy have prompted analysts to worry about a market downturn in the long run.

Changing Requirements

Byron Callan, a defense and aerospace analyst at Merrill Lynch, said it takes time for the defense dollars to trickle down to the broader economy. "There is an expectation that there will be more money for defense, but we won't see that money for at least six months on the commercial side," he said. "What was so significant about September 11 was that it suddenly made defense a growth market, where there had not been growth before. I expect that there will be a lot of commercial companies looking to do business now with the Defense Department, to the benefit of the entire defense sector," Callan said.

"Unless you want to make the case that we're going to have rolling terrorist attacks, this could be an opportunity for the Defense Department to get some things done," Callan said.

Aggressive investment in defense modernization may be one way to "get things done," said Dov Zakheim, the Defense Department's comptroller. Zakheim made the case that the Pentagon should spearhead an economic stimulus package.

"What better way is there to kill multiple birds with one stone than by accelerating the modernization of facilities, really building, that will give the construction industry real work and puts a lot of people to work right now?" Zakheim said during a breakfast with reporters. "We have for years, seriously neglected the modernization of our facilities, housing and other facilities. What we've done is create a situation where we try to get the best people to serve in the military and then we treat them like dirt because they live in substandard housing and work in horrible office environments."

Wolfgang Demisch, managing director of Dresdner Kleinwort Wasserstein, had a less optimistic view. "We have come to a frustrating impasse in defense. There is an expectation that various programs currently in the pipeline, such as the fighter programs, will be put on hold. People thought that funding for modernization would be curtailed to pay for the fighters, but now all that funding is going toward the war effort."

Defense stocks, he said, experienced a 25-30 percent gain in the weeks immediately after September 11. "But the counterpoint is that commercial stocks have experienced a blow, the worst since the energy crisis of the 1970s," Demisch said. "We are looking at a worldwide financial crisis for the air transport industry, and as a result, its entire supplier base is in enormous distress."

Companies that make products used by both commercial and military aviation, such as precision cast parts and turbines, he said, have seen their stocks "whacked painfully." The expectation is that air traffic will continue to shrink, and the government's security procedures are "being applied in a typical bureaucratic fashion--making air travel significantly less convenient and more expensive," Demisch said.

"It is not clear that the people determining the security regulations are very conscious of the financial crisis of the air transport system," he added. "Defense companies that have a substantial commercial presence in air transport will be hurt by current conditions.

Krepinevich noted: "One could argue that the recession could spur the government to provide support to the commercial and aerospace sector." He said that the Pentagon is looking for ways to help bail out certain companies. "Boeing, a defense company heavily involved in the commercial airline business, is at risk because so much of their business is commercial. The Defense Department is now talking about buying C-17s, which Boeing makes, to help bring Boeing out of its crisis," he said.

However, Demisch added that defense and aerospace products are not made or acquired overnight, so the sector will lose huge amounts of money while it waits for direction from the government.

Ben Bernanke, a member of the Business Cycle Dating Committee of the National Bureau of Economic Research, said that based on historical data from previous post-war recessions, the U.S. economy is likely to begin a recovery by July 2002.

RELATED ARTICLE: Pentagon Industrial Policy Rooted in 'Market Economics'

The Defense Department's determination to keep the "winner take all" acquisition strategy on the Joint Strike Fighter (JSF) and the decision to not allow the country's only two nuclear shipyards to merge underscore the Bush administration's aproach to industrial policy, said Suzanne Patrick, deputy undersecretary of defense for industrial policy.

"There are three major tenets that we consider when we make industrial policy decisions affecting major weapons systems or warfare areas," she told National Defense. "These criteria are equally relevant to acquisition policies on major programs as they are to proposed corporate restructuring initiatives."

The first tenet is a "strong commitment to the principles of market economics and our confidence that these market forces and companies' responsibilities to shareholders will generally result in cost-effective, innovative behavior," she explained.

Second is the "importance we place on the operational requirements process as the best way to field weapons systems to war fighters in a timely, cost-effective manners."

The third tenet is the ability "to look as far into the future as practical, to assess our decisions" and make sure that they reflect the Defense Department's "transformation" goals.

In the case of the JSF winner-take-all strategy and the source selection, "it was important that we not engage in 'bait and switch' practices in the end game," Patrick said. "We were also confident that the competitive award process had captured all of the best that our fighter aircraft industry could encapsulate in two very exciting designs."

Members of Congress had pressured the Pentagon to make the winner of the JSF contract, Lockheed Martin, share some of the work with the losing bidder, Boeing. But the Defense Department rejected that notion, on the basis that it was a fair competition and that the rules of the game should not be changed arbitrarily.

However Patrick said, "if Lockheed judges it appropriate now or in the future to bring onto the team design or systems innovations from other manufacturers, we are confident that they will do so.

Having a second JSF team would be prohibitively expensive, she said. "To build and maintain a second production line and design team would have likely cost $500 million to $ 1 billion effectively the cost of 10-20 additional aircraft."

Additionally, "as we looked to the future of tactical aviation, with the operational experience with Unmanned Aerial Vehicles gathered in Desert Storm, Kosovo, and now Operation Enduring Freedom, we are confident that the future of tactical aviation will be much less platform centric," Patrick said. "Hence, narrowing our fighter aircraft industrial base to one team did not appear to be a disproportionate risk."

On the shipbuilding side, the Pentagon endorsed the Justice Department's view that a merger of Newport News Shipbuilding and General Dynamics Electric Boat would have created a monopoly and thus hampered competition. The Defense Department did not oppose, however, the acquisition of Newport News by Northrop Grumman Corporation.

"We viewed it as prudent to maintain the maximum level of competition possible in this sector of shipbuilding," Patrick said.

"As we looked out over the next 20 years, we have the requirement to replace the Trident submarines in the 2020 timeframe," she explained. Ongoing submarine programs such as the Virginia-class, the Jimmy Carter class, and unmanned underwater vehicles are proceeding successfully. Nevertheless, she said, "we could not be as confident as we were in the case of fighters that we would not have to field one more futuristic generation of nuclear attack submarines."

Maintaining two shipyards was considered appropriate, "in order to secure a competitive base both for the potential requirement for a next-generation attack submarine as well as the Trident replacement."