Bowing to Pentagon opposition, Lockheed Martin last month dropped its bid to absorb Northrop Grumman, ending a six-year consolidation wave among American defense contractors. But a larger wave of trans-Atlantic mergers could follow.
Lockheed-Martin is actively seeking European partners, and Britain's GEC may bid for Northrop Grumman. William Perry, former Secretary of Defense, and John Deutch, former CIA director, just formed a firm to advise investment bankers on global deals.
Should we welcome a transnational defense industry?
The Pentagon is charting a new course after flip-flopping on mergers in the 1990s. Its conundrum: how to maintain America's innovative edge in defense technology while facing severe budget constraints. Its answers: oppose competition-eroding mergers, encourage new entry, buy commercial where possible, design but don't build, and, possibly, buy foreign.
These moves are creative and smart. The previous mergers were supposed to save the Pentagon money by eliminating redundant production capacity. Yet despite the implosion of 15 major contractors into four, few weapons production lines have actually been eliminated. Instead, the merged companies have broadened their defense industrial portfolios and enhanced their market power and political access. For the most part, they have eschewed diversification and spinoff of dual-use technologies, minimizing an expected peace dividend.
In response to defense spending cuts of more than 60 percent and the Pentagon's new competition policy, the largest companies are scrambling to export and partner abroad. US firms have dramatically increased their market share from 30 to 47 percent since the late 1980s, despite a worldwide drop in defense spending of more than 30 percent.
But with the Asian crisis and low oil prices, there are more hard times ahead.
So it's a buyer's market. Governments demand offsets more or less equal to the value of their purchases. American firms trying to sell to Europe or Turkey or Taiwan must agree to either build portions of the system there or market their surpluses of other goods in the US.
Why not, instead, merge or partner with foreign firms? The advantages for contractors are several: diminution of competition, access to insider knowledge of foreign procurement, and potential cost savings from exploiting economies of scale.
The end result could be an industry which is truly transnational, with a small number of globe-spanning firms whose research and design might be conducted in one country, prototyping and testing done in another, and production and components spread even further afield.
What's wrong with this picture?
First, there are the perennial cost and supply disruption problems. Fewer sellers generally mean higher costs and prices for weapons, and supply in times of crisis could more easily be disrupted with greater country-by-country specialization.
Second, innovative capacity could be at risk. The domestic mergers have already shifted the balance of power from a market with multiple sellers and one dominant buyer, the Pentagon, to one with a few consolidated sellers and a plurality of buyers. On a number of key weapons systems, effective design competition among domestic suppliers is down to three, two, or even one firm. Yet third- and fourth-place competitors often produce the breakthrough designs that ensure technological superiority.
Although the US has rarely, for political reasons, bought "foreign," the disappearance of top-rated design capacity in independent European firms would foreclose this competitive option.
However, the greatest security danger lies in our diminished ability to control the spread of leading edge defense technologies. If firms become truly international, the flow of completed weapons systems between nations might actually decline even as components trade increases. (Think of the world car and the Chrysler/Daimler-Benz merger).
Personnel and technologies would flow more freely within the walls of firms and across national boundaries, protected to some extent by proprietary rights. The ability of the US and its allies to control proliferation through monitoring the arms trade would be diminished even as the pace of technology diffusion quickens. This scenario might work for cars, but it's not good security policy.
But why, if it's a buyer's market, should we worry about transnational defense firm mergers? Because the industry is moving faster toward collaboration and partnering than are our governments.
Europeans can't agree on a common security strategy or a common defense industrial base. And rather than cooperating to restrain proliferation, US and European firms are competing intensely for developing country markets, supported by huge export promotion subsidies on the part of our governments. The result is an arms race among ourselves.
If the Pentagon and its trans-Atlantic partners do not fashion a workable and prudent defense industrial base strategy, the industry will do it for them. The results are likely to be fewer competitors, higher costs, and leaky military technology. For now, the Pentagon should discourage transnational mergers and fine-tune its competition policy. For the long run, it should lead in developing cooperative security and military industrial policies with our allies.
* Ann Markusen is a Senior Fellow at the Council on Foreign Relations and director of the Project on Regional and Industrial Economics at Rutgers University.