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cal approaches through the maintenance of a large research and development establishment, et cetera, all are constraints which must be included in optimizing the single "objective function" of developing and producing, for minimum peacetime cost, the current and future equipment necessary to maintain, at any point in time, the strategic viability of the U.S. defense posture.

Next, it is critically important to recognize that the defense industrial base is not a single industry, but rather a multiplicity of separate industries, for example, tracked vehicles, munitions, aircraft, ships, et cetera, and each of these has, for historical reasons, very different characteristics; even in such basic areas as structure, labor market, public/private sector mixes, profits, et cetera.

Thus, each of these industries will have different strengths as well as different problems; and, therefore, very different corrective actions. Similarly, it is extremely important to recognize that the defense industrial base is basically a "dual-economy," that is, first at the level of the large prime contractors, and, second, at the level of the smaller subcontractors and parts suppliers. Again the characteristics of these two levels are totally different; and their problems and, therefore, corrective actions, are correspondingly very different.

Consider first the large, "prime" contractor level. Here the data indicate that there is considerable excess capacity existing today in many of the industrial sectors (perhaps excluding only nuclear shipbuilding); that many of the companies are in an unhealthy financial position (and here, even the shipbuilders are included); they have aging plants and equipment; and the Government has created formidable "barriers to exit" for these corporations.

Also, at this level, there is ample "surge capacity." However, current planning for wartime contingencies indicates that (for the likely "scenarios" of the current era) the duration of the conflicts may be too short for the industrial base to respond with significant quantities of major weapon systems, for example, planes, ships, et cetera.

Thus, we may be paying for excess capacity with a high likelihood that it will never be required. Also, at this "prime" contractor level, there are only a very few companies doing a major share of the business; and these are utilizing large amounts of Government-supplied money, plants, and equipment.

Finally, this is the sector to which most of the Government procurement regulations, acquisition practices, and Government "oversight" has been applied.

Thus, this sector would appear to be one in which there already is almost total Government involvement. In fact, the same department is the "regulator," the specifier of new products, the "banker," the judge of claims, and almost the sole buyer.

Yet, one frequently hears claims that this government intervention is grossly inefficient, and frequently self-defeating. Perhaps this results from the Government's de facto assumption that an optimum economic structure has been arrived at through the operation of the "marketplace"; when the data indicate that a true market economy does not, and probably cannot exist at this level.

In the environment of a monopsony buyer and a smaller number of oligopoly suppliers, I believe that the "theory of the second-best" applies, rather than traditional economic theory.

For this case, the theory of the second-best states that when many of the conditions for a free market do not exist, and cannot be made to exist, then creating some additional appearances of free market. conditions may actually reduce economic efficiency.

Let me cite two examples from recent studies. The first was of the U.S. aircraft industry. Here the data would indicate that there is apparently considerable extra capacity in both manpower and plant and equipment, and that it is costing the DOD a large amount of money annually to maintain this additional capacity. A "second-best solution" would indicate that reducing the number of firms in this sector of the economy would still allow for ample competition, ample research and development, and ample surge capacity, while actually allowing more airplanes to be built for the amount of money that Congress allocates-simply by doing it more efficiently in a few, modernized, profitable plants.

Next, consider the shipbuilding industry, where another study showed that the very high turnover of labor in the private-sector shipyards over 70 percent per year-results in very large annual inefficiencies in terms of the numbers of ships that can be built for the amount of money that Congress authorizes. Here the "secondbest" solution would appear to be more "competitive allocation" of work into the shipyards; with the objective of keeping a more constant workload at each of the individual yards.

Notice that the problem, and therefore the corrective actions, for these two examples are quite different; and therefore would be difficult to implement with "uniform procurement policies." However, they could be achieved through conscious Government action that recognized the uniqueness of the industries and of the Government's role therein, and applied "tailored" solutions to each sector.

Returning to my discussion of the "dual economy," at the second level, namely, the subcontractors and parts suppliers, the data indicate that, in many cases, exactly the opposite characteristics and problems appear to exist. Here, the smaller contractors-those that remain after the large amount of vertical integration which has been achieved by the "giants"-are required to use their own plants, equipment. and money. Also, because of the nature of the Government's and prime contractors' "way of doing business," these smaller contractors. are realizing a relatively low return on investment-compared to the prime contractors, or to the small contractors in the civil sector, or frequently, even relative to the "bankruptcy" level.

Also, with the rapid drop in Defense procurements, the "primes" and the Government have been bringing more of their business "in-house," So the defense market dollars available to the "nongiants" have been shrinking even faster than at the Government-to-prime contractor level.

As a result, large numbers of Defense suppliers at this lower-tier level have been either purposely leaving Defense business for the growing and financially more attractive civil and foreign markets, or have been going bankrupt.

Finally, defense weapons systems are becoming extremely complex. This complexity has caused the evolution of high-technology, capital

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intensive specialization at the lower-tier levels. The combination of these trends has resulted in a shrinking number of critical suppliers. Thus, in many important areas, the effect has been that those few remaining suppliers are in a monopolistic position, and thereby able to rapidly raise their prices, and to dictate delivery times. These price increases should, by traditional economic theory, result in large numbers of companies "rushing" to enter this market. Price increases of 300 to 500 percent, in 1 year, have been observed. However, no such "rush" has been found. It is hypothesized that this is attributable to the "barriers to entry" that the Department of Defense has created through its procurement practices that is, military specification; "preferred parts" lists; small-quantity, annual procurements; and low profit.

I believe that this shrinkage of suppliers at the parts level not only affects the production efficiency of Defense procurements, but also creates significant industrial "bottlenecks" for "surge capability" in times of national crisis. A simple example of the latter case was the 1974 request by Congress for the Department of Defense to increase its tank production-as a result of the 1973 Mid-East war-and the inability of the defense industrial base to respond-not because of a shortage of tank-building capacity at the prime contractor level, but because of the inability to get steel castings from a supplier who preferred to do commercial business-and he was the only source supplying this size casting.

Personally, I believe that, at this subcontractor/parts supplier level, the proper "corrective action" would appear to be for the Government to remove the "barriers to entry;" thus, both allowing, and even encouraging, free market competition to take place.

Examples of such actions would be to allow the use of commercial parts and specifications; to require dual-sourcing of critical components; to encourage integration of a firm's defense and commercial product lines; to minimize steps toward vertical integration; and to force more "buy" decisions-rather than prime contractor "make" decisions.

Currently, at this level, the Government "tries not to get involved;" when, in reality, it is again the controlling factor.

Thus, Government action at this level should be directed toward creating a viable free-market economy.

In summary, I believe that at both levels of the defense industrial base, the prime contractors and the suppliers, there is evidence of diminishing economic efficiency and reduced surge capability. I believe that already these areas have reached a point where corrective action is warranted. However, I am even more concerned about the implication for the future if these trends are allowed to continue.

Fortunately, I think that the first, and perhaps most important step has been taken, namely, that the Department of Defense appears to recognize the need to institutionally address the question of economic efficiency and surge capability of its industrial base. This it began to do with studies over the past year, as well as with initial instructions and actions aimed at taking corrective steps.

I also believe that the recent reorganization of the Office of the Secretary of Defense will help to focus attention in this area.

Finally, I believe that hearings by this committee will serve that important function. Thus, I am optimistic that the currently indicated trends can, in fact, be reversed. The corrective actions appear both achievable and practical for implementation. They do not require radical change; but simply modifications within the current economic and political structure. Their implementation should result in "making the system work"-without the need for huge additional budget outlays, and the attendant costs to the American taxpayer.

In my opinion, as I stated at the beginning of my statement, the U.S. defense industrial base, and its Department of Defense counterparts, are both well-managed and strong today; and modifications, which will allow it to remain up with the demand and conditions of the current era, will result in its continued military viability and business strength.

Thank you.

Senator PROXMIRE. Thank you very much, Dr. Gansler.

Before we go to Dr. Kurth, I am going to have to leave and come back. We have a rollcall. I will be back, I hope, in about 7 or 8 minutes. [Whereupon, a short recess was taken.]

Senator PROXMIRE. Dr. Kurth.

STATEMENT OF JAMES KURTH, ASSOCIATE PROFESSOR OF
POLITICAL SCIENCE, SWARTHMORE COLLEGE

Mr. KURTH. Thank you, Mr. Chairman.

I am grateful to you and the committee for the invitation which you have extended me and for the opportunity to appear before you to discuss some issues raised by American defense production. It has always been important for the United States to obtain the best defense, including the best mix of weapons systems, for the money available. It is especially important today because of the impact of three recent developments:

1. The increase in the quantity and sophistication of the weapons systems deployed by the Soviet Union;

2. The increase in the fiscal constraints facing the U.S. Government in a time of severe inflation and;

3. The introduction of precision-guided munitions (PGM's), which some defense analysts believe will make many aircraft obsolete in the future, much as the airplane made the battleship obsolete in World War II and as the machinegun made the cavalry obsolete in World War I.

The recent history of U.S. defense procurement and the present structure of the American defense industry give reasons to think that the weapons systems we buy may not always be the best ones for the challenges that we face, that they may not always be the most cost effective or provide the best bang for the buck.

In the past decade and a half, the United States has bought a number of expensive military systems which were extensively criticized at the time of their procurement as not being cost-effective and which have continued to be criticized as poor investments. The most familiar examples have been the F-111 fighter-bomber, the C-5A military transport, and two systems which were eventually cancelled but not

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before several billion dollars have been spent upon their development and production, the ABM system and the B-1 bomber.

In addition, the United States has procured progressively more accurate ICBM systems (MIRV's), which some defense analysts think have had the effect of destabilizing the strategic arms race, because of their first strike capabilities, leaving us with less rather than more security.

Why did the U.S. Government buy these weapons systems? In each case, of course, there were official explanations given that the systems were of military value. But the real question is: "Did they provide the most military value for the money expended?" and there are good reasons to think that they did not.

It is possible to construct an alternative explanation for these and other cases of U.S. defense procurement, one that focuses on the structure of the American aerospace industry and on the needs of particular aerospace producers at particular times. Relatedly, Jacques Gansler's concern about overcapacity in the prime contractors in aerospace production becomes quite important because overcapacity suggests that we might be buying more of the wrong weapons in the future.

In the course of my prepared statement, I go into some historical detail about why I think certain weapons were bought, why they were bought when they were, and why they took the form they did. I will not repeat this in my oral statement, but I have presented considerable detail about what I call the follow-on imperative. I argue that when a major production line-I identify nine of these-is opening up as certain contracts are phasing out, then the Defense Department has allocated a new contract that is technically superior but is structurally similar to the old contract. In other words, there has been an imperative to give the old contractors a follow-on contract.

This practice of course, has diminished the impact of competitive bidding on a particular kind of weapon system, but more importantly, it is not always obvious that there should be any new system at all in an old production sector. This is especially so because of the recent evolution of four functional categories or production sectors that I identified in my prepared statement, that is to say, bombers, fighter bombers, missiles, and antimissile missiles. For example, bombers and anti-missile missiles now seem to be obsolete. Many fighter bombers and fighters may become obsolete in the future, ICBM's, MIRV's and especially the MX that is being considered today, are becoming more destabilizing. So a good argument can be made that in certain production categories we should not even have any new weapons systems. And if we should continue to produce new weapons systems in a par ticular category, like fighters, an important question is who should get the contract? In my prepared statement I argue that competitive bidding has not been the prime explanation for why certain weapons systems contracts have been awarded to the corporations that received them.

The analysis presented in my prepared statement does have some implications for the future. I will discuss some of these implications

now.

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