Mr. ADAMS. If the economy is in a recession when these changes take place- Representative HAMILTON. That's very, very clear. But the adjustment we would go through in defense spending, you are not worried about the impact that is going to have on people out of work? Mr. ADAMS. I don't think it is a central concern right now. Mr. GANSLER. This period is a lot better than the post-Vietnam one in that respect. We don't have the cutbacks in NASA, the cutbacks in commercial aircraft that we had at that time. IMPACT ON FINANCIAL MARKETS Representative HAMILTON. Mr. Lee, you've paid a lot of attention to the financial markets. What is going to happen here with regard to stock values, investments in the defense industry, financial markets and all the rest, as a result of this peace dividend? Mr. LEE. The defense companies' stock prices by and large sell for very low multiples. That is going to continue. The defense companies are going to have a very difficult time raising capital if they choose to stay in the defense business. Smaller companies, I expect, are going to be purchased by larger companies. There will be some companies that choose to get out of the defense business altogether. Representative HAMILTON. Are we going to see a big shakeout in the defense industry, here; mergers, acquisitions, failures, and that sort of thing, in the next few years? Mr. LEE. We have been seeing a lot of mergers and acquisitions in the past few years. If you've been paying attention, particularly in the electronics area, there have been a number of small companies that have been absorbed by larger ones. Lockheed, for example, purchased- Representative HAMILTON. You see, as a result of the peace dividend, more of the same? Mr. LEE. It's going to happen faster because we're going to move the defense budget down faster, so the industry's going to shrink. Representative HAMILTON. Will that be good or bad for the indus try? Mr. LEE. The industry's going to shrink. Representative HAMILTON. Is that good? Mr. LEE. I think it has to happen. I don't think that the defense budget is going to support the defense industry that we have right now. Mr. GANSLER. It is not just the price multiple of the declining market; they now have heavy debt structure, and low profit and that will make it tougher. DEFENSE INDUSTRIAL BASE Representative HAMILTON. Do you see any threat in this shakeout that occurs to the defense industrial base? Mr. LEE. I think this is a problem that we need to pay attention to. As I mentioned in my testimony, I think there is a legitimate national security reason for saying that there are certain critical things that we need for our national security. And it may be that we have to have an explicit public policy of subsidizing those criti cal needs because the private sector economy will not provide those things. And I think that we need to take a look at that, and not just let those things go away without having considered the implications of it. to? Representative SCHEUER. Which critical needs are you referring Mr. LEE. We have had situations where you couldn't get certain types of equipment; you couldn't get ball bearings or you couldn't get particular types of electronics equipment, or you found that the only producers of certain types of chips, or the only producers of certain things were foreign producers. And those things were critical to weapons systems that we thought we needed, that were important for our national security. Mr. GANSLER. Those critical technologies, the things that defense badly needs, tend to be at the lower tiers, not the prime contractor, and those are the common, "dual use" technologies that we are talking about that, in fact, could have a positive effect on U.S. competitiveness in the civilian sector, if properly stimulated. Representative HAMILTON. What is going to be the result of all of this changing the defense industry on American technology prowess, anything? Mr. GANSLER. It depends on how we go about doing it. Mr. ADAMS. Everything is how you go through the change; nothing is automatic. My sense is, if we are self-conscious about the public and private sector roles in America's technology future, and think about the areas that Jack Gansler has been talking about, what areas a public sector needs to play a role in the stimulation and development of technology, then, out of the change, could even come some resources that could be profitably put to America's competitiveness in this situation. Representative HAMILTON. Are you optimistic or pessimistic about our capacity to make this change? Mr. GANSLER. Pessimistic. I'm afraid there are still too many people saying that what we have to do is to let the free market operate. And the problem is, we don't have a free market; in defense, we have a perverse market with a single buyer and only a few suppliers. And even in the civilian market, we have, in the case of the European or Japanese, we have industry and government cooperating against our firms competing against each other. And I am afraid that, if we continue in that direction rather than establishing some form of an explicit technology strategy-that would focus on those critical industries with some government, at least, encouragement of those industries-that we are going to continue the trend that we have been having in those areas that Doug Lee listed of critical technologies. They are all going offshore. INDUSTRIAL POLICY Representative SCHEUER. You were talking about a specific technology strategy. Now, do we need a national industrial policy now at this point? Is this a government role. Who is going to determine this explicit policy? Mr. GANSLER. I think we do have to identify those industries that are critical to national security. Representative SCHEUER. Who is going to identify them? Mr. GANSLER. I would argue that that should be done by the executive branch. Representative SCHEUER. All right. Please proceed. Mr. GANSLER. It should be a very limited number; it should be defined as those that are rapidly changing that are essential to defense, that are indicated going offshore rapidly. We need to do something to stimulate those and to create incentives for people with high-technology skills to go into those areas. We have done that in the past, successfully; we are actually doing some of that today. I would argue that Sematech is an example of one of those; superconductivity is another example. Representative HAMILTON. Do you agree with these comments, Mr. Lee? Mr. LEE. By and large, I think that is right; we do not need some macro, big government policy. What we need is a policy that explicitly says that we need certain things and we're going to pay for them. And that part of the cost of providing for the national security is to pay for these specific technologies that are critical-that we will not get any other way. Representative HAMILTON. Do you agree with that, Mr. Adams? Mr. ADAMS. I think that is right. I would agree with that. I would say that, I think I'm more optimistic than Jack Gansler. This may be because I look at two things; one, is the ability of a number of defense contracting companies who do a significant amount of the defense business who have begun their own process of adaptation, and I expect them to be able to carry it off. The other reason I'm optimistic is because we tend to not pay adequate attention to the successes, particularly, that American multinationals have had in establishing themselves in global markets. The National Bureau of Economic Research study about 4 years ago concluded that the share of global production in manufacturing markets held by American-based multinationals hasn't changed since the 1950's. We have a lot of capability to adjust, adapt, and succeed in the international markets. Mr. GANSLER. If I could make one point. It is not sufficient, it is necessary but not sufficient to be able to identify these critical technologies and to stimulate them. Far more important, undoubtedly, is the overall economic and cultural environment, the educational shift, the creating of the capital environment, the money environment in which long-term investment is rewarded, rather than short term; that savings are rewarded, rather than consumption. We need to shift, basically, to an overall environment in the United States geared toward more competitiveness. And if we do that, then clearly focusing on a few selected technologies can make a big impact. It can't if the overall environment is negative. INTEREST RATES Representative HAMILTON. Do any of you see any impact on interest rates? Mr. ADAMS. It could be but I would suspect that it could be in either direction. It is hard to know. Representative HAMILTON. It doesn't worry you very much, as you think about these problems? Mr. ADAMS. I don't think it is going to be major. If anything, the likely impact would be positive; that is, the margin interest rates might go down as a result of, over time, a reduction in the Federal deficit. This might contribute to it. Representative HAMILTON. Would you say that we have a successful economic adjustment after Korea and Vietnam? Mr. ADAMS. After Korea, I would say, yes; after Vietnam, I would say, no. Although—— Representative HAMILTON. Do you agree with that, Mr. Gansler? Mr. GANSLER. Not particularly, because of the macroeconomic environment. It is not what we did specifically in defense but basically we did what we are doing now; we borrowed, and that drove up the interest rates. CONCLUSION Representative HAMILTON. OK. Do you have any parting wisdom for the committee here, gentlemen? We have had a good session. As Congressman Scheuer has mentioned, on several occasions, and we are most grateful to you for starting us off on these difficult questions. You have contributed significantly, each one of you, and we are grateful to you. Thank you very much. Your full statements, of course, are made part of the record. [Whereupon, at 12 noon, the committee adjourned, subject to the call of the Chair.] ECONOMIC ADJUSTMENT AFTER THE COLD WAR TUESDAY, DECEMBER 19, 1989 CONGRESS OF THE UNITED STATES, Washington, DC. The committee met, pursuant to notice, at 10 a.m., in room 2359, Rayburn House Office Building, Hon. Lee H. Hamilton (chairman of the committee) presiding. Present: Representatives Hamilton and Scheuer. OPENING STATEMENT OF REPRESENTATIVE HAMILTON, CHAIRMAN Representative HAMILTON. The Joint Economic Committee will come to order. In the first session of this series on "Economic Adjustment After the Cold War," a week ago, we heard testimony about the possible changes in the defense budget, assuming the current favorable trends in European developments and United States-Soviet relations continue. The experts we heard from were in agreement on several important points. First, that for the next few years the downward trend in defense spending will be in about the same range as in the past few years. Second, that in the near term savings from defense cuts are likely to be modest. And third, that the Defense Department will probably prefer to make most of the reductions in manpower rather than hardware, although a more balanced approach would be more desirable in the view of the witnesses. Today, we want to look more closely at how defense reductions will influence the economy and what measures, if any, ought to be taken to make the transition to a post-cold-war era a smooth one. We confront major choices about how to employ the so-called peace dividend. Should it be used for deficit reduction, tax cuts, new spending programs, or some combination of those purposes? Is this an appropriate occasion for a major reordering of priorities? Will the size of the budgetary savings make a difference in performance of the economy on a national or regional level; and should government policies be modified accordingly? We are quite pleased to have with us today, to respond to these and other questions, three highly respected economists. Charles L. Schultze is very familiar to this committee as a former Director of the Bureau of the Budget, a former Chairman of the Council of |