In April, the Department of Defense released a report on the financial health of the defense-industrial base, spelling out three key findings: the defense industry is financially healthy, the DoD does not need to change its profit and incentive policy, and the Pentagon can procure the goods and services that the American warfighter needs to effectively defend our nation.
Talk about missing the forest for the trees.
The report’s finding should have instead been that America’s defense-industrial base is failing our warfighters and taxpayers, as the Pentagon has willfully and with foresight created today’s monopolistic, overregulated and costly defense marketplace. That marketplace has left the DoD without the ability to procure at scale the goods and services it needs to fight a major war, demonstrated by munitions shortfalls from the conflict in Ukraine. It’s also left the Pentagon in need of a change to its profit policy as CBS’ “60 Minutes” segment on price gouging in the defense-industrial base recently showed.
The origins of today’s defense marketplace are as follows: First, the leadership of major defense primes are mostly compensated with stock awards, which, while substantial, are expected within our capitalistic system. Wall Street then rewards these companies with higher share prices based upon their ability to provide profits for dividends and stock buybacks. But thanks to the Pentagon, these returns are less a result of competitive market forces and more a result of industry consolidation.
In the 1950s and in the 1980s, the Pentagon’s spending power created a healthy, competitive marketplace where defense firms competed on both price and innovative capabilities. This marketplace fostered free and open competition, equipping the United States with the best military in history. Despite this success, the Pentagon killed the proverbial golden goose by consolidating the defense-industrial base in the 1990s, leaving fewer suppliers and, therefore, little competition.
Industry consolidation is but one piece of the puzzle when it comes to how the Pentagon has elevated prices for taxpayers. Another is the Pentagon’s misguided divest-to-invest strategy, which devotes an ever-greater share of the department’s investment dollars to research and development rather than adequately funding procurement. R&D has thinner profit margins, meaning that for every dollar the government spends on R&D, few are able to become profit for contractors.
As the prices for weapons and components increase, the Pentagon orders less of each. With less purchased, the primes are poised to negotiate harder for higher prices so that they can maintain or increase their total profits, further raising the price of their products and leading to even fewer purchases. This means that, in effect, the divest-to-invest strategy is a pricing-to-procurement death spiral, threatening readiness and fair prices.
Elevated prices are also a consequence of the interactions between prime contractors and their array of subcontractors. Not subject to the same payment terms or timely cash flow from the government as the primes, the subcontractors receive less cash themselves. This squeezes the suppliers, already often sole- or single-source, leading to less redundancy and less capacity. The suppliers left standing then become economically powerful, as “60 Minutes” correctly noted.
But what’s most important here is that this results in a lack of surge production.
An inability to surge production is also a product of rosy planning assumptions where the Pentagon’s leaders essentially assume away the problem. The defense-industrial base is healthy if you assume only one very quick war. If this assumption isn’t correct, the Pentagon then believes that allies will pick up the slack, but their weapons’ cupboards are barer than ours.
In short, forced consolidation, faulty Pentagon planning assumptions, a focus on R&D at the expense of procurement, and the cash flow structure of the major defense primes have led us to the situation that we find ourselves in today: We’re in need of warfighting capabilities — a lot of them — but cannot produce them at scale and at prices that a functioning capitalistic market would allow.
Thankfully, the Pentagon can start to turn this around. First, when starting the acquisition of new weapons systems, it should err on the side of not developing them as joint programs, which are essentially a synonym for “contract-to-monopoly.” Consolidation of buying power into the purchase of one system kills off competitors and creates a monopoly; the market for fighter jets shows this to be true.
Secondly, the Pentagon should procure much more, and it should do so by making multiyear procurement contracts and block buys the rule rather than the exception.
Lastly, the federal government can break open the doors to competition by eliminating unnecessary regulations that make it difficult and costly for emerging startups to do business with the DoD.
Failing to take these actions will mean that we’ll be stuck with a defense-industrial base that’s unhealthy, not meeting the needs of the warfighters and, on the most basic level, not providing the American taxpayer with a fair deal. And that’s an industrial base that we shouldn’t accept.
Retired U.S. Army Maj. Gen. John Ferrari is a senior nonresident fellow at the American Enterprise Institute think tank. Ferrari previously served as a director of program analysis and evaluation for the service. Charles Rahr is a research assistant at AEI.