Implications of prolonged recession for industrial structure

As I wrote in January in my essay Arming the Bug Hunt, the dead hand of bureaucratic and legislative meddling is presently working hard to prolong the current recession. That this would happen is almost tragically obvious. Anyone cranky enough to still believe in unreconstructed Keynesianism is liable, as Luigi Zingales put it a few weeks ago, to tell a recovering alcoholic to drink a few glasses of red wine per day, because it’s said to be good for long-term health.

But as always, we ask what this means for us in the arms business? Looking at the question across industries, Lasse Lien, of the Norwegian School of Economics and Business Administration (NHH), and Peter Klein, of the University of Missouri, writing and commenting in their blog Organizations & Markets, recently offered several predictions for the structural implications of what now could be a downturn extended, as in the 1930s, by governmental fiat. I should note that I have slightly amalgamated their views for my argument:

1. Increased specialization, both horizontal (de-diversification) and vertical (further de-integration of supply chains). A relative shortage of capital and erosion of margins means that firms will give priority to funding their core businesses, assuming that they value these most, and that this is where the most attractive options lie.
2. Increased concentration, meaning increased market shares at the end of the episode. As other firms refocus and marginal players struggle, multiple potential merger targets will arise. A firm which wants to be active in the restructuring of its core industry will need capital to participate. Strong firms in an industry are likely to gain more share as others fail, and as the strong take over the weak.
3. Increased experimentation, as turbulence points to new opportunities. Experimentation tends to follow industry shocks, and while some might warn that capital- or time-intensive experiments could unpopular for some time, consider that the 1930s was the most technologically progressive in all the 20th century.

Since we are here mostly interested in the arms industry, we might look at the last coincidence of a recession and a downturn in military spending: the early 1990s. Restructuring did not begin in earnest until 1993, as this is a slow-cycle, capital goods business. Restructuring accelerated towards the end of that decade—the reigning viewpoint on warfare in the 1990s, which seems a bit dated now, took some time to take hold.

1. Diversification didn’t work then, and won’t now. Specialization was not at all what took hold thereafter; rather, several large arms makers drove for diversification. True, vertical de-integration in certain sectors—most arguably transport aircraft—has caused problems, but it has been necessary all the same. What’s certainly true is that the margins of the largest and most diversified contractors have lagged those of the mid-sized and more focused firms. That’s not a good record. Thus, over the next several years, we will all be looking for the efficient hybrid solution which seeks to achieve the right mix of technical competence and cost containment. Diversification is probably done as a strategy, but unwinding some of the worst deals will take some time.

1. Concentration will work in a few places, but only selectively. More concentration within the US would be, ceteris partibus, unhelpful—unless the US government drops its squeamishness about foreign sourcing. Where that will fly, look for underperforming firms to be absorbed. The helicopter industry in particular arguably has at least one too many major producers, and the US Army and the US Coast Guard are clearly happy with their Eurocopters. This suggests that the government could be convinced not to raise antitrust objections against Sikorsky’s rumored pending bid for Bell. All the same, no degree of shuffling the deck of shipyard ownership is likely to solve the Navy’s budgetary problems. There are limits to what scale and scope can achieve, and quite a few sectors of this industry have found them.
2. Experimentation is probably the way forward. Much of this experimentation may be done on the cheap, with modular line extensions of existing products. James Carafano of the Heritage Foundation makes an important point in the DC Examiner about how many of the weapons designed and fielded during the Cold War on not just still on the job for US forces, but are actually proving very valuable in combat. Perhaps his most notable example is that of the A-10 Thunderbolt (Warthog)—while designed for destroying Soviet tanks invading Germany, 196 of the aircraft soldier on today providing close air support to ground troops in Iraq and Afghanistan. It’s hard sometimes to distinguish between 20th Century and 21st Century weapons, but when the Warthog’s Mavericks and GAU-8 cannon get complemented with JDAMs, it gets a whole new lease on life.

It’s hard, that is, to distinguish clearly between a 20th and a 21st century weapon, particularly when old kit can work quite well with an appliqué of modern precision and networking. As I’ve argued before, scale and scope can be useful in that role, but clever solutions ultimately prove winners when budget constraints shift inward.