After posting my recent article from Defense Acquisition Research Journal (“How to Bail Out a Defense Contractor”), I received and posted the following comment from Seth Weissman, a professor of economics at the Eisenhower School of the (US) National Defense University, where I too was on faculty across two academic years:
Interesting article, as I expect from you. [JMH: thank you, Seth!]
I was surprised that you didn’t mention/consider second-order effects. The (often reasonable) expectation of some form of bailout incentivizes risk-taking, which increases the probability that some form of bailout will be required.
There is an alternative to bailout, which is buyout. I’m not in favor of government production in general, but the threat of buyout (in special cases) might both mitigate concerns about the industrial base and counter incentives for industry that might otherwise seek to “gamble for redemption.”
Re: government ownership: I don’t see evidence firms like Fincantieri (50% Italian government owned) are less profitable/efficient than fully private-owned peers. Do you have any insight into that?
I promised (in the comments as well) a thoughtful response. Here goes.
I think that Seth is quite correct about the second-order effects. I thought that I had indirectly addressed that on page 173 of the article, in this passage:
The affair has been cited as evidence that defense contractors can shake down governments by citing the risk of their own financial leverage. Indeed, from the 1950s through the 1990s, U.S. contractors generally carried twice the debt load of comparably sized non-defense U.S. firms. This commitment to future debt service limited room for renegotiating procurement contracts, which paradoxically increased the value of the firms by increasing the ex ante costs of bankruptcy, and transferring those to the government (Spiegel, 1996).
The reference, of course, is Yossi Spiegel's "The role of debt in procurement contracts," in the Journal of Economics and Management Strategy, vol. 5, no. 3. Over at Tel Aviv University, Spiegel has done some other interesting work on the economics of procurement and regulation, which is available at his website: https://www.tau.ac.il/~spiegel/. It’s quite possible that management at Lockheed realized that the company could shake down the government if the C-5 and L-1011 development programs went badly, and figured on the gamble. Similarly, would Airbus have actually launched that remarkably unprofitable A380 project without its governmental backstop? And as comfortable as I have found that jet (thanks, Lufthansa!), did the world really need a double-decker super jumbo? Probably not.
But as for second-order effects generally, I could and should have made my narrow point more clear. I would have liked to have explored the question further, but I ran out of space for an article in DARJ. I will aim for that the next time I write on the subject, and I should mention it the next time I teach on it.
On the next point, governmental buyouts give me pause as well, but I do think that Seth makes an important suggestion. These happen, even in the United States. The US federal government took control of Government (er, General) Motors in 2008, concluding that the company was more useful recharged (that’s my electric vehicles pun) than liquidated. The government made its money back, and it is once again doing some interesting work in defense contracting. On the other hand, the federal government’s consolidation in the 1970s of passenger rail service into Amtrak has left the country saddled with a cash-devouring perk for well-to-do intercity commuters in the Northeast (I’m talking about you, Joe) at the expense of the rest of the country. That has been the situation for about 50 years and running. Now, with about a third of the country working from home, and quite successfully, the Biden Administration wants to dump a bunch more money into such “infrastructure” (and not-so-infrastructure), including that beloved Amtrak. Politics what they are, these things have a tendency of going zombie, and for the long run.
But what if the firm is more tailored to production intended for the government—say, for the military or intelligence services? Is there less risk of zombification of industry if the need is narrower? My trepidation continues here as well. Just think of the US military’s depots, arsenals, laboratories, and shipyards. They’re not exactly engines of efficiency and innovation, but they soldier on, year after year, as the leadership of the military cannot quite say “basta!” in a public hearing before members of the Depot Mafia (er, Caucus) in the US Congress.
And yet, we now have some very beneficial examples of organic industrial capabilities provided with efficiency and innovation, in the form of the military’s software factories, like the US Air Force’s Kessel Run and the US Space Force’s Kobayashi Maru. One has to admire the branding, or at least the cheekiness of the branding. Perhaps these will grow into sprawling, cash-devouring jobs programs, but I do not sense that they are fated so. If these two military services can maintain the right culture in those relatively small units, they may continue to do great work for years to come. How to know what’s essential for that culture over the long run is another important research question in defense economics and military sociology. In any case, it is likely that we successfully create such organizations ab initio, and not through fire-sale buyouts.
Regarding profitability, I can address the particular case of Fincantieri, and for that matter, the sole larger Italian defense firm, Leonardo (née Finmeccanica). It is not impressive. Let us consider their EBIT margins (earnings before interest and taxes, divided by revenues) before extraordinary items, as this will get at the overall, ongoing utility to the company to those with claims on its residual output (that is, the bondholders, the stockholders, and the tax people). In 2018 and 2019, Fincantieri made 7.6 and 5.5 percent, and Leonardo 5.8 and 8.4 percent. Deduct what you owe the bondholders and the tax authorities, and there is not much left over for those holding equity. Defense contractors in the United States generally do much better.
And yet, even here, there may be value in that lack of value. Last year, Fincantieri won the US Navy’s FFGX competition, for ten to twenty new frigates, with a version of its much-admired Fregata Europea Multi-Missione (FREMM). That the American admiralty loved that ship was no surprise; I had been hearing that from retired officers and officials for some time. The surprise was the bid, which probably beat that of all competitors, for what may have been the most capable ship on offer. Fincantieri is an efficient shipbuilder, but really—how did our Italian friends do that? The answer may be found in Fincantieri’s victory-lap press release, which thanked the Italian government for its support. The terms are not publicly known, but one can imagine that Fincantieri decided to bid at or below cost on the first few, gambling that a good learning curve would lead to profits later. If not, hey, our big shareholder is offering to cover us, just for the value of the Italian-American defense-industrial relationship. Profits may not be the government shareholder’s sole source of value. In most of the economy, that would be very, very bad. In defense, there may occasionally be another answer.
On a side note, for the United States, a country in which people love to complain about Europeans not spending enough on their defense, this is a delightful outcome. Italians are spending directly on American defense. Really—it’s a net transfer of value ex ante from Italian taxpayers to anyone in the United States who values its navy. What’s not to like? Well, you could be one of the losing bidders, talking about level playing fields, and a lack of that offers its own problems in the long run. But even in the United States, losing money for market access is not generally an anti-competitive issue for the antitrust authorities.
The question of Fincantieri, of course, begs Seth’s broader question: what systematic evidence do we have on the comparative profitability of privately-owned versus partly publicly-owned defense contractors worldwide? I have not seen such a study, but it would be easy enough to effect. Just download the financial data and run the tape, so to speak. I would be interested in examining the full panel of data for trends over time, particularly to test for the effect of changes in the percentage of private ownership, whether by privatization, public acquisition, or just additional private or public investment. When I have some time, I may look into this—which means, unfortunately, not this week. Or month. Or maybe in 2021 at all. I have a few things going on.
James Hasik is a senior research fellow in the Center for Government Contracting at George Mason University, and a senior fellow in the Scowcroft Center on Strategy and Security at the Atlantic Council.
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