An Economic Strategy to Control Arms Proliferation

For 45 of the past 50 years, defense budgets were largely decoupled from economics. Vast expenditures on defense during the Cold War were debated and decided in a compartmentalized fashion, separated intellectually and institutionally from debates over economic policy. The life-and-death pressures of a nuclear arms race with the former Soviet Union clearly trumped periodic concerns about the price tag attached to various pieces of our defense establishment, as well as occasional conflicts with other international economic or foreign policy interests. When it came to buying national security for the United States, money was no object.

Since the end of the Cold War, however, a lot more attention has focused on price tags. Procurement outlays on major defense systems in the United States have fallen by about 40 percent from their peak in the 1980s, and spending by our allies has declined by even greater amounts. Other military establishments around the world have ratcheted down their force structures and spending by equally significant amounts.

As a result of this heightened attention to the bottom line, the impacts of arms exports on the costs of maintaining an economically viable defense industry has over the past five years begun to play a growing role in decisions by the United States and its allies to export high-tech weapons systems. Linkages between the economics of the maintenance of national defense establishments and political-military security issues are clearly visible as never before. Nowhere are the connections between the two more obvious and challenging than in East Asia, where the principle (though often not the practice) underlying U.S. policy is to keep economic and security relationships on nominally separate tracks.

Emerging as the sole global military superpower (1997 U.S. spending on R&D and procurement of weapons systems was roughly equal to that of Europe, Japan, Russia, China,Iraq, Iran, and North Korea combined), the United States finds itself in a curious and contradictory position today. We continue to subsidize our allies’ defense industries through a network of relationships developed during the Cold War, but compete against these same allies for sales in third-country markets. Our allies, pressed by the huge fixed costs of maintaining their defense industries, increasingly turn to questionable customers abroad in an effort to successfully compete against the giant U.S. companies that today account for half of global sales. These same U.S. companies press an increasingly cost-conscious Pentagon to support them in competing for exports to some of these marginal customers, arguing that equally capable European systems will be sold if U.S. systems are not allowed to enter the competition and that the United States should aggressively try to capture the benefits of larger production runs and scale economies through these exports.

The upshot is that the United States today is in an indirect arms race with itself-or more directly, with foreign allies with whom it cooperates technologically and competes economically. In the medium to long run, there are some real dangers to confront if we stumble unthinkingly down this road. The world could become a more dangerous place as more advanced military technology developed on the U.S. taxpayer’s nickel leaks into global markets more quickly. And the U.S. may find itself in the position of having to significantly increase its future military spending in order to deal with high-tech U.S. weapons technology that has been distributed too widely and too quickly. But neither of these outcomes should be viewed as inevitable.

The economic fundamentals of our quandary reside in the cost structure of many key, high-tech defense industries, where system costs are dominated by various economies of scale-in assembling and sustaining essential design capabilities, in systems R&D, in start-up costs, in production capacity, and in learning curves. The price of entry into development and production of the most advanced weapons systems is a large fixed investment, with unit costs declining sharply as the scale of production increases.

A fundamental element of the national security policy of many nations (including most U.S. allies) is the creation and maintenance of their own ability to produce at least some advanced weapons systems. During the 40 or so years of the Cold War, defense spending was large enough in most countries with pretensions to producing advanced weapons to enable production of these systems in sufficient volumes to at least approach affordability. With the widespread decline in national defense budgets, however, the only way in which many nations will be able to maintain a viable industry is by exporting a much larger portion of their output to overseas customers. This is true in Western Europe, where despite trans-European defense industrial consolidation and halting steps toward a single European defense market, tremendous economic pressures to export leading-edge systems outside the NATO alliance remain in force. It is equally true in Japan, where with the active support of the Ministry of International Trade and Industry, Japan’s defense industry is currently mounting a campaign to relax current policies prohibiting defense exports. It is even true in the United States, where, since 1995, formal conventional arms transfer policy for the first time has explicitly recognized economic impact on the domestic industrial base as a considerable factor in decisions on arms exports.

The Big Picture

In even the medium run, lessened inhibitions on the export of advanced weapons-and increased competition for these sales among the United States and its allies-may have significant effects on the political and military balance in many regions, and East Asia may very well prove to be the test case measuring how well we can manage these new realities. In the long run, because retention of a significant technological advantage over adversaries is critical to U.S. military strategy, proliferation of advanced capabilities through the export of weapons by our allies may ultimately be the threat forcing us to once again increase our own defense spending and accelerate development of new generations of systems at a time when budget realities give us little margin for doing so without sacrificing other national priorities.

One excellent example of this phenomenon is use of the so-called “grey threat” (as a recent RAND study described it) to justify rapid development of the F-22 fighter. Proponents of the new fighter argue that the imminent production of European fighters such as the Eurofighter, Rafale, and Gripen that begin to approach the quality of current U.S. front-line fighters and the necessity for the Europeans to export these aircraft to reduce their unit cost make it likely that our forces will need to deploy even more advanced fighters in the not too distant future in order to guarantee the assumed substantial margin of superiority over aircraft in the hands of conceivable adversaries. Indeed, once it seems likely that our allies will be willing to sell a relatively potent system to a foreign buyer, there is a considerable argument for supporting the sale of our own equivalent system on the grounds that we might as well reap the political and economic benefit and the advantages of a closer military relationship for ourselves. In effect, given sufficient competition from our allies, there is a perverse but compelling logic to us becoming our own “grey threat.”

Thus, there is a complex self-reinforcing dynamic at work. With declining defense spending, exports have become critical to the very survival of most defense industries outside the United States. Retention (or creation, in some cases) of economically viable, indigenous defense systems capabilities is viewed as fundamental to national security in many nations, which leads to aggressive economic competition for defense export opportunities. The increasing economic pressure to export ever more advanced capabilities, in turn, may alter delicate strategic balances in sensitive regions. Changes in the strategic balance may trigger even greater or wider interest in acquiring advanced systems and ultimately create more pressure to accelerate the pace of development of new systems by the most advanced military powers. One can dimly imagine two possible new equilibria: a regime with much higher levels of defense spending, where the economic pressure to export the most advanced capabilities has subsided to more manageable levels, or the construction of a more cooperative regime for arms sales, where the handful of military powers with any realistic potential to develop the most advanced military systems agree to some degree of mutual restraint on exports to third parties, perhaps in exchange for some program of industrial and technological cooperation that ensures the survival of core defense industrial capabilities deemed essential to national security. The latter idea has gone by various names-a suppliers’ cartel, an inner circle, etc.- and is probably best viewed as an experiment to be pursued, rather than a crystal clear vision of a particular endpoint. The East Asian defense market could provide an excellent opportunity for testing this approach.

The competitors

Three countries supply most of the advanced weapons systems to East Asia: the United States, Europe (which in practical industrial terms, is beginning to look like a single European conglomerate in many, though not all, defense sectors), and Russia. Japan has capabilities in defense systems that are highly advanced, but until now has enforced a self-imposed ban on exports. China does not produce the most sophisticated systems but is an important exporter of middle and low-end equipment.

U.S. industry is the 600-pound gorilla, accounting for about half of worldwide arms transfer deliveries. At least one reason for this is very simple: The United States depends far more on developing new technology and systems. U.S. defense R&D spending accounted for 70 percent of the total 1994 defense R&D spending by the United States, its NATO allies, and Japan.

The United States also consumes almost half of the defense goods acquired by this group. Japan is second with 16 percent of the total. Indeed, given the dominant U.S. investment in R&D, the real question is why the United States has only a 50 percent share of global defense trade. Is the United States that inefficient? Are the performance advantages of U.S. systems that much more costly at the margin?

Casual observation suggests that the United States is not grossly less efficient than its allies, and although the squeezing out of marginal performance advantages on the bleeding edge of the technological frontier may be disproportionately costly, this too seems unlikely to explain the bulk of this gap. Rather, it seems likely that the United States, through a variety of policy choices, has in effect subsidized the development of high tech weapons systems by its closest allies. The mechanisms have included a deliberate policy of liberal and inexpensive technology transfer to allies through coproduction, licensed production, and codevelopment programs, and a variety of policies such as waiver of recoupment of R&D charges on export sales of components and systems, intellectual property policies, and so on that make it possible for foreign competitors to acquire some of the key components of high tech weapons systems at prices that may approach their marginal cost of production.

Buying a U.S.-built radar design at only a modest premium over production cost and inserting it in a European fighter, for example, allows the European systems integrator to market a state-of-the-art platform without investing in an enormously costly development effort on the radar subsystem. Having a U.S. defense contractor work as a joint venture partner on your air-to-air missile may provide you with access to technologies developed at great U.S. taxpayer expense.

This is not to say that doing this is irrational from the U.S. perspective. Strengthening its allies militarily (including their industrial capabilities) is a security interest of the United States that was given priority over possible implications for longer-term economic competition during the Cold War. Often, the allies built protective walls around their defense markets, and giving them access to U.S. technology was part of the price for slipping over the walls. The decision was an economic one; selling them something, with some return, was better than selling them nothing, and earning no return on technology that in any event had already been paid for. The decision also reflected a political judgement; industrial cooperation strengthened these alliances. And the decision was a military one; given that these countries would be fighting side-by-side with the United States, why not give them the same equipment to use in order to build greater operational military coherence?

The structure of incentives within the U.S. acquisition system was another factor promoting bargain-basement technology transfer to allies. U.S. defense contractors were, after all, contractors. The costs of technology development were funded primarily by the taxpayer. Unlike the situation in commercial high tech, a company did not have to define a pricing structure for its output that allowed for a reasonable return on technology investments to be recovered, in order to remain viable. Furthermore, because there often were competing U.S. contractors able to offer competitive solutions, foreign governments, with considerable monopsony power, were able to play them off against one another in order to negotiate the most favorable possible terms in acquiring U.S. technology. Because the government was forbidden from favoring one contractor over another in competing for foreign sales, U.S. policy did nothing to improve the bargaining position of U.S. firms.

U.S. contractors, of course, always had their own economic self-interest to guide their decisionmaking. If a company decided, for example, to transfer technology representing a taxpayer investment of $4 billion to Japan for $800 million in licensing fees, it presumably was making the judgement that in the long run its potential return on sales lost to future Japanese competition making use of those technologies was valued at less than $800 million. But if government investments in similar technologies were also earning returns for other U.S. companies, it is easy to see how the company’s calculation of a floor on what it would be willing to accept for use of the technology might logically diverge from a national calculation.

In short, the structure of the U.S. acquisition system naturally lends itself to speculation that the United States is shouldering much of the burden of development cost for systems procured and built by its allies. That is, U.S. policy, in addition to underwriting the cost of sustaining the most formidable and effective defense industry in the world- its own- also in effect underwrote its own industry’s principal competitors. U.S. policies supporting defense exports are least a part of this story.

The market

In part because of its emergence as a potential focus for regional military competition and in part because of the rapid economic growth that has enabled rapidly growing military expenditures, East Asia’s importance in global defense markets is increasing quickly. As recently as the 1992-94 period, for example, Arms Control and Disarmament Agency (ACDA) statistics show East Asia accounting for about 15 percent of global arms transfer deliveries. Intelligence community estimates of future requirements suggest that over the remainder of this decade, the East Asian share of deliveries will double to 30 percent, roughly matching regional markets in the Middle East (30 percent) and Europe (27 percent). Current data seem to show this forecast on track, with East Asia accounting for 20 percent of world defense expenditure in 1996 and almost half of global sales of large conventional arms. Although the recent economic turmoil in East Asia may dim the prospects for such sales over the next several years, the structural forces promoting a regional arms race (the growing role of China as a military power, continuing tensions on the Korean peninsula, unresolved territorial claims and boundary disputes, and a historical legacy of rivalries and conflicts) are likely to fuel a continuing regional military competition into at least the first decades of the next century.

The bulk of the East Asian arms market largely consists of four relatively large national markets, and three considerably smaller ones. The four big markets are South Korea (24 percent of deliveries during 1992-94), Taiwan (20 percent), Japan (15 percent), and China (14 percent). The smaller players are Thailand (7 percent), Singapore (5 percent), and Malaysia (4 percent).

Although the U.S. share of the East Asian regional market (54 percent) is only slightly higher than its share of the world market (50 percent), there is considerably greater variation within individual national markets. The United States was the overwhelmingly predominant supplier in Taiwan (100 percent of deliveries over 1992-94) and Japan (97 percent), but accounted for less than half of sales in Korea (with the balance going mainly to European suppliers).

Taiwan, Japan, and Korea all have intimate security relationships with the United States, but Korea has been more disposed to trade increased technology transfer for performance, favoring suppliers able and willing to transfer a greater measure of technology over those offering the best-performing products. Other systems that the Koreans have purchased, such as German diesel submarines, simply do not have competitive U.S. suppliers. U.S. laws, which prohibit foreign corrupt practices, may also have discouraged Korean sales, if recent public trials of government officials are indicative of the procurement culture.

China buys 97 percent of its advanced arms from Russia, whose willingness to sell advanced weaponry to a neighbor with which it has had occasionally antagonistic confrontations is clearly related to the dire economic straits that its armaments industry now faces. But in international meetings, knowledgeable Russians have also suggested that hardliners within the Russian military increasingly see the China relationship in strategic terms as an offset to a reinforced U.S.-Japan security partnership.

All four major East Asian markets are actively seeking to use their defense systems markets as a tool in building up their aerospace industries. The distinction between commercial and defense applications of these technologies is often a very blurry line. It is no secret that all of these countries aspire to become world class builders of air and space systems, and civil and military programs are frequently intermingled. For economic reasons, then, as well as because of political and military rivalries, the nations of East Asia are likely to continue to be major customers for weapons systems and defense technology. And for economic reasons, too, those who have provided them with advanced capabilities will probably continue to sell them what they seek.

Status quo

U.S. policy supports defense exports through three principal avenues:

Granting of export licenses. Weapon systems and major system components are all subject to export control. In principle, licenses are granted only when it is in the security interest of the United States, but an explicit recognition of arms exports’ role in strengthening the U.S. industrial base was added by the 1995 Clinton administration conventional arms transfer policy. There are no broad criteria or principles that guide decision-making on license applications; the methodology is explicitly case-by-case, with no guarantee of logical consistency within or across regions. There has been some discussion but no broad implementation of general guidelines that would specify under what circumstances and to what nations differing levels of advanced technology could be released, as a tool to improve the consistency and coherence of the licensing process.

What actually happens is that a nation requests a license to learn about or actually buy something (which not infrequently follows informal contacts with a U.S. contractor wishing to sell it), and that is followed by an interagency review process in which Defense, State, Commerce, ACDA, Energy, the intelligence community, and possibly the National Security Council can play significant roles. The agencies not infrequently have different views (economic and trade interests vs. security considerations vs. proliferation concerns vs. diplomatic issues) and as the Presidential Advisory Board on Arms Proliferation Policy observed in its July 1996 report, “Bureaucratic warfare rather than analysis tends to be the modus operandi in what is often a protracted process of plea bargaining and political compromise that may not reflect long-term national objectives.” Needless to say, the significant potential for uncertainty and delay built into this process-albeit now much improved from a business perspective-can remain an obstacle to exports.

Congressional prohibitions have placed further restrictions on policymakers in specific cases of regional arms transfers. On the other hand, one can argue that with the increased recognition of economic benefit as a legitimate arms export policy objective, the system has been gradually tipping toward a presumption that, except in the case of particularly disreputable would-be customers, if some country is able and willing to sell a particular capability to a buyer, then it might as well be the United States.

Diplomatic and administrative support. As the U.S. foreign diplomatic infrastructure became aware that encouraging exports was a priority of current government policy, a greater involvement in even-handed support to U.S. contractors in winning competitions for military exports developed over the past few years. The support took the form of sharing unclassified insights on what is going on within often-opaque budget planning in foreign governments, U.S. embassy officials lobbying local government officials, U.S. military personnel lobbying foreign militaries, and senior political appointees lobbying their foreign counterparts. In my experience, this has been perhaps the most important and effective element of U.S. policy support for military systems exports.

On the other hand, I have also observed questionable excesses. One good example occurred in East Asia, where an ambitious young ambassador, with minimal interaction with local U.S. military staff but presumably greater contact with the U.S. contractor eager to make the sale, was pressing local defense officials hard to buy an advanced military helicopter. Behind the scenes, senior military staff from the U.S. Pacific Command were scratching their heads in befuddlement, observing that the local military was still struggling to master tons of recently acquired equipment. Furthermore, what was the country’s neighbor-also a U.S. ally-going to think of this proposal? The operative policy seemed to be that if some enterprising salesman, official or unofficial, convinced the locals that they wanted something, then it might as well be the United States that does the selling.

Financial subsidies to exports. U.S. defense contractors have lobbied successfully for some new financial supports for defense exports by arguing for a “level playing field.” The leveling argument has both a domestic component (armaments should receive the same kind of treatment that other goods receive) and a foreign component (foreign governments give their firms financial support in exporting, and therefore we should too).

This logic is attractive at first glance, but it has two problems. The first is the implicit assumption that defense exports are, putting aside the special nature of their customers and application, like other traded goods. The second is the assumption that broadly-focused export subsidies are likely to be a cost-effective tool for increasing export sales.

Generally, weapons systems are not like other traded goods in that a national security exemption has exempted them from the subsidy and antidumping disciplines of the General Agreement on Tariffs and Trade (GATT). Thus, although it is true that producers of industrial goods making use of R&D funded by other government agencies are not forced to pay an R&D recoupment charge (charges to foreign customers covering a portion of the government’s investment in R&D), the extent to which those export sales of goods can be subsidized by government are severely limited by the ability of foreign competitors to seek countervailing duties and antidumping orders. No such restraints apply to weapons systems, which are presumed to be covered by the national security exemptions in the GATT. In fact, you can reasonably argue that “dumping” (pricing exports below full average cost of development and production) is normal practice in international competition in defense systems.

U.S. defense contractors have sought the waiver of R&D recoupment charges, a policy that would have some particularly important economic implications in calculating the economic benefit to the Department of Defense (DOD) from defense exports. First, it means that the benefits will be felt mainly through cost declines derived from improved economies of scale and progress along the learning curve (and possibly through avoidance of shut-down and start-up costs when exports keep lines “warm”) rather than through spreading of R&D costs over a larger output. Second, as already mentioned, it means that foreign users of defense components have potential access to U.S. technology at marginal cost, enabling them to be competitive in systems where they might otherwise be unable to compete against U.S. producers.

R&D recoupment charges have been waived since 1992 for commercial sales. For foreign military sales made on a government-to-government basis, DOD has long had the discretion to waive R&D recoupment charges on sales to NATO, Japan, Australia, and New Zealand and has routinely done so. In 1996, Congress granted authorization to do so in other cases.

Doubts about the efficiency of general subsidies as a tool to promote defense exports are raised by an analysis of actual markets for defense systems. DOD’s 1994 forecast of arms exports divided arms deliveries into two categories: goods already under contract for future delivery and goods not yet under contract. The global split for worldwide arms trade for 1994-2000 was about 50/50 in these two categories.

Within the “not yet under contract” category, foreign purchases were divided into three categories: where the United States was the only source for the system the customer was likely to specify; where the United States was not in competition (it did not produce an equivalent product or did not sell to a particular customer as a matter of foreign policy); and where the United States was in competition with other foreign arms producers. Of deliveries made and anticipated during 1994-2000, only 11 percent are in the third category, and 48 percent are in the first. Thus, U.S. arms exports would be at least 48 percent of world sales over this period, and at most 59 percent. With such a small part of the market in play, an efficient export subsidy policy should be selective, picking customers and sectors where real competition is in evidence and where it is likely to have a significant impact on DOD’s industrial base.

The same analysis also suggested that arms exports to East Asia were not likely to be a particularly fertile orientation for an export-promotion policy. Of the “competitive” market opportunities available to U.S. firms, only 7 percent of possible sales over the 1994-2000 period were found in East Asia.

An “inner circle” approach

With defense downsizing in full swing around the globe, all major producers of high-tech armaments other than the United States face a virtual economic crisis in their defense industries. Unless they are willing to give up maintenance of a national capability to produce advanced military systems as a national security objective (exceedingly unlikely), they will be pushed to close off their national markets to foreign-built systems and dramatically increase exports. In the long run, this is likely to raise significant problems for the United States. In East Asia, unrestrained proliferation of advanced conventional military capabilities is likely to further aggravate what already appears to be one of the most difficult future areas for U.S. foreign policy.

The obvious alternative is to work through some sort of system of industrial and technological cooperation with major U.S. allies (Europe and Japan) that will maintain access by U.S. defense producers to these important markets while permitting our allies to maintain a core defense systems capability and will restrain the unchecked proliferation of advanced systems exports. As the only nation that can maintain an economically affordable advanced defense sector without relying on exports, the United States must play a leadership role in constructing such a system. The massive investment in military technology, which in effect underwrote the development of allied industrial capabilities in the first place, continues to provide enormous leverage for this purpose.

One approach would be to encourage the formation of what might be called an “inner circle” of arms producers. To put it most bluntly, the idea would be to focus on controlling diffusion of the most advanced capabilities, where there are really only a handful of countries capable of producing and marketing sophisticated weapons systems. An inner circle of close U.S. allies would be given access to the U.S. defense market, and the United States access to their markets, as part of an agreement to work together on joint development and production of advanced systems for use within the limits of this narrowly defined “common market.” In exchange for being given access to the U.S. market and selected U.S. defense technologies, participating countries would accept negotiated restraints on exports of systems and technologies developed within the “inner circle” to those outside.

In this way, two potent economic incentives (access to U.S. technology and markets) would be combined so as to support two major U.S. foreign policy objectives: restraint on exports of the most advanced weapons systems and closer military cooperation and cohesion with U.S. allies. It is simply unrealistic to suppose that the European countries will give up their ambitions to maintain their own defense industrial base. Without something like the inner circle to guarantee the economic viability of European defense capabilities, their only alternative will be to export in a fairly indiscriminate fashion to relatively dubious customers.

An additional advantage of the inner-circle approach is that it can be defined and refined incrementally. In the beginning, its domain could be quite narrow, negotiated on a case-by-case basis. For example, the United States could initially experiment with this approach in very specific systems-ballistic missile defense systems, stealth cruise missiles, or stealth radar-with a handful of very close allies. Given a track record of initial success, it could then be expanded to cover additional types of systems and eventually, perhaps, become an integrated framework covering production and export of a whole range of advanced weapon systems.

Incremental expansion could also cover new categories of membership, so that instead of having a single inner circle, the system could be more like concentric circles. Close allies would have the greatest degree of access, and the greatest degree of restraint would be imposed. The outermost circle would include virtually everyone but also be associated with the least forceful restraints-an expansion and elaboration, perhaps, of current global agreements covering international export of sensitive military technologies and weapons of mass destruction. Intermediate levels of inclusion and restraint between these two limits could be negotiated where it made sense: bringing Russia into the fold, for example, or covering sensitive but somewhat more widely diffused advanced military technologies mastered by a larger number of players. In short, the inner circle idea could be viewed as an experiment rather than an endpoint: a graduated and progressive construction of an international regime blending restraint and cooperation in military weapons systems production and sales, using pragmatic and selective principles for inclusion of participants and technologies.

Some might argue that this is an impractical and utopian approach that would never survive in the rough and tumble of the real world. In fact, however, “impractical” restraints on export of components and systems for missiles and weapons of mass destruction, though far from perfect, currently serve us well in reducing the dangers from proliferation of these systems. And there are real examples where an incremental inner-circle approach has shown itself to be practical. When the United States, Germany, France, and Italy sat down and agreed in 1995 to pool funding and technologies in a cooperative development program for a common theater missile defense system-the Medium Extended Air Defense System (MEADS)-all four partners agreed that no export sales could take place without common assent. Though France later dropped out of this program when it finally felt the pressures of defense budget cuts in 1996, MEADS showed that export restraints linked to a sharing of funds, technology, and production in a common acquisition program can be negotiated successfully and with strong-willed and independent partners. Out of such incremental first steps, an inner circle of armaments cooperation and export restraint can gradually be built and later expanded.

One thing is certain. Weapons exports are part of a global economic reality. Inducing others (Europe, perhaps Japan, and ultimately Russia) not to engage in irresponsible proliferation of advanced capabilities in Asia requires some global cooperation in constructing a regime that permits legitimate national security interests in maintaining defense establishments and curbing uncontrolled proliferation to be reconciled with the economic realities of a high-tech defense industry that is fundamentally global in outlook.