Why Globalization Will Not Affect the Defense Industry:

Political Incentives against Cross-Border Defense Restructuring

By

Eugene Gholz
Visiting Assistant Professor
Patterson School of Diplomacy and Intl Commerce
University of Kentucky
455 Patterson Office Tower
Lexington, KY 40506-0027
egholz@alum.mit.edu

March, 2002

Abstract

Apostles of globalization have sought to confirm the irresistible nature of the forces
buffeting nationally organized business by arguing that even the defense industry is
reorganizing along global lines. Advocates of cross-border mergers, who trumpet recent
deals and promise additional ones still to come, allege five major advantages:
consolidation of fixed costs, expanded market access, diversified political risk,
rationalized R&D planning, and enhanced access to innovative technology. Trans-
Atlantic as opposed to intra-European mergers might offer additional advantages by
improving NATO interoperability and/or shoring up political support for the alliance.
But these predictions rest on questionable logic, principally because they presume that
government buyers primarily choose contractors on the basis of efficiency or
technological prowess. A more politically informed analysis suggests that cross-border
defense industry mergers are unlikely to make much economic, political, or strategic
difference in the post-Cold War world.

I would like to thank Dan Byman and Harvey M. Sapolsky for helpful comments on an
earlier draft. An earlier version of this paper was presented at the RAND Corporation.
 For most of the 1990s, journalists and financial analysts covering the defense

industry harshly criticized European aerospace and defense electronics firms for adapting

slowly to the end of the Cold War. While American defense companies busily paired off

in mergers or spun off divisions to focus on particular product lines between 1990 and

1997, the Europeans took little action. It seemed that the defense sector's close ties to

national governments would prevent cross-border restructuring from extending

globalization to such a "critical" sector.1

Yet globalization apostles were undaunted. Even in the early 1990s, some firms

made small, largely unheralded cross-border moves: for example, Rolls Royce bought

Allison, an American jet engine maker, and British Aerospace (BAe) and Matra linked

their missile divisions. For a time, major European players like BAe, Vickers, and GEC

in the UK; Arospatiale, Thomson-CSF, Matra, and Dassault in France; and Daimler-

Benz Aerospace (DASA) in Germany held back. But international defense collaboration

has always been a Holy Grail for European politicians, and governments stepped up their

criticism of big defense firms late in 1997, fearing that the European domestic arms

industries would somehow be "crushed by U.S. giants."2 In 1998 and especially 1999

1
Richard Whittle, "Down in Arms," Dallas Morning News (January 19, 2000); "Platform Envy: European

and American Defence Planners Are Rethinking Strategy. So Is the Defence Industry," The Economist

(December 12, 1998), p. 23; John Tagliabue, "A Call to Unite Arms in Europe," New York Times

(December 3, 1998); Anne Swardson, "French Breakaway Leaves European Arms Industry Adrift,"

Washington Post (August 19, 1997), p. C1.

2
Charles Goldsmith, "U.K., France, Germany Call for Mergers in Europe's Defense, Aerospace Industry,"

Wall Street Journal (December 10, 1997), p. A18. For a review of some of the earlier efforts, see Keith

Hayward, The World Aerospace Industry: Collaboration and Competition, London: RUSI, 1994.
European firms negotiated a series of major consolidations. Among prime contractors,

BAe and GEC merged (forming BAe Systems), as did Arospatiale and DASA (forming

the European Aeronautic, Defense and Space Company, a.k.a. EADS). Many other deals

were announced among niche producers. In 2001, major missile and defense electronics

firms in France, Italy, and the UK followed with cross-border mergers (forming

MBDA).3 While no top-level trans-Atlantic merger has yet been consummated, BAe

Systems now owns a substantial defense electronics business in the U.S. (combining the

former Tracor and Sanders) and Thomson-CSF and Raytheon have combined their air

defense businesses through what is expected to be a tightly integrated joint venture.4

Apostles of globalization now point to the defense industry as proof that the forces

promoting the "new economy" are strong enough to invade even industries linked to

national security, the traditional core source of the nation-state's power.5

The open question going forward is whether these deals matter: did firms initially

resist mergers for a good reason because they offer few benefits? Or will the mergers

3
Michael A. Taverna, "New Missile Giant to Expand," Aviation Week and Space Technology, Vol. 154,

No. 19 (May 7, 2001), p. 31; Michael A. Taverna and Robert Wall, "New Missile Giant Prepped for

Operations," Aviation Week and Space Technology, Vol. 154, No. 12 (March 19, 2001), p. 41.
4
Other trans-Atlantic collaborative relationships are apparently proceeding on this model -- for example,

EADS and Northrop Grumman have announced major joint ventures of their airborne radar and unmanned

aerial vehicle lines, while Boeing and MBDA are forming a close relationship making missiles and bombs.

Robert Wall, "EADS Eyes Penetration of Fortress America," Aviation Week and Space Technology, Vol.

155, No. 14 (October 4, 2001), p. 71; John D. Morrocco, "Boeing JDAM Pact Deepens MBDA Links,"

Aviation Week and Space Technology, Vol. 155, No. 6 (August 6, 2001), p. 61.
5
Ann Markusen, "The Rise of World Weapons," Foreign Policy, Issue 114 (Spring, 1999), pp. 40-52.
and joint ventures transform the defense industry, as globalization has radically reshaped

many other businesses? Major cross-border investments in the defense industry are still

in their very early stages, preventing an empirical analysis of their effects. But that does

not mean that analysts can only fall back on the rhetoric of the opinion pages and weekly

business magazines.6 We know a good deal about the incentives imposed on defense

firms' strategies by the unique character of the sector's powerful (essentially

monopsonistic) buyer. We can therefore predict with a high degree of certainty that the

quest for economic benefits through cross-border restructuring in the defense sector will

be like other quests for the Holy Grail: perhaps arduous, certainly loudly proclaimed as

important by the participants, but ultimately futile.

This article will consider five conventional wisdom explanations of the benefits

(for Europeans) of cross-border defense industry mergers: reduced duplication of

investment to cover fixed costs; expanded market access; diversification of political risk;

improved planning of R&D efforts; and enhanced access to innovative technology. On

close examination, none of the five benefits is likely to be very substantial, either because

the economic benefits of cross-border deals are likely to be quite small when all costs are

accounted for or because government buyers are unlikely to be interested in what

6
For examples of such "defense globalization is coming" rhetoric, see Anthony L. Velocci, Jr.,

"Consolidation Juggernaut Yet to Run Its Course," Aviation Week and Space Technology, Vol. 155, No. 23

(December 3, 2001), p. 48; Pierre Sparaco, "Paris 2001 Sets the Stage for Multinational Players," Aviation

Week and Space Technology, Vol. 154, No. 21 (May 21, 2001), p. 82; Howard Banks, "Foreign

Entanglements," Forbes, Vol. 164, No. 5 (September 6, 1999), p. 174; "Transatlantic Aerobatics," The

Economist (June 5, 1999), p. 59.

efficiency gains are possible. The article concludes with a discussion of the effectiveness

of trans-Atlantic defense industry ties the alternative touted by some defense analysts.7,

Again, analysts need to focus closely on the buyers' interests when considering the deals'

effects. The specific advantages often attributed to trans-Atlantic mergers the expected

smoother interoperability of military forces that are equipped by an internationally

integrated arms industry and the closer alliance cohesion that might come from integrated

industry support for the alliance really derive from cooperation among buyers rather

than sellers. In sum, none of the seven hypothesized advantages of cross-border mergers

is likely to obtain.

Framework for the Analysis

Supporters of moves toward a transnational defense industry for the most part

predict future benefits, primarily increased efficiency in the defense business.8 Many

government reports on transnational defense are couched in that language, but the subtext

often reflects the politics of defense industry employment, as does the limited empirical

7
See, for example, Adams, p. 12; Alexandra Ashbourne, "Trans-Atlantic Defense Alliances Best Idea for

Europe," Defense News (August 23, 1999); Harvey M. Sapolsky and Eugene Gholz, "Another European

Mistake?" Financial Times (May 20, 1998).

8
For example, the extensive discussion of cross-border defense industry collaboration and restructuring in

Todd Sandler and Keith Hartley's survey focuses on possibilities for increased efficiency (and potential

costs of collaboration due to transaction costs, increased contractor monopoly power, etc. measured in

reduced efficiency). See Todd Sandler and Keith Hartley, The Economics of Defense, New York:

Cambridge University Press, 1995, Chapter 9. Sandler and Hartley are actually agnostic on the desirability

of efforts to promote European defense industry collaboration. They principally call for additional

economic research.
record on government interest in (and resistance to) cross-border deals. On the industry

side, increasing efficiency is an important competitive strategy for normal business, but it

is only a means to an end. Firms' ultimate goal is to increase the present discounted value

of risk-adjusted profits. In the politicized defense sector, first-order business strategy

requires responsiveness to monopsonistic government buyers, and those buyers' interests

often guide defense firms to maximize profits by means other than cost cutting.9 Table 1

summarizes three major views of the defense industry and their predictions about buyers'

and sellers' strategic decision-making.10

The goal of this article is not to disprove empirically the efficiency theory's

predictions. Instead, this article highlights the premises of the cross-border merger

advocates, questions whether those premises actually obtain in the post-Cold War world,

and suggests an alternative view of the political economy of post-Cold War defense

procurement choices. Based on that political economy view, this article argues that any

mergers will bring little change or rationalization to the industry. Ultimately, time will

tell which set of predictions will be fulfilled. Those empirical results will offer insight

into which theory of the post-Cold War world is correct: the "mergers are beneficial"

9
For evidence that politics dominates post-Cold War defense procurement strategies in the U.S., including

through the merger wave of the mid-1990s, see Eugene Gholz and Harvey M. Sapolsky, "Restructuring the

U.S. Defense Industry," International Security, Vol. 24, No. 3 (Winter, 1999-2000), pp. 5-51.
10
A related categorization of three alternative views of defense sector business-government relations can be

found in Eugene Gholz, "The Curtiss-Wright Corporation and Cold War-Era Defense Procurement: A

Challenge to Military-Industrial Complex Theory," Journal of Cold War Studies, Vol. 2, No. 1 (Winter,

2000), pp. 35-75. See also Thomas McNaugher, New Weapons, Old Politics: Americas Military

Procurement Muddle (Washington, DC: Brookings Institution, 1989), pp. 3-12.

view, based on efficiency considerations, or the "mergers are marginal" view, based on

political considerations.

Table 1: Summary of Three Theoretical Frameworks

Efficiency Military Strategy Political Economy

What does Best price / value Best performance Political strength

government demand?

Budgeteers (OSD, Warfighters (CINCs, Politicians (Congress,

Who decides what to service staff) JROC) executive appointees)

buy?

Currency of National strategy / Employment

procurement Cost as an mission requirements concentration (logroll,

decisions Independent Variable key legislators)

Firm strategy Restructure Push the state of the art Lobby

Role of foreign Competition to price / Specialized providers of

suppliers innovation niche products Excluded

Economies of Scale

The defense business allegedly can benefit from international mergers through

two kinds of scale economies: firm-level scale, in which added total revenues give firms

"critical mass" to participate in the defense business, and plant-level scale, in which

consolidated manufacturing operations eliminate overcapacity and wasteful overhead

expenditures.11 The idea of critical mass sounds good for pundits seeking a quick

soundbite, but it has little theoretical basis in defense economics and is unlikely to be

relevant to the existing political situation in the defense sector. The plant-level argument,

on the other hand, rests on sounder principles, but it is unlikely that politically oriented

firms can or will take advantage of plant-level scale economies.

Firm-Level Scale

Defense firms are multi-product firms think of management as controllers of a

portfolio of related investments. Each weapon system may be produced in a different

factory, or several products may share a single facility. Either way, the first order

economies of scale in production are product- or at least plant-specific.12 Adding more

11
For the firm-level argument, see Alessandro Politi, "On the Necessity of a European Defence Industry,"

in Wilfried von Bredow, Thomas Jger, and Gerhard Kmmel, eds., European Security, New York: St.

Martin's Press, 1997, p. 109. For the plant-level argument, see Sandler and Hartley, pp. 194-5; Neil

Cooper, The Business of Death: Britain's Arms Trade at Home and Abroad, London: Tauris Academic

Publishers, 1997, p. 116.

12
Consolidating the production of several products in a single facility will naturally reduce overhead costs

and may otherwise increase efficiency for example, broader workforce experience could yield learning
products to the firm's portfolio expands overall revenue, increasing firm-level "mass," but

it does not increase the efficiency of production of any particular weapon system.

Expanding the portfolio will smooth variation in the firm's revenues by diversifying risk,

as long as the chance that each of the firm's contracts might be cancelled is independent

of the status of its other contracts.13 But the only mechanism by which that risk

diversification can reduce production costs is by reducing the firm's cost of capital raised

in private markets (lenders demand a smaller risk premium on a diversified corporation's

bonds). However, governments rather than private markets supply most of the capital in

the defense sector, so this route to cost reduction and efficiency is of marginal

significance.

Pro-merger analysts sometimes justify the critical mass argument on political

rather than economic grounds: perhaps unmerged firms will simply be too small to attract

curve benefits for all programs in a plant. Lisa Burgess, "Lockheed Martin Links C-130J Buys to Cost of

F-22," Defense News (December XX, 1998), p. 1.

13
Technical performance on various development contracts, for example, will be less than perfectly

correlated but not totally uncorrelated. The overall technical competence of the workforce contributes to

performance on every project: if the workforce is relatively unskilled, every project is threatened, while if

the workforce is top class, every project is more likely to succeed. On the other hand, technological

unknowns in pushing the state of the art are project-specific: some products turn out to be more technically

feasible than others. Similarly, a change in military doctrine might threaten a particular missile project but

not a new type of radar. But an entire firm can develop a reputation for non-responsiveness to its military

customers that may threaten all of its projects at once. For an example, see Gholz, "The Curtiss-Wright

Corporation." For discussion of risk diversification in defense procurement, see Eugene Gholz, Getting

Subsidies Right: Government Support to High Technology Industries (PhD Dissertation, MIT Department

of Political Science, February, 2000), Chapter 2.

the political attention required to win contracts. Journalists like to talk about firms'

"lobbying clout" in articles about mergers.14 If such clout is important, then firms should

have a strong incentive to pursue whatever merger prospects are available. The problem

with this argument is that the pre-merger firms are hardly politically fragile: Northrop

Grumman, notable for its failed attempts to merge with Martin Marietta, Hughes, E-

Systems, and Lockheed Martin, is a more than $9 billion-a-year company.15 "Small"

defense firms are very unlikely to be politically impotent. Most of them are bigger now

than they were when Cold War critics of the "military-industrial complex" considered

them to be unstoppable juggernauts on Capitol Hill.16 Likewise in Europe, some

financiers consider Thomson-CSF to be too small compared to BAe Systems and EADS.

But Thomson-CSF is more than large enough to attract considerable political attention

and commitment.17

Moreover, in political terms, the $9 billion-a-year prime contractors may turn out

to be just the right size, because bigger firms face political diseconomies of scale.

Politicians may feel that they have already given adequate support to a big company after

fighting for one of its projects, leaving others less well protected in later defense budget

14
Bruce Orwall, Steven Lipin, and John R. Wilke, "Lockheed Deal Likely to Pass Muster," Wall Street

Journal (July 7, 1997), p. A8.

15
Elizabeth Douglass, "Life after the B-2: Northrop Grumman Has Seen Its Share of Setbacks," Los

Angeles Times (September 20, 1998), p. D1.

16
See, for example, Gordon Adams, The Iron Triangle: The Politics of Defense Contracting, New York:

Council on Economic Priorities, 1981.

17
Vago Muradian, "Richard: U.S., Europe Growing Protectionist, Barriers Must Drop," Defense Daily

(February 23, 2000), p. 5.

fights. As a result, the political procurement theory should predict limits to firms' interest

in building critical mass.

The critical mass argument also extends to European fears of subordination in

trans-Atlantic deals with their larger American "partners." The idea is that intra-

European mergers should be completed first to bulk up the European position for later

trans-Atlantic negotiations.18 In this view, efficient, trans-Atlantic mergers are presumed

to be inevitable.19 But the relative pre-merger sizes of European and American firms

should not affect the management of the post-merger firm very much.

Implicitly, the European politicians fear that management after a trans-Atlantic

merger will be dominated by Americans, who will close the firm's European facilities or

will ignore the preferences of European buyers.20 It is true that one of the things that

management buys when it acquires another firm is operational control of the business (a

privilege for which the acquirer may pay handsomely). Most of the time, the exercise of

that operational control is the mechanism by which the merger is supposed to increase

efficiency. Unless the Europeans believe that the Americans would close European

factories out of pure spite (which seems highly unlikely), they are actually resisting deals'

potential efficiency gains.

18
John Lovering, "Which Way to Turn? The European Defense Industry after the Cold War," in Ann R.

Markusen and Sean S. Costigan, eds., Arming the Future: A Defense Industry for the 21st Century, New

York: Council on Foreign Relations, 1999, p. 361. With the formation of BAe Systems and EADS, the

leading European firms are now hardly smaller than their American counterparts.
19
Politi, p. 110; David Lister, "Racal Deal Typifies Era of Consolidation," The Times (London) (January

14, 2000), p. 31.

20
Sandler and Hartley, p. 186.
 Furthermore, if European markets offer a profitable weapon system development

opportunity, no defense firm whether its management is European or American will

ignore it. Both BAe and Boeing are happy to design and build as many different products

as they profitably can, regardless of the buyers' geographic locations. If European

politicians feel that they cannot afford to spend enough in their defense budgets to make

the development of Europe-specific weapons profitable, then that is a problem to be

resolved by the buyers in the procurement bureaucracy. The industrial structure of the

sellers will not change the problem one way or the other.

Plant-Level Scale

Economies of scale at the plant level depend on post-merger firms' shedding of

excess capacity a politically difficult task.21 For example, British stock market analysts

endorsed the BAe-GEC merger, because they believed that BAe management has a good

record in the 1990s of streamlining overhead through internal restructuring.22 But post-

merger defense firms' strategic planners may not even be interested in closing plants:

given the government-dependent nature of the defense business, increases in production

efficiency may not translate into additional contracts or higher profits, and cuts in the

production base could even undermine political support for contracts.

21
Alexander Nicoll, "The Sauce for the Goose May Not Suit the Gander," Financial Times (April 29,

1998), p. 25; Alexander Nicoll, "Leaner and Meaner but Far From Extinct," Financial Times (November

16, 1997), p. 5.
22
Daniel Michaels, "British Aerospace President Must Deliver," Wall Street Journal (September 3, 1999),

p. A9.
 Industries with high levels of fixed costs for research and development and for

physical plant spread their fixed costs over as many units as possible efficiently

reducing average unit costs and prices. Mergers typically yield financial benefits because

redundant manufacturing plants can be closed, reducing fixed costs for a given level of

output. Firms can then increase revenues and profits, because cost reductions allow them

to undercut competitor's prices. That is the normal incentive for mergers, and it is the

logic that is presumed by the advocates of cross-border defense industry consolidation.

Even though the defense sector has high fixed costs and excess capacity, that is

not enough to make the usual merger logic operate in this case. Defense procurement and

commercial sales decisions are based on different factors, and defense buyers rarely

respond to cost-reducing efficiency benefits of post-merger economies of scale. In low-

threat environments specifically including the post-Cold War world for American and

European defense planners defense procurement contracts are more likely to be

distributed according to pork barrel politics.23 The military costs of "bad" procurement

23
In defense, almost everyone agrees that the ideal would be for civilian leaders to choose strategic goals,

for operational military experts to set military doctrine to meet those goals, and then for the procurement

bureaucracy to purchase whatever weapons are needed to implement the doctrine. This ideal means-ends

chain follows the prescription for "political-military integration" in Barry R. Posen, Sources of Military

Doctrine, Ithaca, NY: Cornell University Press, 1984, pp. 53-4, 233-6. Even in this third alternative view

of defense procurement choices (threat-based planning, contrasted with the economic efficiency and

political economy views emphasized in this article), efficiency plays at best an indirect role. For the

contrast to the politicized "military-industrial complex" in the UK, see Mary Kaldor, "Britain," in Mary

Kaldor and Genevive Schmder, eds., The European Rupture: The Defence Sector in Transition, Lyme,

NH: Edward Elgar Publishing, 1997, p. 59.

choices are not a salient political issue in times of low threat, but job losses in the defense

industry are politically painful.24 Efficiency is unlikely to play a major role in allocating

defense contracts. In fact, inefficiency may be politically desirable: managers with higher

sunk costs may lobby harder to win a place at the defense budget trough, and plants with

more excess workers can mobilize more grass roots support for the defense budget.25

Moreover, politicians and defense planners do not lack for alternate uses for

defense dollars even in these days of budget surpluses, so firms' commitment to post-

merger efficiency enhancements is likely to be low.26 Even if firms can avoid annoying

their political customers, can consolidate fixed investment from multiple defense plants,

and can reduce costs, the savings will likely be diverted either to the pork barrel

maintenance of other, less efficient defense firms or out of the defense budget entirely.27

Procurement bureaucrats may also renegotiate even fixed price contracts ex post to

eliminate firms' "excess profits." The threat of such renegotiation limits contractors'

24
If defense sector political interests are already well organized as when a low threat period follows a

sustained period of high threat during which firms and workers sunk specialized capital into factories and

careers in defense production pork barrel pressures will be particularly strong. See Gholz and Sapolsky,

"Restructuring the Defense Industry," pp. 16-7. In the European context, see Politi, p. 102.
25
Deutch et al., p. 58, emphasize the political importance of preserving defense sector jobs in Europe as a

constraint on industrial restructuring. See also Sandra I. Erwin, "Defense Industry Trans-Atlantic Forays

Feature Deals that Preserve Local Jobs," National Defense (September 1, 1998), p. 32.
26
David Wessel and Greg Hitt, "Lawmakers Discover That Surpluses Can Be As Vexing As Deficits,"

Wall Street Journal (July 29, 1999), p. A1.

27
Kaldor, p. 60.
incentives to pursue efficiency gains.28 An efficient defense firm should not expect to

appropriate much of the benefit of its merger efforts, and so it should not be likely to

pursue plant-level scale economies.

In this political economy view of defense procurement, defense firms should not

be criticized for using the political process to win contracts. They are simply maximizing

their profits given the political and economic constraints of their sunk investments

exactly what they should be doing in their shareholders' interest. But that behavior makes

the prospect of merger-induced capacity rationalization bleak, and it undermines the

economies of scale argument for cross-border defense industry mergers.

Market Access

Defense firms also may benefit from economies of scale by extending their

production runs spreading the cost of their existing physical plant over more units.

Advocates of the market access explanation for cross-border defense industry mergers

argue that gaining a foothold in a foreign market through the acquisition of an overseas

firm can increase the number of weapon system units produced.29 The deal may induce

more than one government to buy an identical or nearly identical weapon system through

28
William P. Rogerson, "Incentive Contracting in Defense Procurement," MIT Security Studies Program

Seminar, October 27, 1999; William P. Rogerson, "Excess Capacity in Weapons Production: An Empirical

Analysis," Defence Economics, Vol. 2, No. 3 (July, 1991), pp. 235-49.

29
Fitchett, "U.S. Seeks More Defense Technology Cooperation;" John D. Morrocco, "Transatlantic Links a

Crucial but Elusive Goal," Aviation Week (May 24, 1999), p. 28.
the promise of some local production in each country.30 But to the extent that the

extended production run requires spreading manufacturing or assembly facilities into

more than one country, cross-border mergers add to both scale and fixed costs,

counteracting the potential benefit.

In Europe in particular, domestic markets are considered too small for "national

champion" firms to achieve economies of scale, so transnational mergers that bring

access to a Europe-wide market are allegedly essential for efficiency and

competitiveness.31 BAe Systems' management has wondered out loud if the only way to

expand in the biggest market in the world the U.S. defense procurement market is to

merge with a U.S. prime contractor. Speculation is focused on Boeing and Lockheed

Martin, especially the former due to existing ties to BAe on the Harrier, Meteor, and

Nimrod projects.32

The principal economic concern for defense firms contemplating cross-border

mergers should be their ability to repatriate profits from the target market. Specifically,

the decision to make a foreign acquisition should depend on the cost of the purchase

being less than the present discounted value of the future stream of repatriated profits.

Unfortunately, political resistance to exporting profits from defense contracts is likely to

30
Richard A. Bitzinger, "Globalization in the Post-Cold War Defense Industry: Challenges and

Opportunities," in Ann R. Markusen and Sean S. Costigan, eds., Arming the Future: A Defense Industry for

the 21st Century, New York: Council on Foreign Relations, 1999, p. 309.
31
Bitzinger, pp. 321-3.
32
Alexander Nicoll, "America in its Sights," Financial Times (December 14, 1999), p. 19. BAe also has

ties to Lockheed Martin, for example on the JSF prototype development contract.
be high similar to the political resistance to arms imports purchased with cash.

Moreover, unless cross-border mergers increase production per unit of fixed investment,

there is no reason to believe that the deals will add any value: why should acquired firms

be systematically under-priced? In fact, due to domestic political concerns with

sovereignty and maintenance of independent defense production capabilities, firms are

more likely to be over-priced. The result is that firms should not have much incentive to

pursue transnational defense consolidation.

Meanwhile, the market access hypothesis is internally inconsistent with respect to

the determinants of defense acquisition choices the government side of the equation.

On the one hand, national markets are called too small for producers to achieve minimum

efficient scale an economic argument based on the idea that governments select their

defense suppliers by considering efficient production and low cost. Cost-effective

imports can undermine inefficient national champions trapped in domestic markets,

because an efficient international arms trade is presumed to exist. At the same time,

transnational mergers are justified using an argument about imperfections in the

international arms market: governments (usually implicitly) will only buy weapons that

meet domestic content requirements. European governments negotiated multinational

procurements throughout the Cold War on the principle of juste retour, where production

shares were allocated politically according to investment shares rather than according to

efficiency. The result was often the maintenance of redundant facilities at high cost.33

33
House of Commons, Trade and Industry Committee, Third Report, British Aerospace Industry, Vol. 1.

London: HMSO, July 1, 1993, p. 22.

 Embarrassment at Europe's reliance on American forces for striking power in the

Kosovo war might diminish national pork barrel pressures in European weapons

acquisition if Europe attempts a rapid "catch-up" in military capabilities. But the most

likely short-term result of raising the prominence of efficiency and capability in

procurement decision-making would be an increase in European imports of established

American weapon systems.34 Such catch-up would not require any cross-border defense

industry mergers. Instead, the Kosovo experience has been used to jawbone European

defense companies and procurement bureaucracies into more intra-European

collaboration and/or mergers.35 These plans will be slow to bear fruit, as they mostly

pertain to new projects that will require major technical development before production

decisions can be made. To that extent, they seem to be part of the normal European

political process with frequent rhetorical allusions to market access and economies of

scale but little real concern for production efficiency.

Political Risk

New weapons frequently push the state of the art, which introduces technological

uncertainty into defense procurement. Simultaneously, buyers introduce political

uncertainty by changing specifications, budget levels, and other features of procurement

34
William Pfaff, "Europe Is Moving Forward With Its New Defense 'Identity'," International Herald

Tribune (November 25, 1999).

35
David R. Sands, "Bid To Create EU Army Stalled," Washington Times (January 9, 2000), p. C11.
contracts faster than even the most nimble defense firms can adapt.36 Those changes

drive up development and manufacturing costs.

One way that procurement bureaucrats and defense firms seek to manage political

uncertainty is to make highly optimistic technical and scheduling promises, compounding

technological uncertainty.37 Another way that some firms (and governments) have

sought to adapt, particularly in Europe, is to entangle procurement programs in

international collaboration. Long-term multinational programs may be difficult to cancel

because steady participation becomes a foreign policy commitment;38 alternatively,

multinational programs may diversify producers' risks, if a project can survive profitably

even if one of its buyers backs out as a result of changing political winds. Such

international collaboration need not require defense industry mergers (cooperation among

procurement bureaucrats would be sufficient), but industrial link-ups might facilitate

multinational procurement deals.39 Cross-border projects, however, may actually

increase rather than reduce or diversify political risk.

36
This hypothesis presumes, without substantial justification, that the whims of politicians are irrational.

At least some of the time, politicians are judging changes in the international threat environment correctly

and are serving national security by changing procurement requirements. The changes almost guarantee

cost overruns and schedule slippage on weapons contracts, but those "problems" may represent substantial

savings relative to buying an unnecessary platform or continuing a project made obsolete by adversaries'

doctrinal adaptation or innovations.

37
Harvey M. Sapolsky, "Equipping the Armed Forces," Armed Forces & Society, Vol. 14, No. 1 (Fall,

1987), pp. 113-128.

38
Lovering, pp. 360-1.
39
Especially if the market access hypothesis were true.
 The argument that procurements are more difficult to cancel when they involve

more than one government that is, the argument that transnational mergers would

actually reduce political uncertainty seems particularly weak. As advocates note,

international collaborations frequently specify withdrawal penalties for governments that

do not follow through with planned purchases and for firms that fail to meet contractual

obligations, but such penalties are hardly unique. Withdrawal penalties are standard

features of purely domestic defense contracts, too: the government pays penalties for

early "cancellation for convenience," while the firm pays in case of "cancellation for

default."40 If anything, international penalties may be more difficult to enforce.41

Linking defense procurement to foreign policy through cross-border deals is also

unlikely to reduce political uncertainty. In exceptional cases, treaties or memoranda of

understanding on collaborative weapons procurement have proved extremely durable.

European firms and governments were scarred by the Concorde project, on which France

and especially Britain felt trapped as costs soared and sales prospects dwindled.42 On the

40
Deciding fault in cases of early contract termination often leads to complex and expensive legal disputes

most notably now in the long-running litigation between the U.S. government and General Dynamics and

McDonnell Douglas on the A-12 program. Nanci Fonti, "Court Negates Award Against Pentagon in

General Dynamics, Boeing Lawsuit," Wall Street Journal (July 2, 1999), p. 14.
41
Europe may be able to mitigate this problem if defense contracting and compliance trials come under the

jurisdiction of the European Union along with the hypothesized advent of Europe-wide procurement

decision-making.
42
John Costello and Terry Hughes, The Concorde Conspiracy: The International Race for the SST, New

York: Charles Scribner's Sons, 1976; Pierre Muller, Airbus, L'ambition Europenne: Logique d'Etat,

Logique de March, Paris: L'Harmattan, 1989, pp. 229-30.

other hand, there have been countless cases of cancelled European collaborative projects.

Especially if procurement decisions involve pork barrel allocations to defense firms,

cross-border procurements may be particularly vulnerable to cancellation: countries may

try to pass the buck on the pay-offs to powerful interest groups. If two countries jointly

fund a weapon, and each country is confident that the other is committed to the product,

then the governments may race to cancel the project first leaving their erstwhile partner

with the bill for supporting the defense industrial base.43

Defense firms would also be worse off with multinational rather than domestic

politics. Firms should exploit whatever leverage an international merger can contribute

to launching new programs if they are sure that at least one government will eventually

accept delivery. At a minimum, if the cancellation proclivities of multiple governments

were not correlated (or were negatively correlated), the multinational procurement

contract would diversify the firm's political risk.44 However, few defense firms would be

confident in the continuation of a multinational program after one or more partners

dropped out. Multinational efforts usually specify that particular components of a

weapon system be developed and produced in each participant country. As a result,

43
This buck passing hypothesis could be tested with detailed process tracing of cancelled or cutback

multinational procurements, but I am not aware that anyone has done so yet.
44
This condition would certainly obtain if procurement were purely motivated by domestic concerns that

is, by the "need" to support the domestic defense industry and by the size of the domestic defense budget.

But to the extent that contractor performance enters the calculation, along with international strategic

concerns, the governments' procurement decisions are likely to be positively correlated. In that case, risks

would not be diversified.

every participant becomes vital to the program's success.45 If any one drops out, costs for

the entire program are likely to soar, because a replacement component will need to be

hurriedly developed and produced by an alternate supplier. The overall program will

frequently fail. Under those conditions, even if an international deal could significantly

reduce the probability that each individual partner would back out, the joint probability of

a successful program would tend to drop. International defense mergers, then, are not a

good strategy for managing political risk.

R&D Planning

The spectacular rise in R&D costs for new weapon systems over the past fifty

years has made the control of R&D costs increasingly important to defense reformers.46

Most defense R&D is performed by private firms especially the more expensive applied

research and systems development and competition among firms to meet the military's

specifications for new weapons may lead to redundant effort among fragmented private

45
The development of the first Airbus, the A300, is one such example: when the British government

withdrew from the consortium, the remaining partners found a way to keep the British contractor, Hawker

Siddeley (HSA), involved as a subcontractor, because the airplane needed the wings that HSA had

developed. That scramble was surely expensive and time consuming. Keith Hayward, Government and

British Civil Aerospace: A Case Study in Post-War Technology Policy, Manchester: Manchester University

Press, 1983, p. 95.

46
Jacques S. Gansler, Affording Defense, Cambridge, MA: MIT Press, 1989, pp. 171-3.
contractors.47 Thus another alleged advantage of defense industry mergers is that they

offer the opportunity to rationalize R&D investment.48

Cross-border defense mergers might be especially likely to yield savings through

rationalization. The defense establishment in each country can to some extent use

regulation to limit R&D redundancy among domestic contractors, but procurement

authorities have no way to prevent redundant effort in other countries. The European

Union's troubled technology policy efforts of the 1980s and 1990s tried to address exactly

this concern for commercial high-tech firms, with only limited success.49 But

international defense mergers could internalize R&D planning within a single

organization, solving the economic problem without infringing on sovereignty.50

However, the scale of the potential R&D savings from mergers is unclear. At the

micro level the level at which specific weapon system components are developed the

problem-solving approaches adopted by competing firms' design teams may not overlap

very much. Over the years, defense firms have developed technical specialties and

some analysts even argue that the various design teams have competing, incompatible

47
J. A. C. Lewis, "US Giants Threatening to Overrun Europe," Jane's Defence Weekly (February 9, 2000).
48
Robert P. Grant, "Transatlantic Armament Relations under Strain," Survival, Vol. 39, No. 1 (Spring

1997), p. 117.
49
David C. Mowery, "Does Airbus Industrie Yield Lessons for EC Collaborative Research Programs?"

University of California at Berkeley Consortium on Competitiveness and Cooperation Working Paper No.

92-2, July, 1992.

50
Bitzinger, p. 309.
philosophies or cultures.51 If the work done by the pre-merger partners is substantially

different, then mergers offer little potential R&D cost savings.

Furthermore, design team consolidation may have technical costs. The optimal

response to technological uncertainty is to pursue parallel research solutions, all targeted

at the same technical problem. In other words, fragmentation diversifies technological

risk.52 If R&D funding levels are maintained after consolidation of design teams, then

more efficient planning of the R&D effort might result in an even more diversified

technological approach and perhaps result in fewer program failures induced by

technological uncertainty. If, on the other hand, R&D accounts are cut in response to

consolidation, defense procurement will face the same tendency toward technological

over-promising as it has in the past.

Of the various alleged benefits of transnational defense industry integration, the

political economy theory predicts that R&D rationalization faces the smallest barriers.

Defense firms earn most of their profits on production contracts, and they often lose

money on the R&D phase of projects under the current procurement system.53 If better

R&D planning might be designed to diversify their technological uncertainty, the firms

should have an incentive to cooperate. Moreover, while the R&D process absorbs the top

51
Jeffrey A. Drezner, Giles K. Smith, Lucille E. Horgan, Curt Rogers, and Rachel Schmidt, Maintaining

Future Military Aircraft Design Capability, R-4199-AF, Santa Monica, CA: RAND, 1992, p. 14.
52
Gansler, p. 224; Henry Ergas, "Exploding the Myths about What's Wrong," Financial Times (June 26,

1985), p. 17.
53
Karen W. Tyson, J. Richard Nelson, Neang I. Om, and Paul R. Palmer, Acquiring Major Systems: Cost

and Schedule Trends and Acquisition Initiative Effectiveness, Alexandria: Institute for Defense Analysis,

March, 1989.
end of the defense industry's skilled labor, scientists and design technicians account for

only a small portion of the industry's base of political support. Government officials who

worry about the level of post-merger employment should not fear the political effects of

R&D rationalization. At the same time, however, neither managers nor politicians should

be expected to give strong support: while they have little to lose from R&D

rationalization, it is also difficult to imagine either group appropriating a substantial gain.

Technology Access

Perhaps the most natural expected benefit of transnational defense industry

mergers comes from the sharing of technology.54 No single firm nor even a

combination of all the defense firms of any single country should be expected to

produce every type of weapon system and component at the technological cutting edge.

"Critical technologies" lists first drawn up by the U.S. Department of Defense and other

agencies in the 1980s at the height of the fears of American industrial decline showed

that the U.S. led in some areas but had fallen behind in others.55 Political rhetoric

originally called for U.S. technology policies to catch up in lagging areas and to exploit

its leads where possible; today, with the U.S. economy growing and minimal direct

security threats from high-tech adversaries, the rhetoric calls for industrial combinations

that offer technological synergies. This argument exaggerates the differences in

54
Bitzinger, pp. 309-10; Morrocco, p. 28.
55
Lewis M. Branscomb, "Targeting Critical Technologies," in Lewis M. Branscomb, ed., Empowering

Technology: Implementing a U.S. Strategy, Cambridge: MIT Press, 1993, p. 47. Similar DoD lists are still

cited in the trans-Atlantic weapons trade debate. See Grant, p. 115; Sandler and Hartley, p. 229.
industrial capabilities among defense firms and ignores the mechanisms short of merger

by which prime contractors can share the benefits of innovations.

While a static snapshot of defense firms' intellectual property would reveal

pockets of relative advantage and weakness, the world of weapon system development

and procurement is actually dynamic. No advanced military power buys weapons strictly

off the shelf.56 More to the point, the goal of gaining access to technology through cross-

border defense industry mergers is to aid the development of new, innovative weapon

systems. None of the first tier defense contractors, American or European, lacks the

technical ability to work up a new design as long as the development project receives

enough financial backing. And none of the first tier firms, American or European, should

be systematically more expensive in pursuing technological development unless it is

saddled with more than the normal level of political uncertainty or with additional

transaction costs associated with a complicated collaborative venture. The point is that

technological leadership on an innovation-by-innovation basis is temporary or illusory.

When Boeing joined Matra BAe Dynamics (MBD) in the Meteor air-to-air

missile program, Boeing's spokesman announced that the American contractor would

contribute expertise in low-cost manufacturing techniques and systems integration know-

how to the project.57 Yet the French and British partners in MBD hardly lack those

capabilities: both BAe and Matra have developed complete, technically successful

missiles in the past. What Boeing uniquely brings to the partnership is American

56
Even export versions of established weapon designs are generally customized to some extent for each

national military purchaser.

57
Alan Cowell, "Boeing in Deal to Develop Missiles Overseas," New York Times (October 21, 1999), p. 4.
participation defusing what would otherwise have been a Europe v. U.S. competition

between MBD and Raytheon to outfit the Eurofighter.58

Moreover, if a country or firm decides for some reason that it would prefer to gain

access to some particular intellectual property by negotiating a deal (merger or otherwise)

with another defense contractor, it should not expect that deal to be cost-free. In a merger

agreement, the valuation of each of the participating firms includes the present

discounted value of the net income from future sales of its intellectual property. That

value should be close to the price that the technologically "backward" firm would have to

pay to buy the advanced components by negotiating a production subcontract with the

"advanced" firm.59 Either way, there is no such thing as a free lunch in international

defense industry mergers.

Trans-Atlantic Deals

None of the five hypotheses about the advantages of cross-border defense

industry mergers is truly specific to mergers within Europe, although advocates have

specifically cited all of them in that context. Trans-Atlantic mergers might equally

increase economies of scale, expand market access, diversify political risk, improve

planning of R&D efforts, and/or enhance access to innovative technology. To the extent

58
Jim Hoagland, "A Global Riddle," Washington Post Weekly Edition (November 1, 1999), p. 5.
59
Any price differences between the two types of deal should be traceable to the value placed on strategic

control of future investment options derived from the intellectual property. It is often sufficient, however,

to obtain technological access through international subcontracts, which are quite common in the defense

sector. They are sometimes used to gain access to innovative technology, and they are sometimes used to

elicit political support for the international arms trade (in that case, the subcontracts are known as offsets).
that those alleged advantages of cross-border European deals have been undermined by

the above arguments and evidence, however, so too are the arguments for trans-Atlantic

ventures. The incentive to follow through on opportunities for economies of scale in

mergers is muted, because efficiency concerns may be overshadowed in procurement

decision-making by pork barrel politics. Arguments that cross-border mergers could

diversify or even reduce political and/or technological uncertainty also rest on

questionable premises about the nature of the risks in defense procurement and of the

motivations behind defense procurement choices.

The strongest case for consolidation seems to derive from the limited benefits of

R&D planning, if the planning can be implemented in a way that preserves a diversity of

technological investments. On the other hand, the magnitude of this advantage always

open to question may be particularly small from trans-Atlantic mergers in the near

term. The strong post-Kosovo war criticism of European weapons programs as

technologically inferior to their American counterparts reduces the likelihood that

substantial R&D inefficiencies exist in current programs. Even if European firms are

technologically as capable as their American counterparts which seems likely their

existing backlogs of R&D projects are directed at significantly different problems from

those on which their American counterparts are working. Consequently, few truly

redundant R&D efforts could be eliminated by trans-Atlantic deals. The natural

exceptions to this argument about limited technological overlap stem from those trans-

Atlantic joint venture developments like the Joint Strike Fighter that are already in

progress. Those ventures highlight the possibility of gaining most of the alleged

advantages of R&D planning without the need for any merger activity.
 The most prevalent specific argument for trans-Atlantic as opposed to European

defense industry mergers proposes that mergers might solve problems with NATO

military operations that derive from incompatibilities among weapons produced by

national champion defense industries.60 Communications and intelligence processing

aids have been especially singled out for criticism in recent coalition military

campaigns.61 Mergers, however, are neither a necessary nor a sufficient solution to

interoperability problems among allies. In fact, because of contractors' incentives to

adapt the technical specifications of their bids closely to buyers' specifications in their

"request for proposals" announcements, mergers are unlikely even to facilitate improved

interoperability.

In both the U.S. and in Europe, the most successful defense contractors are the

most responsive ones: whatever specifications are announced by procurement agencies,

whether harmonized with allies' weapons or not, firms will promise to meet them. The

multinational progeny of defense industry mergers will follow national specifications or

harmonized international ones just as closely as national champions do. Such

responsiveness is their best strategy to remain profitable.

Furthermore, the problem for coalition warfare stems from differences in

equipment specifications among the allies, which derive from differences in strategic

vision and pork barrel inclinations. Those differences have persisted since early in the

60
Grant, p. 112; Transatlantic Mergers Promoted by Nominee For No. 2 Pentagon Post, Aerospace Daily

(March 24, 2000).

61
Hunter Keeter, "Gansler: Globalization, Interoperable Tech Keys to Future," Defense Daily (August 2,

1999); Frank Wolfe, "Gansler: Pentagon Open to Foreign Linkages," Defense Daily (July 8, 1999), p. 1.
Cold War, and they are likely to persist well into the future. The burden should fall on

proponents of cross-border mergers to show that interoperability problems are now more

pressing or more easily solved on the demand side than they were during the Cold War.

Advocates of trans-Atlantic deals have also proclaimed an even more difficult

mission for the mergers: perhaps they can shore up flagging political support for the

NATO alliance. This argument specifically recognizes and exaggerates a potential

disadvantage of intra-European defense restructuring. Trans-Atlantic defense merger

advocates fear that industrial competition between "Fortress Europe" and "Fortress

America" might undercut public support for strategic and operational defense

cooperation.62 Conversely, cross-border defense firms might actively lobby to maintain

alliance ties providing additional support for the alliance with roots in the pork barrel.

As with the other arguments in favor of cross-border mergers, though, this

argument is not supported by a clear understanding of state behavior. Why do states form

alliances and, specifically, what roles do industrial organization and international trade

and competition play in alliance politics? In one of the most explicit statements by trans-

Atlantic merger advocates, John Deutch, Arnold Kanter, and Brent Scowcroft cite

political and cultural community, common military defense, and shared burdens and risks

as the underpinnings of the NATO alliance.63 In the cultural case, it is difficult to see

62
Deutch et al., p. 56.
63
Deutch et al., p. 55. The first pillar is consistent with the modern literature in security studies about

strategic culture, and the second pillar follows the more traditional realist literature on alliances. Shared

burdens must be born with some end in mind and are not themselves a reason to form an alliance. Realists
how either defense industry mergers or hard-fought defense industry competition could

change US-European ties. The defense industry is hardly a high-profile arbiter of

American or European culture. In the long run, a deal between Disney and Canal Plus

might aid cultural homogenization and that is precisely one reason that such an

international merger would be politically controversial. But in the short run the time

frame in which NATO supporters are looking for help from the defense industry

cultural affinity is immutable to industrial organization.

Similarly, if alliance ties principally rest on realist concerns about military

defense, then only strategic debates about threats and capabilities not industrial debates

about R&D planning or the location of manufacturing plants can support the NATO

alliance. At best, the role of the defense industry in this vision of alliance support

devolves to the dubious interoperability argument that cross-border mergers can augment

the military capabilities of the alliance.

Advocates of trans-Atlantic defense industry consolidation are more likely to hide

rather than trumpet the pork barrel support that they hope trans-Atlantic defense mergers

would provide to the NATO alliance. If NATO is a political holdover no longer well

suited to the international threat environment, then pork barrel support for the alliance is

support for grand strategic disintegration that is, for national security policy means not

linked to the ends preferred by state leaders. Fortunately, the potential influence of

defense firms' multinationality in bending defense policy is small. In the post-Cold War

world, the primary source of defense firms' political strength is their commitment to

would probably agree that failure to share burdens might be a sign of differences in grand strategy that

could limit the effectiveness of an alliance as a means to "cause" security for member states.
major facilities that employ substantial numbers of voters in specific geographic regions.

For the exact reason that cross-border defense mergers are unlikely to yield much

efficiency from economies of scale, they are also unlikely to affect firms' lobbying

strength: mergers will not change firms' local political presence. Moreover, the mergers

are also unlikely to affect firms' lobbying strategy: defense firms are already active

supporters of the NATO alliance especially of post-Cold War moves to expand NATO

membership. Even as firms from various NATO member countries compete aggressively

for contracts, often with U.S. v. Europe overtones, they unite to actively support the

alliance.64 A more explicit "Fortress Europe" v. "Fortress America" competition would

be no different: European and American prime contractors would compete hammer and

tongs for contracts, but all would try to expand the alliance and its aggregate procurement

budget.

Conclusion

This article has examined seven major advantages cited by advocates of cross-

border defense industry mergers. Five hypotheses are most frequently applied in the

context of intra-European restructuring, although their logic should apply to trans-

Atlantic deals, too. The other two hypotheses are specific to trans-Atlantic ventures. In

every case, however, the arguments relied on a questionable efficiency-based view of

post-Cold War defense procurement decision-making. Under an alternative view,

64
Russell Mokhiber and Robert Weissman, "Arms Sellers Calling Shots," Baltimore Sun (May 16, 1999),

p. 1C; Stephen Green, "Defense Industry Rivals Fight to Profit by NATO Expansion," San Diego Union-

Tribune (January 18, 1998), p. A-34.

domestic politics often "pork barrel" politics are more important. This view suggests

very different predictions about the benefits (or lack thereof) of cross-border defense

industry mergers. Consistent with this political economy framework, and despite rhetoric

to the contrary, neither industrialists nor state leaders strongly support cross-border

defense link-ups. Few concrete changes should be expected in production organization,

technological success of new weapon systems, political support for defense budgets, and

national strategic decision-making.

In time, more post-Cold War evidence will become available to test the efficiency

theory of defense procurement against the political theory. The seven alleged

mechanisms for increasing efficiency through transnational mergers may be fertile

ground for those tests -- intrinsically valuable as evidence about defense procurement

decision-making in the most important markets in the world (especially the U.S.) and also

a measure of the "irresistability of globalization." In the meantime, however, defense

firm managers, procurement bureaucrats, and politicians concerned with national security

should be cautious in presuming particular, beneficial effects of cross-border defense

industry restructuring.