Streetwise Professor

Thinking about the dysfunction of Russian military procurement got me thinking about what is going on here in the US.  Perhaps it’s not quite as dysfunctional, but it is definitely not healthy.  Shipbuilding, for example, is a mess.  The experience with the USS San Antonio is embarrassing.  But everywhere you look–Global Hawk and F-35, as prominent examples–you see huge cost overruns and seemingly interminable delays.  Bright spots appear to be limited to crash programs to develop fixes needed on the ground in Iraq or Afghanistan.  But when it comes to major new weapons systems, it’s a litany of failure.

Back in 1998, I was offered the Admiral Crowe Chair in the Economics of Defense Management at the Naval Academy.  I applied for the chair primarily out of the thought that it would be an interesting experience to return to Navy and stand at the other side of the classroom; getting a chair in my 30s would have also been something of a coup.  But it was too far from my where my research interests were at the time, and I was sure the novelty of role reversal would have worn off quickly.  (Also, I was put off by the cynicism regarding the Midshipmen and the seriousness of the uniformed administration about the importance of education expressed by the civilian faculty I spoke to–many of whom had been my instructors when I was a Mid.  A pretty disillusioning experience, and I didn’t have that many illusions going in.)

To get the job, I had pitched a transactions cost economics-based research agenda.  If I had taken the position, I planned to focus on how the consolidation of the defense industry would change transactions costs–notably, bargaining costs between the government and the contractors, and and the potential for opportunism by those parties.

I haven’t followed the issue closely in recent years (ironically, my research on clearing started about the same time as I was offered the chair), but my intuition is that transactions costs have a lot to do with the chronic problems in procurement, especially for big ticket items.  Shipbuilding for surface ships and submarines is dominated by single firms.  Two firms dominate aircraft production.   Everywhere you look, there are essentially bilateral monopoly contracting situations, and there are heavy investments in specific assets.  Information asymmetries abound, especially for technologically complex weapons.  There is little competition ex ante given the small number of viable contractors, and huge opportunism problems ex post.  Agency problems are likely to be acute: the officers who are supposed to be monitoring contractor performance often have their eyes on more lucrative jobs with the same contractors in the future.

Just looking at production costs and scale economies, you can make a credible case for consolidation.  But production costs aren’t all that matter.  Transactions costs are important too.  And it is my sense that the consolidation wave that accelerated dramatically with the end of the Cold War has dramatically inflated those transactions costs.  They aren’t an accounting item, but they show up in cost overruns on already inflated initial estimates and frequent and extensive delays in bringing systems on line.

The very nature of military contracting means that transactions costs are likely to be high, especially for cutting edge weaponry.  The means of controlling these costs are themselves costly.  You sacrifice scale economies when you support multiple duplicative suppliers who can provide competition and information (based on performance comparisons).  Government-operated suppliers (like Navy shipyards of yore) that also can serve as an outside option that constrains private contractor opportunism are often inefficiently scaled, and subject to low-powered incentives that can impair performance.  But incurring these costs is often a way of saving a greater sum in transactions costs.

Unfortunately, I see no way of reversing what has transpired in the past 20 plus years.  Which means that we are condemned to a future of continued bloated costs and waste when it comes to defense procurement.  Given that this same future will be one of straitened fiscal circumstances, in which defense spending is certain to be cut, defense will be ground between the upper and nether grindstones of inefficient procurement (driven by high transactions costs in dealing with dominant contractors) and reduced procurement budgets.

Defense is a legitimate function of government.  Because it is a legitimate function, it is an area that is not subject to Eugene McCarthy’s dictum that “the only thing that saves us from bureaucracy is its inefficiency.”  Here, the inefficiency gravely compromises the government’s ability to do what it justifiably should do.

I wonder what would have been the reaction to this research agenda, if I had taken the Crowe chair.  Not well, I think.  Not because it was flawed, or likely to be misguided.  No, it probably would have not gone well for me precisely because I think it was likely to identify some serious problems, and that would have made some people and firms vastly more influential than I very unhappy.  Doing that at Navy in particular would have been expounding blasphemy from inside the temple, as it were.  So it was probably wise to choose as I did, and focus on finance rather than defense.