Streetwise Professor

July 19, 2011

Irrational Rationalization

Filed under: Economics,Military,Politics,Russia — The Professor @ 10:05 am

Strategy Page has an interesting post on the Russian procurement dilemma, cleverly, ironically–and accurately–titled “The Wisdom of the Czar.”  It points out that Putin’s plan to “rationalize” the Russian defense sector by consolidating suppliers into megafirm monopolists is resulting–surprise, surprise–in these firms demanding high prices from the government:

he Russian military is buying lots of weapons again, and they don’t like the prices. So the government has told the military that they could buy foreign weapons and equipment if they found the prices for Russian equipment too high. This is in response to Russian firms believing they could charge whatever they want, secure in the knowledge that they are probably the only Russian supplier for an item, and that the higher price provides cash for bribes (to get procurement officers to sign off on the high price with no questions.) This was the case even with government owned defense companies, largely because of the corruption. The government believes the new policy will curb corruption (as foreign suppliers are less likely to offer bribes), get gear at lower prices and bring in new technology. But there are other reasons for the high prices, like inefficient or incompetent subcontractors the need for even defense firms to pay bribes to get things done.Part of this problem was caused, ironically, by a Russian effort to save their defense industries. In the wake of the post-Cold War collapse in Russian military procurement, defense companies were consolidated, with government help. The latest of these efforts puts all Russian helicopter companies into one firm; Russian Helicopters. To accomplish this, the government bought a majority of the stock in these companies. Thus Russian Helicopters now owns 75 percent of Rostvertol, 72 percent of Mil Moscow, 99.8 percent of Kamov, 60 percent of Stupino Machine Production, 75 percent of Ulan-Ude Aviation, 66 percent of Kazan Helicopters, 100 percent of Kumertau Aviation, 81 percent of Reductor-PM and 75 percent of Progress Arsenyev Aviation.

. . . .

Russia has already consolidated fixed-wing aviation companies. The situation here was, in some ways, even more desperate. Two years ago, it was determined that the company that produces the MiG-29 (and all earlier MiG combat aircraft) was worth less than a nickel (about 3.5 cents, to be more precise). This valuation was calculated by auditors who were ordered to determine the worth of the company prior to a reorganization. MiG, along with Sukhoi, Tupolev, Irkut and others, was merged into one large firm; UAC (United Aviation Corporation). Russia started UAC off on a firm fiscal footing by investing billions of dollars into the new corporation. The government does not want the money wasted, as was the case with RSK MiG (which, as of first of the year, owed $1.5 billion, and lost $363 million). Executives associated with RSK MiG are being prosecuted for corruption. In comparison, Sukhoi’s worth was estimated to be $230 million, and the firm has been making money (on brisk sales of its Su-27/30 line of jets). But that was an exception, as the other aviation firms were in bad shape, although none as dire as MiG.

Yes, many of the companies were in dire financial circumstances.  But the “solution” to that problem, created, Sorcerer’s Apprentice-like, another and arguably worse one: a decline in competition.  This raises the market and bargaining power of the now-merged groups, leading to higher prices and higher transactions costs (e.g., more rancorous and time-consuming negotiations).  Moreover, it deprives the government of valuable information, since the performance of one contractor cannot be compared to and benchmarked against the performance of others.   The prospects for ex post opportunism are also greater, because once a contract is let, the government has nowhere to turn if the contractor demands more money or delivers poor quality ex post.*

The creation of “national champions” is therefore making chumps out of the nation.

Great work, VVP!  Maybe women stripping will be a welcome distraction from a clear-eyed examination of the actual consequences of your clever ideas.

* I should note that the US is running into similar problems as a result of the consolidation of the defense sector over the last 20 years.  This is particularly noticeable in shipbuilding, with the complete FUBAR of the USS San Antonio being the most pronounced example, but not the only one.

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1 Comment »

  1. Maybe that’s why they threaten to buy foreign from time to time. I hear the M51 is an excellent SLBM.
    P.S.
    When LM wins, Boeing gets to be a subcontractor, and vice versa.

    Comment by So? — July 19, 2011 @ 8:21 pm

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