Two Indicators: Economics of the defense industry

0:00Support for NPR and the following message come from Edward Jones. A rich life isn't always a straight line. Unexpected turns can bring new possibilities. With a hundred years of experience navigating ups and downs, Edward Jones can help guide you. Let's find your rich together. Edward Jones, member SIPC. This is Planet Money from NPR. So there's this company called Transdime. It's in the business of selling spare parts for helicopters and planes. And one of the parts they sell is this half-inch piece of metal called a drive pin. Several years ago, the military needed some of these drive pins, and it contracted with Transdime to buy some.

0:44But then in 2019, Pentagon officials reviewed the deal and found Transdime would charge$4 ,361 for this one little drive pin that the Pentagon says should have cost only$46. We reached out to Transdime for comment, and they dispute the Pentagon's math. They say the price they quoted at the time was fair for this relatively specialized part. Still, for a half-inch piece of metal, some might say that's kind of steep. It doesn't seem right, does it? So I guess the real question is, how do you get from$46 to$4 ,300, right? That, by the way, was Phil McManus. He wasn't involved in the Transdime deal, but he does know a thing or two about military spending because he used to work for the Defense Department negotiating deals with defense contractors.

1:33Phil says this drive pin story is a particularly extreme example of the government overpaying for military equipment. But it's far from the only one. And this is a problem. If you overspend for what you do buy, you can buy less of what you need. In a worst-case scenario, that literally could mean some poor soldier, sailor, or AMN doesn't come back. Hello and welcome to Planet Money. I'm Darian Woods. I'm Adrian Ma. As the U.S. continues to send weapons to Ukraine and Israel, and with more potential military spending in the pipeline, we're diving into the high-stakes economics of the U.S. defense industry.

2:12Today on the show, we bring you two episodes from our daily show, The Indicator. We look at why the U.S. government pays so much for military stuff. And then we look at whether lean manufacturing styles that save money are also leaving the U.S. naked in a crisis. This message comes from Vanguard. Capturing value in the bond market is not easy. That's why Vanguard offers a suite of over 80 institutional quality bond funds, actively managed by a 200-person global team of sector specialists, analysts, and traders. They're designed for financial advisors looking to give their clients consistent results year in and year out.

2:54See the record at Vanguard.com slash audio. That's Vanguard.com slash audio. All investing is subject to risk. Vanguard Marketing Corporation Distributor. This message comes from Dell Technologies. Your new Dell PC with Intel Core Ultra helps you handle a lot when your holiday to-dos get to be a lot. That's the power of a Dell PC with Intel inside. Get yours at Dell.com slash holiday. This message comes from NPR sponsor Veeam. AI promised intelligence, but it also exposed everything people couldn't see, like scattered data and hidden risks. Now there's a new way forward where protection, governance, and AI trust move together.

3:37With Veeam plus Security AI, you can see your entire data estate in real time. Because when resilience, security, governance, and AI trust come together, innovation moves safely and faster. Learn more about accelerating safe AI at scale at Veeam.com. The Department of Defense's proposed budget for 2024 is$842 billion. That is about 3.5 % of the U.S.'s GDP. Phil McManus, the former military contract negotiator, told us that about half of the military's purchases is spent on things that might not be directly tied to the battlefield. For example, things like office supplies, which the government can buy from any number of commercial vendors.

4:22But the other half of the budget gets spent on the big stuff. Missiles, planes, ships. When the government goes shopping for these things, it has a good deal of power, because, you know, who else is going to buy most of this stuff? Yeah, in econ terms, the government has monopsony power because it is basically the defense industry's only customer. And that gives them leverage when it comes to buying these bigger ticket items. The government can say to the contractors, look, before we agree to a price for this plane or this ship or whatever, we want you to open up your books. Show us what it would cost you to make this thing.

4:59It's very intrusive. I mean, we will argue over really small amounts of money. John Hamry heads up a think tank called the Center for Strategic and International Studies. And in a previous job, he was comptroller for the Defense Department, sort of like the Pentagon's chief financial officer. And John says that only after the cost of making an item has been established, only then the government will say to a contractor, all right, let's talk about the price. Let's talk about what would be a reasonable profit margin for you. And it typically ends up being less than 15%. Is that sort of a symbol of the government's power in this equation?

5:38Yeah, it's very much a symbol of the government's power because we can say, if you want to sell to us, you're going to do it on our terms. But here's the thing. Even though the government has this monopsonistic buying power, the defense contractors also have power. And that is because for things like jets and missiles and submarines, there's often only one or two companies that can realistically make these things. In other words, they have monopoly power. It isn't like, well, I didn't like my Ford station wagon. I'm going to go buy a Subaru. You know, we don't have that choice. And interestingly, it is the government itself that is partly responsible for this situation.

6:18For about four decades after World War II, the U.S. was in the Cold War standoff with the Soviet Union. Both sides were building up their militaries. And by the mid-1980s, when John started working for the Senate Armed Services Committee, he says the government was still buying a ton of military stuff. That year we bought over 900 combat aircraft. We bought 27 ships, 3 ,000 combat vehicles. But by the early 1990s, the Soviet Union had collapsed and the Cold War was basically over. When that happened, we'd had a large military and big budgets. We didn't need them anymore. And so the government faced this dilemma.

7:00If it was going to cut military spending, what would happen to all those defense contractors it worked with? Were they just going to go out of business? And this led to an event that reshaped the defense industry for decades, ominously named The Last Supper. Defense industry consultant Doug Berenson says it was organized by William Perry, the Deputy Secretary of Defense at the time. Perry, in 1993, gets together a group of defense industry leaders and tells them, listen, we're about to cut the budget substantially. There's not going to be a lot of new defense programs coming down the pike. A lot of you are going to have to get out of this market and consolidate with each other.

7:40You know, I can't afford to sustain all of you. What, like, there are too many mouths to feed? 100%. You're going to have to consolidate with each other and right-size to an industry that is more appropriate to the era that we are in. So with the government's blessing, the defense contractors started merging and acquiring each other. It's interesting because you often hear about the government wanting to break up big business, not telling a bunch of companies to band together and become big business. It's definitely like a different tune than we're hearing federal regulators say nowadays. That is true.

8:14And before long, about 50 companies eventually merged into the five biggest defense contractors around today. Lockheed Martin, Raytheon, Boeing, Northrop Grumman, and General Dynamics. I think when the department gave its blessing to this period of consolidation, it did not intend to lose competition. From the government's point of view, merging would make defense companies more efficient, give them economies of scale that hopefully they would pass on in the form of lower prices to the government. But in a lot of ways, this is not how it turned out. For one thing, less competition in the industry meant each contractor had more pricing power.

8:55For example, according to a report done by CBS's 60 Minutes last year, there are these shoulder-fired missiles that about three decades ago cost$25 ,000 apiece. Today, those missiles are being sent to Ukraine at a cost of about$400 ,000 apiece. And the sole supplier is RTX, formerly known as Raytheon. Now, in some cases, where there is more than one potential supplier for some new advanced weapons system, the government will try to solicit multiple bids to try to play companies off one another to get the benefits of competition. But Doug says that benefit kind of evaporates once the government chooses who it's going with.

9:34Once you're down to one contractor, that contractor has enormous leverage over you. A prime example, Doug says, is the F-35 fighter jet. This aircraft that is now more than a decade behind schedule and more than$180 billion over budget. But the government, having sunk all this time and money and having built a good chunk of its defense strategy around this fighter jet, it's not about to abandon it. It's locked in. Clearly, they haven't heard about the sunk cost fallacy. Maybe not. It's worth noting that market concentration and a lack of competition are not the only things driving high defense spending.

10:13The experts we spoke to also cited defense industry lobbying and congresspeople who want to hold on to outdated military projects to protect jobs. Also, the Department of Defense's failure to modernize how it buys stuff. And then, of course, there's the fact that the government for decades just wants to build a big military. The kind of military power that the U.S. is able to marshal and sustain and project around the world is completely unmatched by any country on Earth. And if you think that's a good thing or a bad thing, I'll leave that to you individually. But it is enormously expensive. After the break, Weyland Wong and I will consider the threat of a munitions shortage in the U.S.

10:58We look at why it's happening and whether a certain style of manufacturing that came from a car company might be to blame.

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12:30Unleash your superhuman potential today. Learn more at superhuman.com slash podcast. That's superhuman.com slash podcast. Hi, Mary Childs here. So, blood plasma. It is a critical component in all sorts of medicines, and much of the world gets it from the U.S. We're the Saudi Arabia of blood plasma. We have plenty. What's our secret? We pay for it. Paying people for plasma? Most other countries don't allow it. Because it can be coercive, even if it makes economic sense. In our latest bonus episode, we talk about that and more in my extended conversation with economist Al Roth. You can check that out now if you're a Planet Money Plus listener.

13:13If that's you, thank you for your support. If it's not you, it could be. You get bonus content, sponsor-free listening, and our eternal gratitude for supporting the work of Planet Money. Just go to plus.npr.org. Thanks. In Davos last month, Ukrainian President Volodymyr Zelensky gave an address. And to be honest, even Zelensky seemed a little tired of giving the same speech. So I don't like to hear my voice. He doesn't like to hear his own voice, he says. But he went on to underline again just how critical U.S. aid is for a Ukrainian victory. And one particular form of aid Ukraine is running low on is artillery shells.

13:57Ukraine uses various types, but one of the most important NATO standard shells is the 155. 155 shells are these clunky bombshells, 155 millimeters in diameter. Picture a big champagne bottle that will kill you. On the battlefield, they're used in howitzers, these modern cannons. Ukraine is firing a lot of these and similar shells since Russia's invasion, about 7 ,000 a day. But the U.S. and Europe have recently been supplying fewer 155 shells to Ukraine, partly because they can't make them fast enough. Shortages like these have been blamed on a philosophy of manufacturing called just-in-time production.

14:39Just-in-time production is more than just getting things delivered just in time. It's an entire method of manufacturing pioneered by Toyota in the 1930s. Cynthia Cook is the director of the Defense Industrial Initiatives Group at the Center for Strategic and International Studies. There's a focus on efficiency and quality. You're using parts as soon as they come to the factory. Reducing inventory is a key component that saves on storage costs. But it also forces a culture of making higher quality components. Because if your exhaust manifold is misshapen, for example, it's not like you've got a stack of other exhaust parts lying around.

15:17If a part is delivered and it's broken or it doesn't fit, that can shut down the factory line. Just-in-time manufacturing also means factories have to work really closely with their suppliers. That approach will spill down through every level of the supply chain so that everybody is tightly coupled and understands what's happening and can posture to meet demand. In the second half of the 20th century, this approach spread from Toyota to other civilian manufacturing companies. And by the 1990s, people were asking whether the U.S. military should adopt just in time. After the fall of the Soviet Union, the defense budget in the U.S.

15:55plummeted. it halved as a share of national output between the mid-1980s and 2000. And around that time, there were plenty of examples of what a lot of people considered waste in the military. In Iraq, after Operation Desert Storm in 1991, the U.S. had more than two years' worth of ammunition supplies left unused. And so the U.S. military was particularly motivated to learn from the private sector. A culture of just-in-time production and associated philosophies like lean production filtered through the Department of Defense and its suppliers. Contracts were awarded largely to the companies that could provide equipment for the lowest possible cost.

16:34While the Department of Defense was encouraging supply chain efficiency, the type of wars the U.S. was fighting changed. Iraq and Afghanistan in the early 2000s started with a burst of initial intensity, but were mostly long periods of low-intensity conflict. Demand for missiles and howitzers and 155 rounds went way down compared to previous wars. But the war in Ukraine exposed something. Remember, Ukraine uses around 7 ,000 artillery shells a day against Russia. The U.S., mostly through its main supplier General Dynamics, does not make that many. The rate of production before the war was about 14 ,000 shells a month.

17:15That's been expanded. That's been more than doubled. And this doubling still falls way short of Ukraine's usage. It is a challenge. To make matters worse for Ukraine, the U.S. has now been sending more of its scarce 155 rounds to Israel during the Israel-Hamas war. Cynthia says ramping up arms production is not a matter of just flicking on a switch. You have to be real careful about just increasing the size of the plant. You know, there's a lot of safety issues in building these. So the U.S. Army has contracted a new facility in Texas to get built. And it's drawn up some multi-year contracts with suppliers, trying to give them more certainty.

17:53It's also looking offshore. It's paying companies and places as far afield as Poland and India to boost their ammunition production. The military hopes to get to making 100 ,000 rounds a month. And that would be more than a tripling of today. But that won't be till 2025. So how did the U.S. military get into this position, where its supply lines are being tested by a war it's not even directly active in? And that's not even considering what might happen in a larger war if, say, China invaded Taiwan. William LaPlante is the Undersecretary of Defense for Acquisition and Sustainment. And last year at a symposium, he blamed the military's general supply issues on one core thing.

18:34I remember getting lectures about this, that we needed to adopt just-in-time delivery, minimize inventories. and drive your costs down. Well, that's great until something bad happens. And we've paid a price for it. The Military Balance is an annual publication about defense economics worldwide. Robert Wall is its editor. He's been documenting the shortages of everything from HIMARS rocket launchers to utility cannons. It's not just artillery shells. It's happening in air defense missiles and other areas. There are new conflicts popping up everywhere and new strains that make dealing with these challenges even harder.

19:13To Robert, two things happened at once that made the U.S. military supply chain vulnerable. First, there was emphasis on short-term efficiency. But secondly, with Afghanistan and Iraq, the U.S. just got too familiar with a completely different type of warfare. We had gotten used to the fighting phase of conflicts being rather quick. Because if you think back, yes, the U.S. was fighting in Afghanistan for years, decades, same with Iraq. But actually, the intense part of combat operations, those were relatively short. It's maybe a bit unfair to say, but I think the feeling had set in, that's just how wars are.

19:55Robert says just-in-time production is often not appropriate for the military. I mean, just-in-time is the phrase we focus on. But really, what we're really talking about is that everything has gotten so lean that you have no fat in the system. Fat in the military means flexibility in the case of a shock. Cynthia Cook at the Center for Strategic and International Studies is quick to add, though. It's not about throwing out the wider just-in-time approach altogether. The challenge is not an industrial base that relies on just-in-time production. The challenge is an industrial base that doesn't have sufficient resiliency to surge when the requirement to surge exists.

20:33Cynthia says that just-in-time production incorporates a range of principles, not just skimpy inventories. You know, it also means things like getting quality right the first time or close communication with your suppliers. Cynthia would like to see an overhaul of U.S. defense contracting and procurement that doesn't just go for the lowest bidder. Concretely, could that look like the Department of Defense paying for excess production capacity? I guess people and factories that are not really being used at full capacity? You have put your finger exactly on the challenge. When you talk about investing in excess capacity and keeping workers around with nothing to do, that's exactly the challenge.

21:16Just this month, the Pentagon made steps in that direction. The Department of Defense released its first national defense industrial strategy that seeks to fund spare production capacity. In some ways, this is a perennial debate. Like, should a country keep a full standing army in a time of peace? Or in the civilian world, how big should stockpiles of masks be in case of another pandemic? But what the last few years has taught us with Ukraine and the pandemic is that keeping low inventories has real costs. On the next planet money? It was considered a kind of ludicrous, crazy idea. Rekha U-House studies industrial policy, where the government gets super involved in an industry to try to achieve some kind of goal.

22:02Now, economists have generally hated it, but it's become the new hot thing. It just, like, all happened. Yeah. And not only has it happened, but it's happened so fast. It's become, like, Biden's signature economic policy. Does this kind of policy even work? That's on Friday's episode. These episodes were produced by Cooper Katz McKim with engineering by James Willits and Maggie Luthor. They were fact-checked by Sarah Juarez and Angel Carreras and edited by Patty Hirsch and Caking Cannon. I'm Waylon Wong. This is NPR. Thanks for listening.

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