What the Pentagon's largest-ever contract teaches us about market forces in the defense industry
We are about to enter an era of defense austerity. Two years ago, President Obama famously said the days of giving defense industry a "blank check" are over, and Defense Secretary Robert Gates made good on the pledge. But we're not there yet.
Case in point: The F-35 Joint Strike Fighter, the Defense Department's largest contract ever, is challenging a basic assumption that competition is better, and feasible, in every case.
The F-35 has been plagued with cost overruns, is behind schedule, and the government is pulling out all the stops to find ways to cut the price. General Electric and Rolls Royce have been developing an alternative engine for the fighter, and earlier this month they offered to put up about $100 million of their own money to finish key work on it, as the project has come under criticism.
What's remarkable about this is that the Pentagon doesn't event want a second engine, having already contracted one from Pratt & Whitney. In 2006, the Pentagon decided to stop funding the development of the second engine for the aircraft, citing a spiraling price tag. For the next five years Congress overrode the DOD's wishes and spent billions of dollars on this extra engine anyway.
In a recent op-ed for the Wall Street Journal, the Chairman of the House Armed Services Committee, Rep. Buck McKeon, praised the initiative as a positive step for the process of defense acquisitions, as it reduced the monopoly power of defense firms. With GE-Rolls Royce paying out of pocket, Rep. McKeon argued, Pratt & Whitney would have a competitor for work that will be worth as much as a hundred billion dollars in the coming decades.
There's little doubt that the defense industry could benefit from more competition. The Pentagon has precious little choice when it comes to the costliest weapons programs like warships or fighter jets, and the result is often outrageous project overruns and lost years of stalled development.
It is not at clear, however, that competition makes sense in this case. At a basic level, competition only works when there is demand -- and the Pentagon hasn't wanted a second engine design for years. Billions have already been spent against the wishes of the Department's budgeteers because Congress keeps funding the program. Supporters do cite sensible reasons for doing so, among them avoiding a fleet-wide grounding if a dire problem surfaces.
But affordability issues are so acute now that such a concern is not enough for the Obama administration to fund the engine. The GE-Rolls Royce engine only saves taxpayer dollars barring further setbacks. In March of this year, the Government Accountability Office noted that both engine projects demonstrated systemic, across-the-board cost overruns and failures to meet basic operational requirements. It's not clear why we should assume the General Electric and Rolls Royce engine will not experience similar setbacks and cost overruns, or how those overruns will be minimized through competition between two similarly over-budget projects.
Presumably, having two engine providers fighting it out will result in less costs and more responsive contractors. Though this has been true in the past, there is no guarantee in the F-35's case. In March, the GAO appealed to the Pentagon's experience with engine competition for the F-16 fighter in the 1980s. However, that appeal rests on uncertain assumptions, including the requirement of competition to produce a minimum amount of program savings. Much more importantly, the F-16 and the F-35 are different aircraft -- the former was meant for a narrow mission for the Air Force, while the latter is meant for a much broader range of missions for all branches of the military.
Indeed, it is difficult to understand how engine competition in the F-35 would actually reduce costs. The GAO criticizes the Pentagon for relying on history to estimate cost overruns, then uses the history of the F-16 program, which saved money through engine competition, to claim that the F-35 will see similar savings. That notion rests on similar conditions, including the Pentagon buying enough competing F-35 engines, which is far from certain. There could be savings in there somewhere, but it's anyone's guess where they actually are.
Times have changed for the defense industry. The financial stakes are higher than ever, and as a result there are different rules now about how far companies will go to win and retain contracts. Since the end of the Cold War, the industry has been consolidating into a smaller number of large firms available to bid on top-dollar contracts. With a smaller pool of potential suppliers of complex goods -- very few companies can build a stealth fighter -- the cost savings from competition becomes less and less certain. A duopoly, where two firms control the market,can be just as problematic as a monopoly (which almost everyone seems to want to prevent).
When the Pentagon tried to buy a new air-to air refueling jet for the Air Force, the entire effort was nearly derailed by the political and legal fight over how the government tried to set up a two-company competition. The initial loser, Boeing Co., became the eventual winner. The Pentagon rejected a rolling competition of tanker aircraft, saying it would be too costly and time-consuming to hold a competition for each round of tanker purchases. Fed up with the endless political wrangling in Congress over the contract, Northrop Grumman Corp., which won the work initially in 2008, bailed out of the bidding contest at the last minute, which basically conceded the contract to Boeing.
If the defense industry truly wants to remain at the forefront of cutting edge technologies, and the Defense Department and Congress truly seek the best value for taxpayers, they will have to come up with a new definition of what competition is. The defense market is not a perfect competition anyway. It is a monopsony -- a market with one single buyer of goods. In theory, this should produce competition and cost savings by the companies that sell products to the Pentagon, since it can demand the most favorable terms. But it almost never does. Instead, in program after program, from the Navy-Marine Corps Intranet to the Littoral Combat Ship, the Pentagon has demonstrated a marked inability to hold contractors accountable for cost overruns and implementation delays.
As newsworthy as General Electric and Rolls Royce's decision seems, a new paradigm of defense competition is still far away. Companies should be encouraged to fund their own program development, but the government needs to fix its contracting and accountability systems if there's to be any hope of long-term acquisitions reform.
Image credit: Ho New/Reuters