Unstated and Unsuccessful

Unstated and Unsuccessful Observations on thirty years of the United States Air Force’s efforts at industrial policy in the transport aircraft industry Version 1.1 — 14 April 2007 JAMES HASIK

Unstated and Unsuccessful Observations on thirty years of the United States Air Force’s industrial policy in the transport aircraft industry If you have no leverage, and you have a company who thinks they're a monopoly supplier, then you're stuck and you ﬂail and ﬁght as we did. — Air Force Secretary Jim Roche, in Andrea Shalal-Esa, 'US's Roche sees price pressure on next air tanker,' Reuters, 10 January 2005 Summary: the USAF’s efforts to manage the industry have largely and repeatedly failed. In the roughly thirty years in which Airbus has been rising as an aircraft manufacturer, the US Air Force has periodically intervened to defend the business of any US-based manufacturer of large commercial aircraft that was threatening to exit the business by allocating work, extending credit, and running interference with the Congress. Today, as the USAF begins to evaluate proposals for its next aerial tanker, the KC-X, the service and the Defense Department are insisting that the competition will be “fair and open”. However, before anyone in the government develops any enthusiasm for managing the competition between Airbus and Boeing, he would do well to consider the history of the USAF’s efforts at industry strategy. While the policy has been unstated, it has also been remarkably and consistently unsuccessful. Version 1.1 — 14 April 2007 © James Hasik, 2007 512-299-1269 • http://www.jameshasik.com • jhasik@jameshasik.com

Unstated and Unsuccessful: Observations on Thirty Years of US Air Force Efforts at Industrial Policy in the Transport Aircraft Industry Regulatory control is problematic, especially for the military. Program managers and policy-makers often assume that as a monopsonistic buyer with legal authority, the government can regulate away the inefficiencies of monopoly. The US Air Force’s arguments in favor of the proposed United Launch Alliance between Boeing and Lockheed Martin have followed this pattern. Unfortunately, extracting performance from a monopolist defense contractor is not a simple matter: the regulator must find ways to remedy the deadweight losses, rent-seeking behaviors, low factor efficiency, and lower incentives for innovation that frequently follow the establishment of monopoly. [1] However, even if extremely close oversight could protect against all of these faults, at least five problems accompany the burden of regulation itself: [2] 1. The appropriate contracting mechanisms are not obvious. Broadly, the government can attempt to motivate manu- facturers through either cost-plus or fixed-price contracting. [3] Cost-plus approaches tend to lead to cost-protection programs in the long-term, and fixed-price approaches under monopoly induce severe informational asymmetries over time. Compensation has a way of creeping into contracts, as managers will find ways to extract rewards through unregulated items that fall under the rubric of empire-building. [4] 2. The informational asymmetries are severe. Faced with a domestic monopoly, the USAF would then need to determine, in the absence of direct benchmarks or competitive prices, what space launchers should cost. Regulators and auditors, however, rarely learn enough about companies to advise management how operations can be meaningfully improved. Rather, government regulators frequently assume that they understand the businesses they inspect better than they actually do, with unfortu- nate effects. 1. For a high level review of the issues surrounding this question, see Carla E. Tighe, ‘Performance Contracting in DoD’, address to the Western Economic As- sociation meeting at Lake Tahoe, 29 June 1998. For the details on a recent and relatively complicated contracting incentive structure related to the National Polar-orbiting Operational Environmental Satellite System (NPOESS), see Robert Graham, ‘The Transformation of Contract Incentive Structures,’ Acquisition Review Quarterly, Summer 2003, pp. 235-259 2. James R. Schlesinger, Murray Weidenbaum, et al., Defense Restructuring and the Future of the U.S. Defense Industrial Base, (Washington: Center for Strategic & International Studies, 1998) 3. See the first chapter of Jean-Jacques Laffont & Jean Tirole, A Theory of Incentives in Regulation and Procurement (MIT Press, 1993) 4. Keith Hartley & Clem Tisdell, Micro-Economic Policy (London: Wiley, 1981), chapter 14 JAMES HASIK Version 1.1 — 14 April 2007 page 3 of 12

Unstated and Unsuccessful: Observations on Thirty Years of US Air Force Efforts at Industrial Policy in the Transport Aircraft Industry 3. The regulatory burden itself rather contributes to the deadweight loss. That is, price discovery in a market economy is efficient partly because it is relatively frictionless. In a command economy, the bureaucracy needed to enforce cost standards tends to grow and entrench itself. It can never be described as economically productive. 4. An onerous regulatory regime imposes its own barriers to entry. Regulating a monopolist introduces the dead hand of bureaucracy into its supplier and customer relationships, which can scare off more commercially-minded firms. The regime itself can even fall into collusion with its customers. 5. Regulatory capture is a near-certain problem. That is, regulators are never completely free of a duty to ensure the health of the industry or firm that they regulate. After a fashion, across industries and agencies, they display a remarkable ten- dency to come to identify the interests of consumers with those of the producers whom they are charged with supervising. [5] The more concentrated the beneficiaries of this attention, the easier the identification of the regulators with the regulated; the higher the ratio of economic gain from to the cost of organizing, the greater the likelihood of success from political investments. [6] Both these relationships tend to favor monopolists in their dealings with regulators. About every decade, the USAF bails out a big transport aircraft manufacturer. These problems are significant and well-studied by economists and jurists. The USAF, however, has a long and inglorious history of failing to properly regulate its suppliers. Three cases involving tanker and transport aircraft illustrate this particularly well, as each in- volves the long-term purchase of large aerospace products by the USAF from a semi-regulated supplier that got the better of the government. (1971) Lockheed and the C-5A. In 1971, Lockheed urgently petitioned the US government for $250 million in loan guarantees needed to launch the L-1011 Tri Star airliner project, and for $500 million in payments to finish its work on the C-5A Galaxy cargo aircraft. Informational asymmetry and a peculiar case of the winner’s curse combined to gravely damage the contrac- 5. Alfred E. Kahn, The Economics of Regulation: Principles and Institutions (New York: John Wiley & Sons, 1971). Notably, Kahn was the last Chairman of the Civil Aeronautics Board, and oversaw the deregulation of the US domestic airline industry in the late 1970s. 6. For a good summary of this, see Sam Peltzman, ‘George Stigler’s Contribution to the Economic Analysis of Regulation,’ Journal of Political Economy, October 1993, pp. 818–832 JAMES HASIK Version 1.1 — 14 April 2007 page 4 of 12

Unstated and Unsuccessful: Observations on Thirty Years of US Air Force Efforts at Industrial Policy in the Transport Aircraft Industry tor’s ﬁnances: the USAF’s insistence on a ﬁxed-price contract in the development of the C-5A transport forced Lockheed into bankruptcy, and this event had been appealing to neither party. [7] The Air Force sought to maintain Lockheed as an alternative to McDonnell Douglas and Boeing as a supplier of large aircraft, particularly since Convair had exited the business just six years before. However, had the true costs of the program been understood upfront, the USAF would arguably have paid considerably less for the aircraft over the course of the contract. To shore up its large aircraft business, Lockheed argued that it also desperately needed low-cost funding for the Tri Star, and Lockheed assured the Air Force and the US Congress that the project would break even at sales of 195 to 205 aircraft. The problem lay in what Lockheed knew, and when it knew it. Subsidy can be costly, as (amongst other problems) it is subject to sharp informational asymmetries: Lockheed knew more about the project than the government, and was able to color its estimates quite effectively to its own purposes. A less-impassioned analysis of Lockheed’s cost estimates—critically, including the company’s cost of capital—predicted break-even at nearly twice that number of aircraft. [8] Indeed, by 1981, when the company decided to terminate Tri Star production, Lockheed had amassed cumulative orders for 244 L-1011s (still not a large number in the context of the market), and the company expected to lose roughly $2.9 billion on the project overall. [9] (1982) McDonnell Douglas and the KC-10. Starting in 1982, the USAF ordered over sixty KC-10 Extender tanker jets from McDonnell Douglas. While the aircraft offered some important features that distinguished it from the KC-135, many sug- gested at the time that the real purpose was to save the DC-10 production line from closure before Douglas’s MD-11 would be ready in 1990. [10] Lockheed had left the large aircraft business the prior year, and the loss of another US-based aircraft line would have left only the upstart European consortium Airbus as competition to Boeing. To prevent this appar- ently unacceptable industrial result, the Air Force needed to justify the purchase of the KC-10s; to do so, the service offered 7. Insights from Mary Beth Savio of CRA International 8. U.E. Reinhardt, 'Break-Even Analysis for Lockheed's Tri Star: An Application of Financial Theory,' Journal of Finance, September 1973 (28 #4), p. 830 9. Robert R. Ropelewski, ‘Heavy Losses Cited in Decision to Terminate L-1011s,’ Aviation Week & Space Technology, 14 December 1981 (115 #24), pp. 26-29 10. This was, admittedly, the estimate of Arnold & Porter, Airbus’s lawyers in the US, in their report US Government Support of the US Commercial Aircraft Industry, November 1991, pp. 103-107. JAMES HASIK Version 1.1 — 14 April 2007 page 5 of 12

Unstated and Unsuccessful: Observations on Thirty Years of US Air Force Efforts at Industrial Policy in the Transport Aircraft Industry the same explanation as it did in the KC-767 affair twenty years later: the KC-10s were needed to guard against imminent and widespread structural failure in the KC-135 fleet. The problem again was that while the USAF was a very efficient manager of transport and tanker aircraft, it could not fore- cast the evolution of the market. Even though the order from the government helped McDonnell Douglas sustain production for a few more years, the DC-10 was not a particularly big commercial success either, as only 446 were built. [11] The KC-10 was entirely analogous to its DC-10 cousin, differing only in its loading system, the size of the cargo door, and strength of the cargo floor, and (naturally) the boom and hoses. [12] A firm understanding of the technical details of the tanker, however, did not help the Air Force foresee McDonnell Douglas’s eventual fate as a commercial aircraft producer: a slow, spiraling exit from the market, and acquisition by Boeing for the value of its military programs. (1990) McDonnell Douglas and the C-17. In 1982, the USAF selected McDonnell Douglas’s C-17 Globemaster III design as the replacement for its rather dated fleet of C-141 Starlifters. Several years of programatic and political wrangling delayed the start of the program [13], in part because the Air Force had bought additional C-5Bs to shore up its fleet in the interim. Since Lockheed had abandoned the large aircraft market a few years before, it was not in a position to cost-effectively propose a new airlifter with the tactical qualities of the C-17, so the company continued to push the C-5. Boeing offered the cargo version of its 747, but the USAF was not remotely interested in sending an airliner into harm’s way. McDonnell’s design was the only appealing choice, and by 1990, McDonnell Douglas was beginning production. It was also running out of money to ramp up that production to full-rate. The contract called for the USAF to pick up eighty percent of the costs overruns (up to a overall contract cap of $6.5 billion), and just two years into the program, McDonnell's overrun was estimated at $450 million. Even with the government assuming four-fifths of the risk, McDonnell was in trouble. In late 1990, the Pentagon suspended further payments, and the 11. Stephen Martin & Keith Hartley, 'European Collaboration in Civil Aerospace: Success or Failure?' Journal of Common Market Studies, June 1995 (32 #2), p. 282 12. Kenneth P. Werrell, Chasing the Silver Bullet: U.S. Air Force Weapons Development from Vietnam to Desert Storm (Washington DC: Smithsonian Books, 2003), pp. 184-5. 13. Kenneth McAlear and William Begert, C-17 and Congress, National War College, 1985 JAMES HASIK Version 1.1 — 14 April 2007 page 6 of 12

Unstated and Unsuccessful: Observations on Thirty Years of US Air Force Efforts at Industrial Policy in the Transport Aircraft Industry anticipated cost overrun had grown to $836 million. [14] In September and October 1990, Douglas repeatedly threatened the C-17 system program office (SPO) that it might stop work on the project if the progress payments were not resumed. The SPO countered with a threat to terminate the contract. After a visit from a coterie of high officials from the Air Force Department, the Commander of Defense Contract Management Command agreed to resume payments, advancing $442 million rather ahead of schedule. [15] In 1992, the Pentagon’s Inspector General found the officials had permitted the company to backdate some records and reclassify some engineering expenses as production costs to hasten the payments. [16] What caused the problem? One might be tempted to cite the declining production run—the Pentagon cut its planned purchase in May 1990 from 210 to 120 jets—but this would only have increased the average subsequent production cost. The first issue was the McDonnell (and its partner General Dynamics) had badly botched the A-12 stealth bomber development, and the development contract for that aircraft was fixed price. When that program was terminated for cause in 1990, McDonnell was left holding the bag. However, the A-12 was not the only financial problem for McDonnell at this point. Con- structive changes to the design of the C-17, demanded by the customer, had led to more than $1 billion in claims against the government by the contractor. At this point, the USAF and McDonnell rather hated one another—which is just about the point where the program started to turn around. To keep the program, McDonnell was persuaded to drop all its claims and to invest more than $100 million in manufacturing equipment, software, and process improvements. [17] In May 1993, Under Secretary of Defense John Deutch told John McDonnell that even though the aircraft was entering operational service, un- less the company's management showed strong resolve to meet the program's schedule and testing requirements, the whole thing would be cancelled. [18] That was not the end of the matter, of course: by this point, the cost overrun had exceeded $1.5 billion, and the issue was so preoccupying at the Pentagon that Air Force Secretary Sheila Widnall was known to joke that the phrase “the troubled C-17 program” was actually one word. McDonnell Douglas, on its own accord, did never really 14. Rick LoCastro, Analysis of the C-17 acquisition: did the Air Force get (sic) their money's worth?, Air Command & Staff College, March 2000 15. Michael Heil, Ethics in an Acquisition Environment: C-17 Case Study, Industrial College of the Armed Forces (ICAF), 1994; and David Mastin, C-17 Issues and Con- cerns, ICAF, 1993 16. George Cahlink, 'Fallen Star: the cautionary tale of a celebrated federal executive's corporate flameout,' Government Executive, 15 February 2004 17. Randy Davis, Bill Phillips, and Bud Vasquez, 'The Phoenix Rises,' Acquisition Review Quarterly, Fall 1997 18. Betty Raab Kennedy, 'Historical Realities of C-17 Program Pose Challenge for Future Acquisitions: Learning From the Past Before Initiating Major Aircraft Buys,' Program Manager, November-December 1999 JAMES HASIK Version 1.1 — 14 April 2007 page 7 of 12

Unstated and Unsuccessful: Observations on Thirty Years of US Air Force Efforts at Industrial Policy in the Transport Aircraft Industry sort out the problems—many, rather, credit the extension of Boeing’s commercial aircraft production expertise (after Boe- ing’s acquisition of McDonnell Douglas in 1995) as ultimately saving the program. (2002) Boeing and the KC-767. In 2001, the USAF sought to begin completely replacing its rather old KC-135 aerial tankers, and took proposals from Boeing and EADS, the primary corporate parent of the now formally-incorporated Airbus. The next year the USAF formally rejected the Airbus KC-330 Multi-Role Tanker Transport (MRTT), a derivative of the A330 airliner, noting that the aircraft would require much more ramp space [19] and somewhat longer runways than its existing KC- 767s. The USAF also argued that Airbus had insufficient experience installing refueling booms aboard its aircraft, and that the project would thus be subject to unacceptable technical risk. The KC-767, however, was an eminently reasonable choice as tanker. The problem resided in the Air Force’s inability to understand Boeing’s production economics, even for an aircraft that had been available commercially for about twenty years. Estimates of the list price on an unmodified 767-200ER (the basis of the KC-767) generally varied from $101 to $115 million. The Japanese Air Self-Defense Force and the Aeronautica Militare Italiana had, in 2002, each ordered four, and at a price of roughly $175 million each, but such a higher price for a military launch customer in such a constrained market may not be shocking. Still, before Boeing’s negotiations with the USAF began, Airbus rather howled at that price, offering its aircraft for at least forty percent less. [20] After an analysis by the Institute for De- fense Analyses, the USAF approached Boeing proposing to pay just $125 million each, arguing that the depressed state of the jetliner market and the size of the order—initially 100 aircraft— justified the price break. Boeing refused to take that little, but protracted negotiations and USAF concessions brought the company to a price of $131 million. [21] To afford this price in the short run, the Air Force then proposed a complicated transaction in which a commercially-funded but USAF-controlled entity would buy the aircraft and then lease them to the government. The USAF argued subsequently that this figure was an excellent deal, as the alternative would have been the development of a wholly new tanker design, at a 19. US Air Force ‘Statement on Tanker Leasing,’ 28 March 2002 20. Marilyn Alva, ‘Can Europe’s Airbus Get Liftoff in a Huge U.S. Military Market?’ Investor’s Business Daily, 10 January 2002 (18 #191), p. A1 21 Bradley Graham, 'Air Force Lease With Boeing Still Under Fire,' The Washington Post, 7 July 2003, p. A02 JAMES HASIK Version 1.1 — 14 April 2007 page 8 of 12

Unstated and Unsuccessful: Observations on Thirty Years of US Air Force Efforts at Industrial Policy in the Transport Aircraft Industry cost of nearly $200 million per plane. [22] That, however, presumed that paying $200 million for the ideal aircraft would have been preferable to paying several tens of millions less for a good aircraft, namely the KC-330, or less than $20 million total for a used-then-modified aircraft, namely refurbished DC-10s. Oddly, the USAF did inform Airbus that it would again look at the KC-330 for its second planned tranche of 100 tankers. [23] At that point, the only change would be the degree of Air- bus’s experience with refueling booms, which would likely still be lacking, since the USAF was the only significant customer for this technology. All other allied air arms use probe-and-drogue refueling. Informational asymmetries and regulatory capture have been a recurring problem in supplier management for the USAF. While these are by no means the only cases associated with regulatory capture or informational asymmetries in defense contracting, they do illustrate how a serial inability by the Air Force Department to understand the economics of its suppliers’ operations or even to distance itself from their fortunes. Indeed, this situation has recurred about every ten years and on every one of the USAF’s major tanker or transport aircraft procurement programs since the 1970s. The chart below notes the recurring theme. Complicated contracting mechanisms, costly regulatory regimes, and administrative barriers to entry have all caused problems, but the root of the issue has been informational asymmetries and regulatory capture: ★ The USAF has been a routinely bad judge of the evolving structure of the transport aircraft market. Since the 1930s, the transport aircraft market (as measured by sales to customers based in the United States) has been continu- ally consolidating. Since the late 1960s, three US firms—Convair, Lockheed, and McDonnell Douglas—have exited the business, and four European firms—British Aerospace, Aerospatiale, Deutsche Aerospace, and CASA—have combined their operations into one. The USAF tried to forestall Lockheed and McDonnell’s exits, and worried mightily about Boeing, but its moves never changed the ultimate outcome. Even the buying power of the USAF was not enough to move the market. 22 Comments by Assistant Secretary of the Air Force for Acquisition Marvin Sambur in John A. Tirpak, ‘100 Tankers: the Air Force seeks a deal to replace its aged KC-135s with leased commercial tankers,’ Air Force Magazine, August 2003 23 Dino Carrara, 'Boeing's 767 Tanker,' Aviation News, March 2003 JAMES HASIK Version 1.1 — 14 April 2007 page 9 of 12

Unstated and Unsuccessful: Observations on Thirty Years of US Air Force Efforts at Industrial Policy in the Transport Aircraft Industry Lockheed McDonnell McDonnell Boeing C-5A KC-10 C-17 KC-767 1971 1982 1990 2002 Complicated contracting The higher price, in part, mechanisms pressed the USAF’s short- term budget constraints, which led to the leasing debacle Informational Inability to foresee Lock- Inability to determine when Inability to project McDon- Inability to accurately model asymmetries heed’s exit from the market McDonnell Douglas would nell’s Douglas’s exit from the Boeing’s costs, even for a exit the market market commercially-derived prod- uct Costly regulatory burden “The troubled C-17 pro- The leasing debacle con- gram” consumed consider- sumed considerable USAF’s able USAF management at- management attention for tention for about three years almost two years Regulatory capture The USAF’s conviction that The USAF’s conviction that Fear of financial distress at The USAF’s conviction that Lockheed would exit the Douglas could be sustained McDonnell Douglas induced Boeing would exit the tanker business induced an alliance induced an alliance with the the USAF to advance the market induced an alliance with the supplier against supplier to purchase a prod- company money contrary to with the supplier against the against the Treasury uct of questionable need its own regulations Treasury Administrative barriers Preselection of Boeing pre- to entry cluded serious offers of new Airbus and refurbished Douglas jets ★ The USAF has in each case been induced to adopt the viewpoint of its supplier. Like people at many government entities with regulatory or quasi-regulatory authority, the USAF’s leadership attempted to sustain industrial competition by working to curtail it. Determined to keep as many firms as possible in the business (at least in the United States), the USAF bought aircraft that it may not have strictly needed in order to prop up the fortunes of firms that ultimately did not need or could not use its help. Convinced that its technical knowledge of aircraft translated to strategic acumen, the service repeatedly (if JAMES HASIK Version 1.1 — 14 April 2007 page 10 of 12

Unstated and Unsuccessful: Observations on Thirty Years of US Air Force Efforts at Industrial Policy in the Transport Aircraft Industry on a very long cycle) accepted uncritically the assertions of its favored suppliers that open competition would, one way or another, not produce the outcomes that the service desired. This is not to say that the problem has passed, or even been acknowledged. By September 2003, Airbus chief executive Noël Fore- geard was noting that the controversy over the attempt to allocate tanker aircraft contract to Boeing had reinvigorated the company’s interest in the US military market. Airbus, he explained in an interview in the Wall Street Journal, understood the importance of ‘corporate citizenship’ in the US, and was contemplating a US partner to ﬁt out its jetliners with electronics and other systems for US military use. [24] In September 2005, EADS and Northrop Grumman—a company that had never produced jet airliners—an- nounced their agreement to work as a team to propose the KC-330 MRTT as a solution for the USAF’s tanker requirements. The team submitted its proposal for an A330-200 derivative (to be assembled in Mobile, Alabama) to the Air Force in April 2007. The company had made overtures similar to this, though of a commercial nature, twice before. In 1980, just after Lockheed had an- nounced its exit from the commercial airliner business, Airbus inquired as to whether the company would be interested in establish- ing itself as a contract manufacturer of the A320. The goal at the time was probably to blunt criticism from McDonnell Douglas and Boeing about Airbus’s increasing inroads in the US commercial market. [25] In 1986, the consortium attempted to negotiate a joint launch of the A330 with McDonnell Douglas (in place of its MD-11), but this too went nowhere. [26] Notably, both ﬁrms exited the industry, but not without some efforts from Airbus to keep them in. 24 Daniel Michael, ‘Airbus Sees Military-Sales Opening,’ The Wall Street Journal, 15 September 2003, p. A8 25 P. Muller, Airbus Industrie: l’Ambition Européenne: Logique d’Etat, Logique de Marché (Paris: Commissariat Géneral du Plan et L’Harmattan, 1989), p. 154 26 ‘McDonnell Douglas, Airbus Discussing Aircraft Proposal,’ Aviation Week & Space Technology, 16 June 1986 (124 #24), p. 35 JAMES HASIK Version 1.1 — 14 April 2007 page 11 of 12

About the Author James Hasik holds an MBA from the University of Chicago in ﬁnance and business economics, and a BA from Duke University in history and physics. He is a member of the Institute of Navigation,, a member of the Council for Emerging National Security Affairs, and Senior Defense Consultant to CRA International. On the cover A crew from the 660th Aircraft Maintenance Squadron at Travis Air Force Base, California, works on one of the three engines of a McDonnell-Douglas KC-10A Extender. Photograph by Master Sergeant Lance Cheung, and courtesy of the US Air Force.

Unstated and Unsuccessful

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