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Defense Contracting: The War Dividend

Hardware Demands at Home and Abroad Readily Reversed a Downturn

Ed Jones/AFP/Getty Images
Before Sept. 11, the government was considering cutting back on aircraft carriers; since then one more has been added.

The economy hummed along in the 1990s for most American businesses, but it was an uncharacteristically cruel time for the defense industry. That’s because the “peace dividend” that accompanied the end of the Cold War came right out of the pockets of the companies that make weapons and other hardware for the military. As a consequence, 50 major firms consolidated into six during the decade heralded by the collapse of the Soviet Union. General Motors and General Electric all but abandoned defense work. The size of the U.S. military was reduced by one-third.

Beyond all that, an extended “procurement holiday” saw the United States purchase hardly any new planes or ships. Defense analyst Loren Thompson says that while he was chatting with a Navy official at a recent defense conference about those days, the official said the Navy even contemplated cutting back the number of aircraft carriers to six. (There were 10 in the water at the time; there’s an additional one now.)

Then the fundamental defense mission of the United States government was transformed by the success of the 19 jihadists on the second Tuesday morning of September in 2001.

“It is no exaggeration to say that 9/11 rescued the modern defense industry from the worst depression in its history,” said Thompson, who runs the Lexington Institute and is a consultant to several defense contractors.

The al Qaeda attackers caused the rest of the economy to slow to a crawl, but they also launched the defense industry on a new course of growth, expansion and profitability that has hardly relented in the decade since.

Military contractors were soon called to supply the Pentagon with the hardware for fighting not one, but two, essentially old-fashioned boots-on-the-ground, planes-in-the-air wars overseas — which have cost more than $1 trillion between them and continue in one form or another to this day. But at the same time, a whole new industry for protecting “the homeland” was born almost immediately from the incredible sense of vulnerability and surprise that the country felt. (Sept. 11 marked the biggest foreign aggression on American soil since Japan bombed Pearl Harbor 60 years before, and almost no one expected that the weapons would be commercial jetliners.) The opportunities for businesses to invent new machines to guard against domestic attacks, and to help the spy agencies catch the terrorists before they strike again, have proved almost limitless for the past decade.

With sustained deep deficits and a surging accumulated debt now at the forefront of the national agenda, the forecast is unclear for how open the spigots will remain for the national security business. But when it comes to Pentagon spending, even the most dedicated defense cutters have trouble envisioning a return to the sort of complacency that existed before Sept. 11.

Contractors Cash In

The department’s base budget rose from $390 billion in the fiscal year that was nearly complete before the attacks to more than $500 billion in the current fiscal year — a smaller increase than for non-defense discretionary spending. But that total doesn’t include $806 billion spent fighting the war in Iraq and $444 billion spent on the war in Afghanistan through the end of March.

As overall defense spending has risen, so has the amount going to contractors. According to a study released in May by the Center for Strategic and International Studies, “dollars obligated by the DoD to contract awards more than doubled” in the decade ending at the start of this year. In fiscal 2010, the department spent $664 billion on contracting, including baseline and war spending. And the department became more reliant on contractors, too. While non-contract spending at the Defense Department increased by 5.8 percent annually over the past 11 years, contract spending grew by 8.4 percent, according to the report.

A smaller but not insignificant source of business for defense contractors came with the establishment of the Department of Homeland Security and increases in spending among spy agencies. DHS began as the consolidation of all or parts of 22 agencies. But since its first stand-alone spending package was enacted, for fiscal 2004, its base budget has increased by 45 percent — from $30.4 billion to $44.1 billion in fiscal 2010.

In the meantime, the department also has spent tens of billions more on top of that to respond to the non-terrorism-related emergencies for which it is also responsible, Hurricane Katrina principal among them.

Homeland Security, too, has become increasingly reliant on private businesses to help in its work — increasing its spending on contractors from $9 billion in 2004 to $14 billion in 2010. (There is considerable overlap between the top contractors at DHS and at the Pentagon; eight firms are on the lists of the top 20 contractors for both departments.)

The budget grand total for all of the nation’s intelligence agencies was not released publicly until the latter half of the last decade, but it stands at $80.1 billion for fiscal 2010. And the chairwoman of the Senate Intelligence Committee, California Democrat Dianne Feinstein, said last year that the overall intelligence budget had doubled since the year of the attacks on New York and Washington.

The intelligence community has spent billions on satellite programs and added thousands of staffers and contract employees.

Officials with the National Defense Industrial Association and the Aerospace Industries Association — two organizations that represent defense contractors — do not have a tally for the number of businesses that have entered the industry since 2001. But everyone agrees there are more of them than before.

“Contractors expand with increased demand,” said Lawrence Farrell, president and CEO of the National Defense Industrial Association. “Clearly, the numbers are up.”

Farrell says those numbers might have gone up anyway, even if there had not been the Sept. 11 attacks, given that George W. Bush won the presidency in 2000 after campaigning on a platform that included a boost in military spending. But they surely wouldn’t have risen as much without the wars in Afghanistan and Iraq. In the 1990s, there were terrorist attacks, too, but they did not create a bump in business for the industry.

“Some of the threats out there in the world that people weren’t paying attention to still exist, they’re now just paying much more attention to them,” said Cord Sterling, vice president of the Aerospace Industries Association.

The Sept. 11 attacks changed to a large extent what kind of things defense contractors worked on, and, to a smaller extent, who worked on them. Prompted by the wars, as well as the hunt for terrorists and the desire to defend against them, new technologies have cropped up or become more prominent.

Some spending went to things such as the hardening of buildings and armor. Unmanned aerial vehicles, developed before 2001, have taken on a highly visible role in the campaign against al Qaeda along the border between Pakistan and Afghanistan. Communications and computer technology have made significant advances to improve information sharing among spies and on the battlefield.

“The defense industry evolved after 9/11 into three separate and distinct clusters of activity,” said Thompson. “One was the traditional weapons — aircraft and submarines. The second was new network initiatives that were part of the Rumsfeld transformation initiatives. The third was the part of the industry oriented to counterterrorism and counterinsurgency.”

'Magical Thinking'

While the zeal for national security spending brought about some technological improvements and innovation, it also brought with it a certain degree of excess. Congress, especially under Democratic control during the final two years of the Bush administration, heavily criticized how much contractors were charging the government. And some contractors got audiences they probably didn’t deserve with top government officials, says Noah Shachtman, a Brookings Institution fellow.

“There was a time in the first few years after 9/11 where it was really like the golden age of crappy weapons ideas and magical thinking,” said Shachtman, who edits Wired magazine’s national security blog. “All sorts of loony ideas were totally well-funded and pursued,” such as a golf cart that carried a lightning gun, he said.

Some — although not all — of those wackier ideas have since been discarded, and some would-be entrepreneurs have fallen by the wayside. Other businesses remain just as prominent now as they were before Sept. 11, albeit a good deal richer: The top five contractors at the Pentagon before the terror attacks are still in the top five.

Others grew based on the services they offered and how they matched what the federal government was doing. Many companies that have experienced particularly big growth in the last decade — SAIC, ManTech and CACI among them — are all known less for building hardware than for providing professional services such as intelligence analysis and information-technology support.

Now, Democrats in Congress and the Obama administration are looking to cut spending on defense. The president has suggested reductions of $400 billion during the next dozen years, beyond reductions expected from winding down the two wars.

“There is still sentiment in the investment community and in the sector that maybe the industry can weather what lies ahead,” Thompson says, and he labels it a probably foolish belief. “Much the same way large programs have an overhang of spending after they’ve been cut, there will be an overhang of optimism among investors once market conditions have started to erode,” he said.

Consolidation of contractors could once more be on the table, although not to the degree that the industry experienced two decades ago. Since there are only a relative handful of big defense contractors left, the bulk of any mergers and acquisitions would have to be among the smaller players.

New threats not directly related to the Sept. 11 attacks — such as raids on crucial computer networks — will still offer opportunities to defense contractors, Farrell said. But Thompson said that some of those areas that remain promising — including intelligence, surveillance and reconnaissance — could be overcrowded.

History Lessons

Contractors, backed by some experts and congressional Republicans, are warning that while some cuts are prudent, a return to the relative austerity of the 1990s isn’t a good option. The difficulties the United States had responding to its national security needs right after the al Qaeda attacks can be traced to the previous decade’s cuts, they say, and are part of a historical pattern that has hurt the country’s preparedness for new threats dating back to the end of World War I.

“We have a history of drawing down and then suddenly saying, ‘Oops, we went too far, we put at risk our security and our interests and had to ramp back up,’ ” Sterling said, citing the possibility of a new unconventional threat popping up or of another country rising to the level of being a U.S. peer among world powers. “History says it’s a mistake, not just with terrorism.”

Already, the Defense Department is concerned that it has too few space-technology suppliers, vital to military communications and other programs. How to make sure the defense industrial base doesn’t erode is something the Pentagon is studying, Farrell said.

Everyone in the industry is bracing for cuts. But after a long period of prosperity for defense contractors, it’s not totally clear whether the cuts will go down to the bone.

“If we do it smart, we can do it right,” Farrell said. “We just don’t know where it’s going to settle.”

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