War Boom More Pentagon spending could actually hurt Silicon Valley

Hal Plotkin, Special to SF Gate
Tuesday, October 23, 2001

URL: http://www.sfgate.com/cgi-bin/article.cgi?file=/gate/archive/2001/10/23/techwar.DTL

Shortly after the Sept. 11 terrorist attacks, Congress approved President Bush’s request to boost the Pentagon budget roughly 65 percent by 2005 to more than $500 billion. Judging from the recovery in tech stocks since then, many investors appear to be banking on the massive hike in defense appropriations to help revive Silicon Valley’s battered economy.

Major defense contractors such as Northrop, Lockheed and Raytheon will be the primary beneficiaries of the new spending. But much of the money is expected to be funneled through the big players to selected tech firms that supply a variety of high-end electronics, including everything from militarized personal digital assistants to Web-enabled helmet cameras to field kits that can rapidly detect chemical and biological weapons.

Lots of local tech companies are angling to get a piece of that action. What’s less obvious, though, is the price those firms may pay if they become too dependent on Uncle Sam.

To be sure, military programs have often boosted the tech sector in the long run by supporting innovations that would not have been funded in any other way, such as the Internet and the Global Positioning Satellite system. In the short run, however, runaway military spending has often had a devastating economic impact. During the Cold War, for example, the open spigot at the Pentagon helped wipe out nearly the entire domestic consumer-electronics industry.

To illustrate the point, in 1986 the General Electric Company won $350 million in government money in a one-shot deal to design a nuclear reactor that could be launched into space.

At the time, the cash-rich military market looked like a much better place to operate than lower-margin consumer markets, where items such as toasters were going for a comparatively paltry $20 each. So, not wanting to trifle with perfecting ways to manufacture the small stuff more efficiently, that same year GE imported $500 million worth of tape recorders, telephones and clock radios and slapped its brand on the products.

The move contributed to what was called the “hollowing out” of the US manufacturing sector, which led to the loss of hundreds of thousands of good jobs.

Of course, GE later discovered there weren’t all that many buyers for high-margin space-based nuclear reactors. (For obvious reasons, the project was later abandoned.) The last time I checked, however, millions of people were still buying toasters. GE didn’t really get things cooking again until a few years later, when the firm dumped most of its military businesses and refocused its energies on competing more effectively in civilian markets, a strategy that helped turn the company’s CEO, Jack Welch, into a business legend.

In fact, the domestic electronics industry went through its most precipitous and painful decline near the end of the Cold War period. Things were so bad that, as you may recall, many respected pundits claimed the economic future belonged to Japan, which had become the epicenter for the consumer-electronics revolution. It took the end of the Cold War and a revived interest in the civilian economy to get US high-tech firms back on track.

Like then, tech firms are now under enormous pressure to deliver improved quarterly results. In bad economic times, when many private-sector buyers take a hike, the temptation to feed at the public trough can be almost irresistible. The government, after all, is a notoriously generous and absent-minded customer. Profit margins are usually high, and quality requirements often appallingly low. But many of the tech firms that have responded to that siren song in the past have likewise inadvertently set themselves up for some rather big problems.

In San Jose, to cite another conspicuous example, the once locally thriving FMC Corporation temporarily lost its edge when it began manufacturing the tanklike, problem-plagued Bradley Fighting Vehicle in the early 1980s. Many of the problems involved the vehicle’s design and its components, which were selected by FMC without adequate competition, which is a major flaw in these type of secretive, single-source contracts.

In the past, national-security concerns have often been cited as the main reason prime contractors should be permitted to rely on confidential single-source contracts for whatever materials they need. But, in many cases, prime contractors can easily be more open about the components they need without divulging sensitive information about exactly how those items might be used. The secrecy is often overdone, which leads to the worst of both worlds: notoriously high prices combined with uncompetitive levels of performance.

For some of the companies involved, the results have been catastrophic. FMC was a major force in Silicon Valley for decades. But the company suffered a severe downturn and eventually had to auction off its 120-acre tract near downtown San Jose in 1997 after it finally sold off its controversial military business. Thousands of local workers lost their jobs in the process.

There is little doubt FMC would have been far better off had it stayed focused on serving its traditional commercial agricultural markets. In the recession of the early 1980s, going after the lucrative Bradley contract must have seemed like a good idea. Few would have guessed at the time, though, that it would eventually lead to the once-venerable firm pulling up stakes in Silicon Valley just as the region was about to enjoy its biggest commercial boom ever.

Curtailing single-source contracts won’t completely prevent similar problems in the future, but it could help limit them. Without question, it’s more complicated to deal with many suppliers, as opposed to just one. But the economic dangers of not doing so make it well worth the effort.

That’s why, whenever possible, major military contractors should be required to be more open about offering opportunities to subcontractors to supply needed parts, equipment and services. The cost savings of this competition could be passed along to the government. Fortunately, there are many Web-based applications that could be pressed into use to solicit more bids from previously excluded subcontractors.

Government officials should be required to justify their reasons for refusing to put any items up for competitive bidding. If there are good reasons to keep some purchases secret, fine. But the government should not end up buying $4,000 microprocessors when the very same items can be had at Fry’s Electronics for $65.

Take away the tantalizing prospect of easy money, and the military becomes just another customer, which would be good for the entire tech and business community. Tighter controls on military spending will also mean tech firms will have less cause to look at bloated military contracts as their short-term salvation. As a result, companies are more likely to stay focused on the consumer markets, on which their real future depends.

Increasing protections afforded to whistle-blowers will lead to similar gains. The False Claims Act grants a reward of up to 30 percent of any funds recovered by the government to whoever reports the fraud. At present, though, government auditors are usually prevented from receiving awards under this act. The rationale for that longstanding policy makes sense: Auditors should not receive inappropriate rewards for simply doing their jobs.

But there have been cases (most notably at Stanford University in the 1980s) in which auditors have uncovered waste and reported it to their superiors and were then ignored. The government will ultimately save money if its auditors are also covered under the False Claims Act, which would empower them by rewarding them handsomely for making such episodes public.

Finally, the public should also be concerned about the possibility that increases in the military budget will cast a pall over the political process. Living off government contracts makes executives and workers alike more timid about questioning federal policies, criticizing elected officials or contributing to candidates running against incumbents.

Very few businesspeople like to bite the hand that feeds them — which is why it’s generally not a good idea to have those hands belong to Uncle Sam. When a balance of economic forces (meaning the public) runs the government, it’s called democracy. But when a political regime controls the economy, the risk increases of encouraging a far less savory form of government — namely, fascism. People’s hearts often follow their stomachs.

We’re hearing that we are in for a very long war on terrorism. Given the recent attacks, that grim reality may be unavoidable. But the way the Pentagon purchases the supplies and equipment it needs to fight that war will go a long way toward determining what our economy, and American society, will look like after the last shot has been fired.

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