DoD's 'industrial capabilities' dilemma

The Defense Department's new "Annual Industrial Capabilities Report to Congress" is not the industrial strategy that many people in the game say it needs. Instead it is an often fascinating, sometimes bizarre look inside the Pentagon's disconnected policy brain, where, just as with other places in the federal government, up is sometimes down and black is often white.

For example, the report begins with an affirmation of DoD's unshakable belief in basic capitalistic principles: First, competition is the holy mystery that always creates better value. Given that this theoretically is a free market, the department recognizes budget cuts will mean less money to go around, so firms may need to join together to survive. If so, the miracle of the market must be allowed to work -- except when it mustn't:

These forces will doubtless lead to an uptick in the volume of mergers and acquisitions and other industry adjustments in the coming period, and this is normal. The Defense Department welcomes needed adjustments that lead to greater overall efficiency but will require transparency with respect to all contemplated transactions. These transactions will be examined to ensure that the Department’s long-term interests in a robust and competitive industrial base dominate any near-term or one-time proposed savings, that potential organizational conflicts of interest are avoided or carefully mitigated, and that the Department has full visibility into restructuring costs and the potential for continuing capital investment and R&D. The interests of the taxpayer and the warfighter will be in the forefront as the Department reviews proposals that may result in the creation of weaker stand-alone firms less likely to thrive without the necessary capital structure that their larger parent company is able to provide.

So market forces may take effect, except when that's forbidden. We see that sentiment again in core principle number two, in which DoD positively outlaws M&A activity by other vendors:

... [C]ompetition is one of the key drivers of productivity and value in all sectors of the economy, including defense. Accordingly, the Department is not likely to support further consolidation of our principal weapons systems prime contractors.

So: DoD will go along with mergers and acquisitions in some cases, but not others, in order to keep "market forces" active in some areas, but not others. The policy is: It depends. One can begin to understand when defense contractors joke publicly and grumble privately about dealing with Uncle Pentagon.

Moving on to DoD's seventh core principle, the report makes clear that "globalization" of the department's supply base "is not an option -- it is reality." Not only that, if a "globally sourced" component is the best one for the job, it's best to buy it. The key, DoD argues, is to make globalization work the best way possible: Get the best deals while "striking the appropriate balance with security concerns." In other words, DoD is saying, look: There is nothing we can do about the fact that we can only buy some stuff overseas, so let's make the best of it.

But then we come to the section on rare earth materials, the once-obscure, now-famous elements that are essential for today's electronics. Some 97 percent of the world's supply of rare earths come from China, according to the report. No problem, right? We just read about how DoD is accepting the "reality" of a "globally sourced" supply chain. Wrong -- this rare earths situation is a big problem, the report says:

In spite of increasing RE global demand, export quotas from China have reduced by 40 percent since 2009, as China’s export taxes have increased from 10 percent to 25 percent in that same period. These changes have led to higher prices for RE material. Faced with increased RE prices and a decrease in China’s export quota, the biggest issue facing domestic RE consumer companies is the need for a stable non-Chinese source for rare earth oxides (REO). It is essential that a stable non-Chinese source of REO be established so that the U.S. RE supply chain is no longer solely dependent on China’s RE exports. It is also essential to develop non- Chinese RE sources that in total create an RE supply that meets the U.S. demand for both heavy and light rare earth elements (REEs).

The defense market is a small player in the North American market for RE. Typically, the defense market requires approximately seven percent of the overall global market. Yet in some areas, defense usage can be less than one percent. Due to the limits on China’s REE exports, REO prices are projected to increase by 30 to 50 percent in 2011, from mid-2010 levels. As capital investment plans for additional non-Chinese capacity become a reality, prices should significantly trend downward on a similar path as in the 1988 - 1993 period, when market dynamics were very similar to what they are today.

Did you copy that? DoD says China is going to cause a spike in world prices for rare earth materials and that it is "essential" that the U.S. establish "a stable non-Chinese source" for them. The good news is that if and when that happens, "prices should significantly trend downward," and the U.S. and its consumers can't be held hostage for these things. So -- sometimes global sourcing is bad after all.

Maybe the department is making the right calls and maybe it isn't. The complexities and contradictions that emerge even in just the first few pages of this document show how difficult it is even to get an overall grasp on today's reality. Now imagine trying to write a forward-looking, all-encompassing "industrial strategy" that would protect all the big vendors and suppliers over the long term ... no wonder the Building isn't eager to attempt it.

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