The Impact of Recent Political Changes on the Defense Sector

Presentation to the Raymond James Washington Technology & Services Summit

Welcome to the Four Seasons Hotel, and to the only city in America where you can witness two seasons unfolding at the same time.

Right now, Republicans are enduring a bitter winter of popular discontent, while Democrats have entered the warm spring of political renewal.

Spring has been a long time coming for the Democrats, who have seen their political standing steadily eroded by a rising tide of conservatism since the nation’s bicentennial year of 1976.

Back then a young fellow named Donald Rumsfeld was defense secretary, and as he departed office at the end of the Ford Administration he could scarcely have imagined that the coming decades would see a resurgence of his Republican Party.

Not only had Ford lost the White House to Georgia governor Jimmy Carter, but Democrats held a two-to-one margin in the House of Representatives and a solid majority in the Senate.

It looked like the Watergate scandal had handed control of the federal government back to the Democrats, and that they would reclaim the status of dominant national party they had enjoyed from the beginning of the Great Depression to the Vietnam War.

As you all know, that didn’t happen — Carter’s presidency was a disaster, and Ronald Reagan’s election in 1980 began a Republican renaissance that ultimately led to conservative dominance of all three branches of the federal government.

Donald Rumsfeld was away from Washington for most of that time, getting rich in the private sector, so it may be more than mere coincidence that when he returned to the Pentagon at the beginning of the new millennium, the Republican revolution began to falter.

In fact, many Republicans today believe that Rumsfeld’s second run as defense secretary is the main reason why Democrats regained control of both chambers of Congress last November for the first time in a dozen years.

That’s what I want to talk about today — the Democratic resurgence, the departure of Rumsfeld, and what it means for the defense sector.

A Changing Political Landscape

The prevailing view here in River City is that the return of the Democrats won’t change much in the defense sector because Republicans still hold the White House, Democratic margins on Capitol Hill are thin, and both parties are posturing for the 2008 presidential election.

It’s true that the Democratic victory in November falls short of being a realignment — the winners only picked up 29 seats in the lower chamber and six in the Senate, which is not that far off the averages for a midterm election.

Democrats wouldn’t control the upper chamber at all were it not for the willingness of independents Joe Lieberman and Bernie Sanders to caucus with them.

But the conventional wisdom that little will change in the defense sector looks shaky when you consider the broader backdrop against which the Democratic resurgence is playing out…

— First of all, the nation appears to be gradually losing a war, and past experience tells us that when wars end defense spending goes down.

— Second, the President who led the nation into the war has never been highly popular except in the immediate aftermath of the 9-11 attacks, and today his support has shrunken to barely a third of the electorate.

— Third, the absence of attacks on the American homeland since 9-11 has dulled popular awareness of the terrorist threat and diminished the political support for new defense initiatives.

— Fourth, the core of the Bush defense agenda (military transformation) has been discredited by poor performance in Iraq, and its principle architect has departed the Pentagon.

When you combine those security-related trends with other developments on the domestic front — the aging of baby boomers, the budget deficit, and so on — we could be in for big changes in the defense sector.

Obviously, any repetition of the 9-11 attacks would also mean big changes for the sector, mainly on the upside.

But in the absence of such traumas, we may be at a top in terms of both defense spending and Republican fortunes.

Which means we need to pay closer attention to what Democrats might do if they consolidate their hold on power.

So let’s take a look at the Democrats, and ask some questions…

— Who are they?

— What do they believe?

— What interests do they represent?

— What is their defense agenda?

— Who have they put in key leadership positions affecting the defense sector?

Who Are The Democrats?

In terms of who they are, the Democrats trace their origins to the Democratic-Republican Party that Thomas Jefferson and James Madison established in 1792 to battle Alexander Hamilton’s Federalists.

That makes them the oldest political party in the world, but it also makes them something else — the more populist of the two national parties.

From Thomas Jefferson to Andrew Jackson to William Jennings Bryan to Franklin Roosevelt, the Democratic Party has always tended to side with workers against management, farmers against railroads, and immigrants against old money.

In other words, within the peculiar topography of the American political landscape, the Democrats are the party of labor and the Republicans are the party of capital.

So Democrats are less trusting of markets and big corporations, more comfortable with taxes and regulation.

You can see those biases on display in the party’s endorsement of a higher minimum wage and limits on lobbying, and in its criticism of big oil and big drug companies.

However, Democratic views on defense are a good deal more complicated than Republican partisans would have you believe.

Although the Vietnam War soured some Democrats on the military, most of the big surges in defense spending during the last century occurred during Democratic administrations.

If you look at where Republican and Democratic electoral strength is concentrated today, military bases tend to be located in “red” states but military contractors tend to be located in “blue” states.

In other words, the states where the Democrats generate their strongest support at the polls — in the Northeast, on the Pacific Coast, in the industrial Midwest —are also states where there is a substantial defense-industry presence.

The same holds true for the handful of states where Democrats have been gaining new strength recently, namely Colorado, Florida and Virginia.

The alignment of Democratic interests with military production is further reinforced by the demographic characteristics of the defense workforce.

Whereas the ranks of war-fighters are filled disproportionately with people from rural backgrounds who tend to vote Republican, defense plants are populated by blue-collar, unionized workers who tend to vote Democratic.

And the strength of Democrats among civilian defense workers isn’t confined just to the private sector, because workers in military depots and naval shipyards belong to public-sector unions that also comprise part of the Democratic base.

These public-sector unions have been a growing source of Democratic votes in recent years, a development that helps offset the declining electoral impact of private-sector unions.

So the widespread perception that Republicans favor defense contractors while Democrats worry about enlisted personnel is out of sync with the actual alignment of partisan interests.

The soldiers tend to vote Republican while the defense industrial base tends to vote Democratic.

In fact, the defense sector is one place where the divide between capital and labor has very little electoral salience, because in the defense sector even the most senior corporate executives are often Democrats.

If you talk to these executives, they will tell you that Senators such as Clinton, Kennedy and Dodd have been strong supporters of their interests — and then they will mention that Donald Rumsfeld didn’t manage to have a single meeting with a defense-industry executive during his entire six years as Bush’s defense secretary.

Why Democrats Seem Anti-Defense

Rumsfeld’s indifference to the defense industry isn’t so surprising when you consider Republican economic philosophy, because from his perspective the whole sector is a market distortion.

And it also isn’t surprising that Democrats, the party of big government, would be more comfortable with an industry dependent on government funding for its sustenance.

What is surprising is that this underlying symmetry of interests and ideology has gone largely unnoticed.

For instance, last year Merrill Lynch put out an analysis claiming to prove that Republican control of the government is the main reason spending on military technology increases, and Democratic control is the main reason it falls.

According to Merrill, the lowest level of defense technology spending likely in a Republican administration exceeds the highest level likely in a Democratic administration.

It concluded that partisan control is a much stronger predictor of trends in military technology outlays than threats are, accounting for 76% of the variation from year to year.

If that were true, it would certainly help to explain why so many observers think Republicans are better friends of the defense sector than Democrats are.

However, when you look closely at the Merrill findings, some caveats jump out…

— First, the strong correlation between military technology outlays and partisan control only began to appear after Vietnam, when the Democratic Party turned hard left with disastrous electoral consequences for two decades.

— Second, at about the time Democrats were finding their way back to political mainstream under Bill Clinton the Cold War ended, so his administration took office at a moment when there was bipartisan agreement on cutting defense.

— Third, President Clinton inherited from his predecessor the biggest federal budget deficit in history, which gave him a strong incentive to cut both defense and domestic spending.

So it’s a little hard to square the thesis that Republicans favor the defense sector and Democrats favor domestic spending with the historical facts.

The reality is that Dick Cheney killed a hundred major weapons programs while he was defense secretary, and that entitlement spending has risen twice as fast under George W. Bush as it did under Bill Clinton.

Which brings me to the subject of the Democratic agenda for defense in the 110th Congress.

The Democratic Defense Agenda

When comedian Will Rogers remarked that he didn’t belong to an organized political party because he was a Democrat, he captured an essential truth about his party.

The Democrats have always been a loose coalition of interests, both at the grassroots level and in Congress.

Unlike the Republicans on Capitol Hill, who have fashioned a strong leadership structure and limited the power of committee chairmen, the Democrats lack a center of gravity.

When they last controlled the Congress, the Democrats who ran committees did pretty much what they wanted, and frequently ignored the pleas of their leadership for party unity.

Having wandered in the political wilderness for a dozen years, the party now is trying to foster more discipline among its members in both chambers so that they can take better advantage of their majorities.

Nonetheless, it is hard to describe simply where Democrats stand on issues such as national defense because there are so many contending views within the party.

After reviewing the public pronouncements of party leaders and prospective chairmen on relevant committees, I’ve come up with a list of eight defense themes that most Democrats in the 110th Congress will probably embrace.

Here they are in descending order of popularity among the Democratic faithful.

First of all, get U.S. troops out of Iraq.

Party leaders usually describe this position as “redeployment” rather than retreat, but the vast majority of Democrats believe the war was a mistake and that it is not winnable.

They probably won’t use their control of finances to cut off funding and some of them may even back a near-term increase in troop strength, but there’s little doubt the top Democratic agenda item for defense is to get out of Iraq.

Second, prevent new terrorist attacks on America.

Every Democrat in Congress would agree with this goal, although consensus breaks down over how to achieve it.

In general, Democrats prefer stronger homeland security measures and diplomatic initiatives to defeat terrorism rather than aggressive use of U.S. military forces in foreign countries.

The Bush Administration’s notion that if we don’t fight terrorists overseas then we will have to fight them here at home does not get many takers among the Democratic rank-and-file.

In fact, Democrats tend to think that sending U.S. troops abroad to engage terrorists makes the problem worse.

Third, bolster troop readiness and reset battle-worn equipment.

Readiness has been a persistent theme of Democrats on defense for two decades, which helps explain why the Clinton Administration neglected procurement accounts in favor of operations and maintenance on its watch.

Much of the money spent on readiness finds its way to Democratic constituencies such as the workers who do equipment maintenance at military depots, so there’s an electoral angle to the stress on readiness.

The same is true of reset, the refurbishing or replacement of battle-worn equipment — it channels money to repair depots and National Guard armories where the Democrats enjoy significant electoral support.

Fourth, rein in unnecessary spending and crack down on contractor abuses.

Many Democrats believe that military aircraft and warships have grown outrageously expensive, signaling the need for yet another round of acquisition reform.

They also are exercised about the supposed misuse of funds by contractors supporting U.S. troops in Iraq, and plan to launch investigations of the way in which such contracts were awarded.

What they’ll discover is that Halliburton, their favorite whipping boy, has only made a one-and-one-half percent return on its Iraq work, and that soldiers in the field are pleased with the company’s performance.

But the notion of contractor corruption in war zones is too sensational for Democrats to pass up — especially given Dick Cheney’s former ties to Halliburton — so don’t expect this issue to fall out of the Democratic agenda anytime soon.

Fifth, expand benefits for military personnel, dependents and retirees.

Although relatively few Democrats under the age of fifty have served in the military, they feel a strong sense of obligation to support the people who do.

They also recognize that military families have become an important electoral constituency for Republicans, so they are not going to do anything that confirms the families in that preference.

Thus, the recent tendency of Congress to add military benefits regardless of whether they have been requested by the Pentagon or not is likely to persist, putting added pressure on the defense budget.

Sixth, expand ground forces, especially the Army.

This position is a little hard to fathom, since Democrats want to get out of Iraq and that’s the main source of stress for U.S. ground forces today.

However, Democrats have adopted the Army as their favorite service because it seems to be bearing most of the burden of the global war on terror, and retired generals have been calling for an increase in the size of the active-duty force.

During the 2004 presidential election, Democratic standard-bearer John Kerry called for 40,000 more troops, and that idea still has strong support among congressional Democrats.

Seventh, limit the outsourcing of civilian defense jobs to the private sector.

As I mentioned earlier, public-sector unions have become a key source of Democratic electoral support, so many legislators in the new majority have positioned themselves as defenders of federal workers.

That role is reinforced by Democratic distrust of markets and big companies, but it raises questions about how the government will cope with the impending retirement of tens of thousands of federal workers.

Eighth (and finally), position Democrats as strong supporters of national defense.

Democrats know that defense is their key electoral weakness, practically the only area where the Republicans beat them in surveys by a wide margin.

With preparations for the 2008 presidential race already under way, they would like to use their control of Congress to prove that they too are strong defenders of the nation.

That will be a hard idea to sell at the same time they are pushing the Bush administration to give up the fight in Iraq, so Democrats will probably try to burnish their defense credential by giving the military almost everything else it wants.

Throwing money at the military isn’t what most people would expect from the Democrats — especially given their rhetoric about fiscal responsibility — but balanced budgets have never been much of a vote-getter.

The bottom line on the Democratic defense agenda is that it doesn’t reflect much support for new technology outlays, but it also doesn’t herald an era of rapidly declining defense budgets.

What’s likely to change is the composition of defense spending rather than the scale — a point I will come back to at the end of my remarks.

Four Key Chairman

But before I draw some conclusions about the outlook for the sector, there are two other topics I’d like to address — the backgrounds of Democrats running key committees, and the relevance of Donald Rumsfeld’s resignation for the Democratic resurgence.

The reason the Democratic defense agenda seems so uneven and incomplete is that it reflects the views of contending factions within the party — factions that often don’t see eye-to-eye even when they coalesce around a particular position.

Aside from the diversity of Democratic views, there is the fact that the Republicans have been running the government for some time, and Democrats are a bit rusty on the more technical questions.

So it will take a while to translate Democratic convictions and constituencies into policy, and that task will fall largely on the shoulders of a handful of committee and subcommittee chairmen.

Let’s take a look at the four most important chairmen, and ask what their backgrounds tell us about their likely positions on key defense issues.

First, there is Senator Daniel Inouye of Hawaii, at 82 years old the third most senior member of the Senate after Robert Byrd and Edward Kennedy.

Byrd will be running the Appropriations Committee in the Senate, but on most defense issues he will defer to Inouye, chairman of the defense subcommittee.

And who is Inouye?

No doubt about it, he’s a liberal — but he’s also a decorated combat veteran who lost his arm while serving with the 442nd Regimental Combat Team in World War Two.

Inouye and ranking Republican Ted Stevens of Alaska have established a track record of strong bipartisan support for the military on the subcommittee that few observers expect to change — a record reinforced by the interests of Inouye’s home state.

Unlike other Senate Democrats, Inouye has been a steady supporter of missile defense, and he seldom questions the need for major weapons systems.

So the defense appropriations subcommittee is one place where a switch to Democratic control is likely to have minimal impact on military outlays.

The situation is a bit different on the Senate Armed Services Committee, where incoming Chairman Carl Levin does not share Inouye’s enthusiasm for missile defense or the defense industry.

Levin is the most persistent critic of missile defense in the Senate, and has been a strong proponent of arms control since the 1970s.

He has also joined with fellow committee member John McCain in questioning the proposal to lease tankers from Boeing, and more generally in challenging the way the defense industry does business.

However, when Levin served as committee chairman in 2001 and 2002, he focused on military personnel and management processes rather than weapons programs, and it seems significant that he has chosen not to go forward with high-profile hearings on the defense industry that McCain had been planning if he took over the chairmanship.

Although Levin is no great friend of defense contractors, he follows the model of former committee chairman John Warner of Virginia in stressing bipartisan cooperation and avoiding confrontations.

Levin is likely to hew to the liberal line on arms control, missile defense and outsourcing, but he will only rarely question the need for major weapons programs.

The situation in the House of Representatives is, if anything, more favorable for the sector.

The chairman of the defense appropriations subcommittee in the House will be Jack Murtha, a Marine combat veteran who was awarded two Purple Hearts and a Bronze Star for valor in Vietnam.

Murtha has been a strident critic of the Bush Administration’s management of the Iraq war, questioning both the decision to go to war and the way in which troops are equipped.

But he is no one’s idea of a liberal, having voted for just about every major weapons program and even for reinstatement of the draft.

Although Murtha reserves his greatest passion for protecting and paying the troops, he is a good friend of the defense sector who will support increasing money for both readiness and procurement.

Finally there is Ike Skelton, the incoming chairman of the House Armed Services Committee.

Skelton is the product of a military family who was precluded from serving because of a childhood encounter with polio.

Nonetheless, he has done as much as any member of the House to assure that America’s military is well-paid, well-trained and well-equipped.

It was Skelton who warned Secretary Rumsfeld two years ago that the continuous rotation of soldiers into Iraq would eventually destroy the Army’s combat edge, and he has consistently demonstrated a detailed grasp of military strategy and tactics.

He has also been a strong supporter of military investment outlays, stressing the importance of air power and sea power in supporting a vigorous global security posture.

Skelton isn’t a reflexive supporter of every weapons program, but he’s about as good as it gets in Congress when it comes to supporting the defense sector — smart, patriotic, bipartisan, and a true believer in the value of modern military technology.

So if you thought that the Democrats were going to install a collection of peace-niks at the helm of key defense committees, guess again — the new Democratic chairmen are likely to be at least as supportive of the defense sector as their Republican predecessors were.

Rumsfeld’s Departure

The one other factor at work in the Democratic resurgence that I want to address before drawing some conclusions about the outlook for the defense sector is Donald Rumsfeld’s departure from the Pentagon.

Because Rumsfeld tried to stay out of acquisition matters, many observers don’t grasp how crucial his role has been in defining the contours of defense demand over the last six years.

However, he has been a powerful force not only in advancing military transformation, but also in defining what that phrase meant.

In a way, he has been the only force, because the White House delegated management of military transformation to Rumsfeld and exercised very little oversight, while the concept never won much of a following on Capitol Hill.

So as long as Rumsfeld had the President’s support, he was free to decide which investment goals were most important, and which programs would not be priorities in the future.

The Republican Congress often didn’t like the choices he made, but it was loathe to oppose the White House — especially after 9-11 when the nation was at war.

In general, Rumsfeld favored networks, sensors, space systems and unmanned vehicles over the signature weapons platforms of the past, and he favored research over procurement because his goal was to leap ahead in a revolutionary way rather than simply evolving.

He also tried hard to transform defense business practices by shrinking infrastructure at home and abroad, integrating a balkanized management structure, and outsourcing non-core functions.

But transformation has now been discredited by lack of military success in Iraq, and that has opened the way for a wholesale reevaluation of investment priorities at precisely the moment when Democrats are assuming control of Congress.

Without Rumsfeld, the Bush Administration no longer has a vision of what the future military should look like, and that gives Democrats more latitude to enforce their own defense investment priorities.

Sector Outlook

I will now conclude my remarks by offering eight predictions on where the defense technology and services sector is headed in the aftermath of the Democratic election victory.

First, the future vector of spending for military technology and services will be determined mainly by whether we suffer another terrorist attack on the American homeland.

Over the last year, defense spending has broken out of a range that it had previously remained within for five decades.

That range — between three hundred billion and five hundred billion dollars annually in constant 2007 dollars — has been substantially exceeded on the upside due to supplemental appropriations for the Iraq war.

This development means one of two things — either we are at a top, or a new pattern of spending has emerged in the sector.

My guess is that the old pattern will reassert itself in the absence of another terror attack, and spending will stabilize around $500 billion annually under the Democrats.

If there is another 9-11 style attack, though, we are headed much higher across the board in defense spending, with hardware and services portions of the sector both benefiting substantially.

Second, if the top-line of defense spending stabilizes, that will not mean that outlays in each major component of the budget will stabilize too.

Within the consumption accounts, personnel outlays are likely to continue increasing as the Army expands its headcount and healthcare costs rise, while operations and maintenance accounts stagnate or decline in response to diminished activity in Iraq.

I know that most of you are expecting increased activity in Iraq in the near term, but with Democrats in power and the war going poorly, I think that will be a short-lived phenomenon before “redeployment” begins.

Within the investment accounts, procurement outlays are likely to rise as reset unfolds and modernization programs ramp up, while R & D outlays decline in response to the waning of transformation and the transition of development programs into production.

Thus, companies engaged in integrating weapons systems and supporting personnel are likely to fare better than those engaged in research and sustainment.

Third, military transformation will cease to be a significant driver of defense outlays, and many of the programs most closely associated with transformation will wither.

Among the major systems currently in development likely to suffer from the demise of military transformation are the Future Combat System, the Transformational Communications Satellite, Space Radar and the Joint Tactical Radio System.

Most such programs will be restructured rather than canceled, but as they stretch out the military will be forced to investigate cheaper alternatives and also procure more services to support aging systems that the restructured programs were supposed to replace.

This could turn out to be a boon for services providers, who will be needed to refresh legacy systems previously destined for retirement.

Fourth, hardware spending within the procurement account will tend to migrate away from big system-of-system networking projects, and in the direction of more traditional weapons programs.

This trend is dictated by the aging of the Cold War arsenal, the waning of transformation, the difficulty of implementing complex information architectures, and the lack of congressional enthusiasm for big networking initiatives.

Democrats and Republicans alike prefer traditional weapons systems to information networks because it is easier to trace the jobs impact of planes, ships and tanks on particular congressional districts.

That is one reason why military transformation never really connected on Capitol Hill, and why even the most liberal Democrats generally have a good track record of supporting weapons made in their home states.

Fifth, defense demand will continue to follow the commercial economy in gradually migrating away from manufactured goods towards services.

Over the last fifteen years, the share of federal acquisition outlays spent on products has declined from 47% to 40%, while the share spent on services has increased from 37% to 47% (the balance is R&D).

I expect that trend to persist for a variety or reasons, not the least of which is that it is possible to increase the purchase of services without increasing budgets through outsourcing of jobs previously performed by public-sector workers.

Outsourcing is likely to become harder under the Democrats, but given budget pressures and the impending retirement of many federal workers engaged in IT, telecoms, maintenance and other services, it looks like outsourcing will continue to be an important trend in the sector.

Sixth, the most important new service opportunities in the defense sector will typically arise where one of three conditions prevail…

— Demand is outstripping government capacity;

— An aging federal workforce signals mass retirements; or

— No federal capacity to provide a service currently exists.

Where there is an established federal capacity to provide services not facing high demand or mass retirements, it will be hard for outside providers to make inroads under the Democrats.

Not only are Democrats determined to protect public-sector jobs, but their plans to drawdown in Iraq will reduce the future workloads of government depots and supply centers, encouraging managers to pull outsourced work back in-house.

Public-private partnerships may provide companies with one way of avoiding the loss of outsourced business, but those relationships need to be locked in now, before federal employees detect the waning of Iraq-related demand for their skills.

Thus, the forecast for outsourcing of military services is mixed, with more outsourcing in IT and telecoms, but less in depot maintenance and sustainment.

Seventh, the biggest service providers in the defense sector will continue to gain market share in the years ahead, largely at the expense of smaller providers.

You can see that trend already unfolding in the federal IT market, where the share of prime contractor dollars going to big companies increased from 50% to 65% in just two years.

In a defense sector where federal outlays are growing fast the increased market share of big companies isn’t necessarily bad news for smaller companies because the whole market is expanding, but when outlays stop growing, smaller firms are likely to get squeezed.

Not only does the federal government prefer to deal with big, familiar firms that can bundle services, but those firms bring much more marketing clout to the table in pursuing contracts.

So if you were thinking of selling your small services business to one of the majors, now’s the time to do it — as you’ve no doubt heard, they’re in the market for companies with niche capabilities.

Finally, one last development, the biggest companies in defense technology and services will expand their pursuit of non-traditional opportunities in the years ahead.

Many of these companies are worried that defense spending will level off during the rest of the decade, and that the only way to avoid reporting weak year-over-year results to Wall Street is to enter new markets.

Since service skills in IT, logistics and other fields are often fungible across markets, you shouldn’t be surprised to see some of the biggest defense firms pushing into areas like healthcare where you wouldn’t have expected to find them a few years ago.

Well, I guess I’ve talked enough because I’m well over my allotted time, so I’ll stop there…