MERGER TAKES FLIGHT JULY 23, 1997 TRANSCRIPT

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In an eleventh hour decision, the European Union approved "in principal" the merger of aerospace giants Boeing and McDonnell Douglas, averting a trans-atlantic trade war. After a backgrounder by Elizabeth Farnsworth and Tom Bearden, Elizabeth Farnsworth leads a discussion.

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A RealAudio version of this NewsHour segment is available. July 23, 1997: A backgrounder on the approval of the Boeing and McDonnell Douglas merger. NewsHour Links December 16, 1996: Boeing and McDonnell/Douglas announce their merger. Browse the Online NewsHour's Business, Military and Transportation coverage. Outside Links European Union

ELIZABETH FARNSWORTH: For more on defense mergers we turn now to Lawrence Korb, an assistant secretary of defense during the Reagan administration--he is now a senior fellow at the Brookings Institution--and to Pierre Chao, vice president and senior aerospace and defense analyst at Morgan Stanley-Dean Witter. Thank you both for being with us. Fairly dramatic numbers there--ten or so defense contractors, down to three. Is this a positive development, Mr. Korb, for the United States?

LAWRENCE KORB, Brookings Institution: Well, in the short-term, it will be a positive development by getting rid of some of the excess capacity, but I think in the long-term it's going to drive up prices, and it's going to reduce innovation in the defense industry. So I think in the long-term it's not good for the country.

ELIZABETH FARNSWORTH: Mr. Chao, what do you think? Just to get your two positions out here from the beginning.

PIERRE CHAO, Morgan Stanley, Dean Witter: I think we're simply reaping what we've sown in terms of a declining defense budget; that the industry can only sustain two or three key players, and in an environment where we have less money to spend on equipment, we need stronger, larger competitors to take us through this longer period of low defense spending.

ELIZABETH FARNSWORTH: Do you think, Mr. Chao, that the consolidation does lead to savings in the defense industry?

PIERRE CHAO: I think it clearly leads to savings. It's already starting to show up in the company's margins, and simple logic would tell you when you're eliminating duplicate headquarters, research and development and facilities, that you get savings that ultimately benefit the U.S. taxpayers.

ELIZABETH FARNSWORTH: Mr. Korb, savings?

LAWRENCE KORB: Well, there's no doubt that the companies--stock prices are going up and profits are going up, but we haven't seen any savings to the Pentagon. The F-22 plane, which is made by Lockheed Martin, its costs keep going up beyond the projected, so much so that the Air Force has got a special team together to try and hold the cost down.

ELIZABETH FARNSWORTH: And what about the basic premise that because of the declining defense expenditures, there must be this consolidation; that otherwise you'll have all this excess capacity?

LAWRENCE KORB: Well, I think people are using the wrong base year. Everyone is using the height of the Reagan build-up to measure the decline. What they ought to look at is the average spending during the Cold War, and they are getting foreign military sales. So if you take a look at that, the picture is not that drastic. For example, even in real terms, if you control for inflation, what we're spending on defense now is what we were spending in the early 80's at the beginning of the Reagan build-up.

ELIZABETH FARNSWORTH: So you think that there could have been more companies and there still could have been savings, and there could have been efficient production?

LAWRENCE KORB: Very definitely. I don't think that you wanted to go down to three. And, in fact, the Defense Department tried to accelerate this by actually subsidizing the mergers, and they lost control of the process because they gave people an extra incentive to merge because now they could actually increase their profits by merger.

ELIZABETH FARNSWORTH: Okay, Mr. Chao, before we get into the Defense Department's support of these mergers, what about the arguments made by Mr. Korb; that they don't necessarily cause savings, maybe it wasn't even necessary to have all these mergers?

PIERRE CHAO: Yes. Elizabeth, I think we need to be a little careful in terms of some of the statistics. One, first of all, defense spending as a percentage of GNP, if you want to use another measure, is as low as it's been since the end of the Second World War. So if you want to measure from that perspective, we're spending the least we've ever spent on defense. In terms of cost savings, again, if you take a look at some very simple logic, if you see how much an F-16 cost us at the peak of the Reagan era, when we're buying them by the hundreds, compared to how much they cost today, it's the exact same unit price.

Logic tells you the only way you can get the same unit price is by having a decrease in efficiency--an increase in efficiency and a decrease in the price. So I think it's clearly coming through. Taking the F-22 example is a little fallacious to the extent that there are a lot of other elements that drive that, and the fact that the Congress has cut the total amount of the buy raises the unit price. I think you need to look at much more specific examples.

LAWRENCE KORB: Well, let me make a comment on that. The F-16 price went down well before the mergers because Congress told then General Dynamics when they had it, that if it didn't lower the price, they weren't going to buy any more. And similarly, with the C-17, which is a transport plane, which was being made by then McDonnell-Douglas, when their price could not be controlled, the Pentagon said, if you don't control it, we'll buy from Boeing; we'll buy commercial airliners and we'll convert 'em. And so they were able to bring the price down.

I don't think it has anything to do with the mergers--the examples that Mr. Chao cited. And I think measure of GDP, I'm not talking about percentage of GDP. We could afford to spend more on defense. What I'm talking about is actual dollars spent on defense, even controlling for inflation, are now at the same level as they were in the early 80's. And if you take out Vietnam and Korea, it's about the same average as we were during the Cold War.

ELIZABETH FARNSWORTH: Mr. Chao, let me move on to innovation. How do the mergers affect research and development and innovation in the defense industry?

PIERRE CHAO: I think it is accurate to look at it in terms of what's the short-term and the long-term. I think the reality is in the long-term if you look at how much technological innovation the--the amount of money one needs to spend in order to develop a new military aircraft fighter, it's harder than it's ever been before. And I would claim in this period of very low defense spending on an absolute or relative term, it takes larger players with deeper pockets to take these development programs all the way through. It's a whole separate issue in terms of the other debate of can a larger player be as technologically innovative as smaller players, but I would argue that, given its current level of spending, you need the larger players that have the deep pockets, that can afford to spend this money, as opposed to a smaller one, who is at the risk of going bankrupt if you pull one program away. I'd rather see them being larger and broader based and being able to take us through the next decade.

ELIZABETH FARNSWORTH: How do you see the innovation question?

LAWRENCE KORB: Well, I think we both agree that you need to cut down the number of companies. I just happen to think it's gone too far. For example, if you take the Joint Strike Fighter is the new plane that's coming on, and you'll have two competitors: the new Boeing, which has McDonnell-Douglas, and the new Lockheed Martin, which also includes Northrop Grumman if those mergers are approved; if you take a look at what's being produced right now, the F-22 is a Lockheed plane, but Boeing is a subcontractor on that. They have part of the business. The FA-18 is a McDonnell plane, but Northrop Grumman has part of the business. I think both of them are going to know when they do the Joint Strike Fighter, it's like the wildcard in the playoffs in the Eastern division. Both the Yankees and Orioles figure they're going to make the World Series, so they won't push to keep the price down; nor will they push to be innovative. I think we could have sustained at least three players in the tactical aircraft industry.

ELIZABETH FARNSWORTH: Mr. Korb, somebody sitting out watching the show thinks ten, three, two, what does it matter to me; why is this important for the American taxpayer?

LAWRENCE KORB: Well, I think it's important not only because in the long run, without competition, we won't be able to hold the price down. What will we do if we want to go to one of these big three, as we did with the C-17 and say, if you don't lower your prices, we'll buy something else. There will be nobody else that you can do it. I think in terms of innovation, the great innovations have always come from the odd person out. When McDonnell-Douglas and Lockheed were competing on the Joint Strike Fighter, the most innovative design came from Boeing, which had been basically out of the military business for 30 years. And I think the real problem is going to be, how are we ever going to stop a weapons system, because these companies have such political power now. We're talking about companies, all three of which, the three remaining, and that have more people than the Marine Corps, they're going to have, you know, well over 200,000 people; they're going to have political tentacles all over the country, and it's going to be very hard to stop buying, for example, C-130's, which we've been trying to do for years.

ELIZABETH FARNSWORTH: Mr. Chao, respond to that specific point and then tell me why you think this is such an important debate for people to know about and to understand.

PIERRE CHAO: Yes. Actually, Elizabeth, Mr. Korb raises an interesting point. His comment about the Joint Strike Fighter and the innovation coming from outside the industry, if you look at where some of the--if you look at where the technology is leading us and where the cutting edge technology is--mostly in electronics software and other areas, I would claim that a lot of the innovation these days is going to come out of the commercial industry and be brought in. And it's very different from having a set of players--a set of players that know how to deal with the Pentagon and all the bureaucracy that's been established around that in some ways, and I think a bigger challenge for the Defense Department is to find out how do I get this technological innovation out of the Intels and the Microsofts of the world into the Pentagon and make the process that much easier?

If you want to see true decreases in prices and increase in competition, that's a whole separate debate. I mean, why is it important to the American people? Well, one obviously, it's our taxpayers at work, and we want to make sure it's appropriate, and I think the comment--well, it's on the way down to two competitors--I'm in a dangerous situation. Remember, they only have one customer, and we have people like the Congress and Mr. Korb making sure that the industry doesn't get out of hand. I mean, we've had a long history of oversight and controls to make sure that the era of $500 toilet seats doesn't occur again.

ELIZABETH FARNSWORTH: And, Mr. Chao, what about the political point; that these companies will be so big it would be hard to turn them down if they wanted to build something?

PIERRE CHAO: I think we're in a situation where I hate to use the term, but in some ways it's almost like mutually assured destruction, just like the Soviets in the U.S. You have a very powerful customer in the form of the Pentagon and the Congress, and you have companies that--to balance that off. So I think it'll be the status quo, and you won't see the kind of dramatic shifts. I can give you plenty of examples of programs that have been canceled, such as the A12, despite the protestations and the lobbying power of the defense companies.

ELIZABETH FARNSWORTH: I want to ask you both very briefly--there are a couple of mergers yet to be approved--Lockheed Martin's bid for Northrop Grumman and Raytheon's acquisition of the rival missile makers at Hughes Electronics--should they be approved?

LAWRENCE KORB: I think they will because the merger--the merging companies will claim they need it to compete with the other ones that have already been approved, but I do think there will be some safeguards to the point Mr. Chao made the subcontractors like the electronics unit of Northrop Grumman can't just do business with--with Lockheed or Lockheed can't just do business with it.

ELIZABETH FARNSWORTH: Mr. Chao, do you think they should be approved?

PIERRE CHAO: Yes. I would agree. I think when you look at it and you go through the specifics in terms of specific product lines, there's a relatively little overlap in the Lockheed, Northrop, Grumman deal. The only thing that anybody can complain about is its sheer size. And on the Raytheon Hughes, the Pentagon's looking very closely at the air-to-air missile situation. And, like Mr. Korb indicates, I think they'll--it'll be cleared with certain conditions.

ELIZABETH FARNSWORTH: Thank you both very much.

LAWRENCE KORB: Thank you.

PIERRE CHAO: Thank you.

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