Defense Conversion: Bulldozing the Management

Kenneth L Adelman & Norman R Augustine. Foreign Affairs. Volume 71, Issue 2. Spring 1992.

I

The record of massive defense conversion is one unblemished by success, with two notable exceptions: the defense-dominated economies and mammoth military facilities of Japan and Germany, which were converted into civilian production after World War II. Then, the two defeated powers were militarily occupied, their defense industries were immediately destroyed and rebuilt with extensive foreign aid; now, decades later, both countries enjoy economic prosperity.

Similar solutions are being proposed today for the former Warsaw Pact nations, using Western bulldozers rather than Allied tanks, since true defense conversion is readily dismissed as impossible or at least impracticable. There are sound grounds for such dismissal. In our travels throughout the onetime communist countries talking to plant managers, workers, academics and government officials alike we came to sense the staggering obstacles they confront. The greater these obstacles appeared relative to anything known in the West, where defense conversion has largely failed, the darker their prospects seemed. And where the need is greatest, in the former Soviet Union, the impediments are greatest and the trends most pernicious.

Something needs to be done. On that almost everyone concurs. On exactly what, almost everyone seems to differ. We offer our views from a rather unique perspective among analysts of this topic, since one of us has actually had to operate and alter defense production plants over the years.

Defense conversion in the United States has been bedeviled by two conflicting objectives: how to shift firms out of defense and into civilian pursuits, and how to preserve a mobilization base to meet conceivable future defense needs.

Twenty-six years ago an Arms Control and Disarmament Agency report examined attempts at commercial diversification by U.S. defense firms. It found “a discouraging history of failure.” Two years ago ACDA reexamined the same issue and came to the same conclusion: “Successful examples of such conversion are difficult to find. Detailed research has not identified a successful product in our economy today which was developed through a military-to-civilian conversion approach … As of 1990 there are very few concrete examples of actual conversion.”

Defense conversion attempts have been made, some laugh able and in retrospect almost all dismal. Kaman Aerospace successfully ventured into guitar-making, but its effort affected only about 100 workers. Rohr Industries moved from aerospace into mass transit, Boeing Vertol from helicopters also to mass transit, Grumman into the bus-making business and Martin Marietta into the electronic-pager market; in virtually all these cases, the results were disappointing, at best. Nor have prospects brightened recently. The latest ACDA report on the subject states: Studies sponsored by some defense contractors have shown that if they were to attempt conversion projects, about 85 percent would be doomed to failure.” This assessment comes from firms historically accused of making chronically rosy forecasts.

The reason for this solid record of failure is simple: defense work has little in common with civilian work. These two areas demand different skills and marketing techniques and have different cultures and organizations. Clearly the defense business, even in the United States, has little to do with free enterprise. Defense contractors have a single customer who directs them from above, rather than many customers who show their preferences in the market below.

Defense contractors lack expertise in mass marketing and in making high-volume, low unit-cost items. Their distribution network is, in the commercial sense, nonexistent. Their capitalization is modest. Their product servicing is limited. And their bookkeeping and reporting requirements are staggering. Defense firms know little of consumer tastes, establishing customer credit or pricing to compete in the commercial marketplace. They know nothing of market research. Much of their work is performed under cost-reimbursable contracts—they are paid whatever costs they incur, which encourages taking huge technological risks. In a nutshell, defense contractors have adapted to their unique monopsonistic environment in a Darwinian fashion. To further complicate matters, embedded within this monopsony are occasional monopolies, since only a single firm can sell the “customer” a B-2 bomber or MiG-29 fighter.

When venturing out of their natural habitat, defense firms seek to retain the same organizational structure and company culture and to use the same operating methods. This accounts for a majority of defense Conversion failures. Even the few switch-hitting firms—those successfully engaged in both military and commercial work—commonly erect an impenetrable iron curtain between the two sides of the house. And when astute U.S. defense firms acquire a commercial firm, they retain the prior management and culture and give it wide operating freedom. While this approach is best, it precludes any of the synergism that is at least initially used to justify most corporate mergers and acquisitions. Little “value added” is realized, as the defense firm merely becomes a holding company; scant else is thereby accomplished—certainly nothing to help preserve its own employees’ endangered jobs.

Most such acquisitions fail anyway. A recent McKinsey & Co. study done for General Dynamics reveals that 80 percent of commercial acquisitions by defense contractors prove financially harmful. This is not reassuring to defense companies, already heavily burdened with debt and selling at a 60 percent discount in the equity market. Many firms now stand practically one mistake away from extinction.

Postwar experiences of individual U.S. defense companies are distinct from those of the country as a whole. The U.S. economy has expanded in various postwar periods, none as dramatic as that immediately after World War II when U.S. defense spending fell by 90 percent. Defense spending plummeted from 41 percent of NP in 1944 to 6 percent just three years later. But while some 19 million GIs were demobilized, unemployment rates stayed beneath the four percent level.

While a remarkable record, it is a singular experience. For rather than a successful example of massive defense conversion, the post-World War II case was a special instance of defense reconversion. Most wartime defense plants were only temporarily such; they reverted to their prewar civilian activities when the war ended. Enormous demand for civilian goods followed V-E Day, as did the farsighted GI Bill that provided educational, retraining and counseling opportunities for millions who had served in uniform. This enhanced their purchasing power and lifted their living standard. Moreover America’s massive postwar conversion was successful, in part, because of high rates of wartime savings coupled with President Truman’s prudent expansionary economic policy to fuel a quick recovery.

The Korean and Vietnam wars were far less demanding on U.S. industry. Existing defense facilities were expanded rather than new ones created to meet those wartime needs. Worker and capital mobility helped minimize disruptions in those postwar transitions. Most important, all such transformations occurred in a fundamentally sound economy. Herein lies the prime difference between the post-World War II U.S. experience and the present challenges in the newly free Soviet and east European states: their economies were tenuous, at best, long before defense conversion became a top priority. Almost nothing, it now seems, worked—at least not well. And that which did work under the old Soviet system seems to have been confined to the commercially irrelevant defense sector.

In trips across eastern Europe and the former Soviet Union we often found inferior technology, inadequate capital, bankrupt consumers, poor work practices and scant experience with the free-market system they say they now seek. Their defense sectors have just one advantage over those in the United States: they are not seeking to penetrate established and crowded markets already populated with strong and quasi-threatened competitors.

II

That a centrally controlled economy does not and cannot work is now accepted. The once-raging war of ideas—capitalism versus communism, central control versus free enterprise—has ended with the clear contrast between the economies of west and east Germany, Taiwan and China, Puerto Rico and Cuba, and South and North Korea.

While the destination is clear, the means of getting there are not. Libraries are full of books on the transition from capitalism to communism, but few were written on the transition from communism to capitalism. Such manuals are needed now to guide the first crop of newly elected politicians, who worry whether they will have enough time to manage the transition. They fear the attempt may be overtaken by economic collapse, civil war, authoritarianism or some combination. And people now constantly worry about losing their jobs.

Under communism there was no official unemployment, just massive underemployment. Everyone had a job, though nobody had to work. Conversations with plant managers and workers throughout the area led us to a rough conclusion: one-third to one-half of all employees would no longer be needed if their plant had modern technology and competitively oriented management. Efficiently run firms could not afford to keep them on the payroll.

Nonetheless no government can tolerate such massive unemployment, even during a transition period. Never having acknowledged joblessness before, the former Warsaw Pact nations lack both the social “safety net” structures found in the West and the funds to launch such programs. To be unemployed is a big blow to self-image, even in countries where some unemployment is common. But where everyone has been employed for nearly as long as anyone can remember, as in the onetime communist countries, it constitutes a psychological shock of immeasurable proportion.

Besides it has become a phenomenon of modern life—in free and managed economies alike—that when government causes unemployment, people mobilize to resist, but when private companies cause unemployment, people mobilize to find other jobs. After the Pentagon canceled the A-12 aircraft, for instance, thousands of industrial workers were laid off, with hardly a whimper. Yet when a government laboratory or military base is subject to closure, even if it employs only a handful of people, massive political pressure is mounted and is often successful enough to stop the proposed closure—and this in a free enterprise nation.

Thus the main dilemma of defense conversion: how to manage a first-ever transfer from a central to a market-driven economy, starting with bankrupt political and financial structures, ending soon enough to preclude unmanageable social unrest and with as little unemployment as possible along the way. What we have here is a world-class challenge.

III

From Leonid Brezhnev through Mikhail Gorbachev, Soviet attempts at defense conversion have led to some ludicrous results. The Ministry of Aviation Industry was given responsibility to process fruits and vegetables and to make starch, syrup and pasta. A few years ago the minister himself appeared before the Soviet Council of Ministers to boast of creating the country’s first macaroni production line. Under Gorbachev the ministry charged with making nuclear weapons began to manufacture cheese-making equipment. Initially it received orders for 10 units and then, within a few weeks, orders for 2,300 units, causing the plant manager to sigh: “Of course now we are somewhat bewildered.” Stories have been rampant of children’s sleds adorned with titanium runners, of gasoline refiners producing somewhat dubious champagne.

The problem of defense conversion, however, is no laughing matter. And the conversion situation is unique, just as the Soviet economy was unique. The U.S.S.R. spent perhaps three to five times more of its GNP on defense than the United States, and up to 25 times more than Japan. Around one-fourth of all Soviet industrial production went for its military. For a large number of cities in Russia and Ukraine—two republics that accounted for some 85 to 90 percent of all Soviet defense production—this one sector comprised four-fifths of all industrial enterprise.

Over time the distinction between military and civilian sectors became increasingly blurred. The so-called military sector relied upon civilian plants for its raw materials and finished goods all produced under military priorities. And the civilian sector relied upon the military sector for much of its goods. In 1971 Brezhnev boasted that 42 percent of the Soviet defense industry’s output served civilian purposes. In 1991 the 3,000-plus Soviet defense firms made some 2,000 types of consumer goods, including nearly all televisions and refrigerators and some two-thirds of vacuum cleaners and washing machines.

The expansion of the defense sector into civilian production came in part because defense industries seemed the most successful. While enjoying some triumphs in its core business—from launching Sputnik to making first-rate weapons in enormous quantities—the Soviet defense sector’s overall efficiency, even in high-tech military equipment, was far below that of the West.

In its heyday the Soviet industrial-military complex worked as well as it did because it was politically favored and thus generously funded. It received a hefty budget, any needed raw materials and the best and brightest scientists and engineers. It attracted the ablest managers, who received the highest salaries, biggest bonuses and newest dwellings. Its workers lived in the most comfortable apartments of any once-touted “worker’s paradise.”

Whenever bottlenecks developed, the defense sector expanded by vertical integration. The Ministry of Aviation Industry, for instance, made aluminum for its airframes and grew rubber plants for its tires. Assisting those engaged in defense and intervening at the first sign of a dip in production by suppliers were the party apparatchik and KGB operatives. They kept things in line, as they did elsewhere in Soviet society.

Gorbachev left this system relatively intact during his first three years as Soviet leader. In March 1988 he began an energetic campaign for defense conversion—although in an all too typically injurious way. His campaign did not move defense plants into the commercial sector, but incongruously moved at least 260 civil plants into the defense sector as defense management took over ongoing operations in other fields.

Gorbachev had embarked on the wrong path. His faltering attempt at defense conversion was a failure of leadership. Expanding the defense sector further into civilian production merely expanded the military’s role in an already vastly over-militarized society. This approach could not help satisfy popular needs, because in such an environment consumer goods would invariably take second priority to defense manufacturing. As one Soviet production official remarked, “We should not delude ourselves here. We must always remember that we are responsible for defense above all.”

Hence those least willing or able to make consumer products were given authority to do just that. Gorbachev’s conversion plans were devised by the Ministry of Defense and implemented by the military production ministries—neither of which was known for championing reform. Those efforts were like using rabbits to deliver lettuce. Besides, at lower levels many defense managers and technicians resisted such changes. They saw the development and production of consumer goods as less professionally challenging and certainly less rewarding than building spacecraft, precision-guided missiles and supersonic aircraft. They would be less assured of acquiring necessary supplies and having ready markets.

Defense firms generally lack the skills needed for successful civilian work. Their managers face problems at both ends of the business spectrum—in obtaining supplies and finding markets—and in between at running responsive factories. Workers lack the geographical mobility to adapt to a changing labor market. Like their Western counterparts, defense producers in ex-communist states lack knowledge of consumer preferences, marketing, distribution, pricing and commercial accounting. They understand little of market research or turnover cycles, or inventory strategy or promotion. And in the ex-communist nations they understand nothing of capitalization, leverage, depreciation or product warranties. It is not surprising, then, that Soviet consumer goods cost more when produced within the defense industry than by a specialized civilian plant.

Such products were often overdesigned by overly skilled engineers and produced on overcomplicated machinery run by overly sophisticated machinists—all overseen by legions of bureaucrats. Thus washing machines passed through 20 different cycles for each load. And thus Gorbachev’s most celebrated conversion was to have the Votkinsk machine plant, which manufactured all the SS-20 missiles before the Intermediate-range Nuclear Forces (INF) Treaty ended that production, begin to manufacture baby carriages and beer containers. Likewise having airplane plants produce saucepans makes scant practical sense. The tale of a Soviet defense factory reconfiguring itself to make titanium wheelbarrows is indeed a technological breakthrough of the first magnitude—but only for someone willing to spend $10,000 on a wheelbarrow that will last 1,000 years.

Gorbachev’s five-year effort increased consumer output little, if any. It did increase the grasp and power of the Soviet military, which was not helpful to him or his citizens. Gorbachev s approach somehow managed to lower the already abysmal quality of consumer goods while simultaneously raising their prices. He apparently wanted defense conversion in the worst way—regardless of the consequences—and that is how he implemented it.

The new leaders of Russia and Ukraine have already taken the single most important step toward defense conversion by severely slicing defense production. U.S. intelligence reports estimated that Russian military procurement for the first quarter of 1992 was cut by a whopping 80 percent from the same period last year. That figure may be a bit high; other indications are that procurement was down 50 percent. Either figure, though, constitutes a staggering decrease in such a short time. And a discomforting one for that monstrous industrial-military complex.

Since power has devolved to local authorities, plant managers are now scrambling to adjust. In parts of Ukraine the situation has on occasion become both comical and ironic. When a generation ago Nikita Khrushchev bragged that the Soviet Union could produce rockets like sausages, he had in mind heavy missile factories like that in Dnepropetrovsk, Ukraine. Once the biggest integrated missile producing plant anywhere, the Iuzhmash factory recently went into sausage-making—literally. “When we built our first 30 sausage machines,” its chief engineer said, “they all fell apart.” Problems developed elsewhere, as heat chambers for rocket boosters were transformed into high-speed rose-petal dryers to make perfume, booster rockets into farm granaries and trolley buses, and machinery was retooled to churn out umbrellas, tractors and microwave ovens.

More sensible have been changes in the Znamya Truda (“Banner of Labor”) Plant 30 in Moscow—a showplace for the Soviet military aircraft industry as it produced MiG-29 fighters and transport aircraft. Managers there now plan to stop producing MiGs and begin making the I1-114 civilian airliner, currently undergoing flight testing. To help them over the transition hurdle, plant officials attempted to build industrial juice processors, but the results have been nothing short of lemons.

The Klimov Engine Plant in St. Petersburg had long made engines for military and civilian fixed-wing aircraft and helicopters. It now plans to manufacture the engine for a new civilian airliner. To help them through the transition, managers are working to produce shoemaking equipment, but this effort may end as the attempt at juice processors did.

The massive conversion of the defense sector seems dubious at best, although a few such local attempts could conceivably succeed. The new Russian government under Boris Yeltsin has formed some 16 new committees to deal with this problem—an ominous sign in itself, as anyone familiar with the U.S. Congress realizes—and top-level pronouncements have hardly been reassuring.

The good news is that most Russian leaders recognize that Gorbachev was wrong to view defense conversion as paving the way for perestroika. They sense that the reverse is true—moving beyond perestroika to form a functioning market economy must lead the way for successful defense conversion. Hence Yeltsin’s adoption of shock therapy for the whole Russian economy.

And hence Mikhail Bazhanov, the head of the Russian State Committee for Defense Industry Conversion, lamenting last January that there is no market to help defense conversion. The defense complex must “be taught the market,” he said in a televised interview. “Furthermore, one cannot talk about real conversion. I call it convulsion rather than conversion.” Bazhanov recognizes the ill-conceived attempts made by most defense factories thus far:

They are looking feverishly for what they should do, if only to earn something, if only to provide social support for their workers. Pans and beds and whatever else you like are therefore indeed being produced, along with hat stands and coat hangers—you name it. Children’s beds that often cost more to produce than they’re worth.

While on the mark with the problem, Bazhanov is off track on the solution. He still views defense conversion as a centralized effort—one demanding a complete catalogue of every plant’s qualifications, technology, output and potential: sort of a centralized decentralization. Bazhanov talked as if his committee (or any committee for that matter) could manage “a conversion program for the enterprise, then for the region” and then “an overall program for the conversion of Russia.” For this, he said he needs “approximately 150 billion rubles” for the next five to six years, “and incidentally I am calculating this according to the prices that were in force before now. Such huge sums are required even though “so far not a single kopek has been allocated for conversion. At any rate, I haven’t seen any.”

Should such funds miraculously come his way, Bazhanov would begin his “certification of production facilities,” encourage them to branch out and “offer those enterprises technologies that we have in the committee’s data bank. That is “the only way.”

But centralized planning for defense conversion can work no better than centralized planning for economic development. The plans of Bazhanov, who worked for many years in the Soviet industrial-military complex, have been roundly and rightly criticized by Russian free-market advocates. That is not “the only way.” There is a better way, as we will present shortly.

V

No central east European country was as thoroughly militarized—or is as economically failing, politically splintering, ethnically clashing or bureaucratically stifling—as the U.S.S.R. While these populations often complain about their predicament, they now at least have hope. This, like so many other things, they lacked for a half century.

Being smaller, more monolithic and certainly more manageable, east European states have greater opportunities for outside aid to make a genuine contribution. The ex-Soviet Union is simply so large that plausible levels of foreign aid cannot be expected to make a dent, other than in specialized areas such as medical supplies. And in eastern Europe the living standard has been higher and the work ethic stronger than in the former Soviet republics. Forty-five years of communism is less corrosive than seventy-five years.

One U.S. automaker reports that its plants in western Europe are 25 percent less productive than those in the United States (which in turn are generally less productive than those in Japan), leaving little to the imagination about the productivity in eastern Europe—let alone Russia, Ukraine, Georgia and the other republics. Plants across ex-communist lands are hopelessly outdated—”veritable museums of industrial archaeology,” as aptly put by one commentator. A visit to those factories turns one into a Rip Van Winkle in reverse.

East European countries, however, are at least heading in the right direction, toward privatization. Over half the defense plants in Czechoslovakia, Poland and Hungary have now been slated for such conversion or, for many, closure. In east Germany an aggressive program is underway to privatize all manufacturing—an effort destined to succeed given the support of its wealthy cohort, but surely with much greater difficulty and more delay than ever anticipated.

In many cases east European governments have simply flung defense concerns into the commercial marketplace—”the sink-or-swim school” of conversion. Most of these are not real “companies” at all, but factories. For years their managers have been told what to build, their workers when and how to build it. Much to their current disadvantage the defense factories in eastern Europe produced mostly small arms or component parts; in the case of larger systems, their factories and products were simply copied from Soviet designs.

Though east European technology lagged a generation behind the Soviet Union’s, at least those countries led in management skills, particularly Hungary. Budapest gained a decade head start in moving toward a free-market system through a tacit agreement with Moscow, which tolerated economic experimentation as long as the political line was toed.

The enormous demands on industrial managers in a free-market eastern Europe pale in comparison with the demands placed upon policymakers overseeing and directing this transformation. Many of their new political leaders were former dissidents; they were intellectuals, poets or unionists, not managers. Some patriots spent many of the communist years confined in jail, and thus lack essential experience. Poland’s second postcommunist prime minister admitted that “my experience in politics was close to zero” before he took the key political position.

Now that their countries are strapped for hard cash, they are tempted to continue making military equipment for export. President Yeltsin has explicitly supported arms export in his public statements. This becomes worrisome, since those countries with the most hard cash to buy weapons are precisely those Middle Eastern or Persian Gulf nations that the United States might wish not to be more heavily armed. It is also worrisome since it just postpones the day when massive defense conversion must be tackled.

The classic example of such an exporter is Czechoslovakia. Its inspiring playwright-turned-president, Vaclav Havel, was one of the most defiant opposition leaders. He nonetheless reversed initial plans to phase out the country’s defense production, due to Czechoslovakia’s need for hard cash and to preserve jobs. Ethnic tensions also played a major role, since drawing down the defense business would have devastated the poorer republic of Slovakia, which manufactures some 75 percent of the country s arms. In east European states, defense production has been geographically concentrated, with many regions almost wholly dependent upon defense. In one area of Czechoslovakia, for example, the local economy was dominated by a huge underground plant originally built before World War II to manufacture tanks for defense against the Germans. Captured and operated by the Germans throughout most of the war, it eventually fell into the hands of the Soviets. Today it is largely unused, a monument to past wars—and to future environmental cleanups.

The breakup of political links has shattered market relationships. Other former Warsaw Pact nations used to account for half of Czechoslovakia’s arms sales—formerly the seventh largest in the world—but these countries no longer want the weapons, nor can they afford them. Consequently many Slovakian defense plants have huge inventories, few customers and a government with an increasingly desperate need for hard currency. Thus the Navel government has approved a $200 million tank sale to Syria and a rocket launcher sale to Iran, both over the West’s strong objections. Recent reports tell of Slovak-made weapons heading to factions in Yugoslavia and to Syria.

Such may be the pain of transition. And the transition will be long and hard. After all it took the already developed nations of Japan and West Germany a quarter century—aided by benevolent foreign occupation and massive infusions of foreign assistance—to convert their economies after World War II. It took South Korea about the same time after its war in the early 1950s, again with massive aid (but no occupation).

People are understandably frightened. Polish President Lech Walesa reflected this sentiment when addressing the Council of Europe last February: “Nowadays our own people are not getting the feeling they are better off … Democracy is losing its supporters. Some people even say, ‘Let’s go back to authoritarian rule’.” And in fact, Poland has gone through three prime ministers in the past two and a half years, largely as a result of its jolting economic reforms.

Capitalism demands individual initiative, an often alien concept for those who lived under communist rule. But promising signs are emerging, including the thriving black market in Moscow, which prompted David Johnson at Plan-Econ in Washington to identify the main defense conversion problem as: “They don’t have any experience with how to do it legally.”

VI

Defense conversion throughout the ex-communist states leads to a bundle of woes that accompany the unprecedented leap from communism to capitalism, from communes to companies. They raise several questions.

Ownership. Who owns the land, building or company originally seized by the communist government? Or by the Nazis and then by the communists? What date does the government choose to honor restitution? Or should the government not honor restitution giving the land or real property back and instead merely honor compensation? Who owns the plant? The center, the local authority or the plant manager?

Privatization. How is one to convert existing facilities from the government to private hands? Who gains ownership, since few citizens (besides high-ranking ex-communists with suspicious sums of money) have the means to buy major facilities? How much foreign ownership will be allowed? Can an investor be certain that the laws made today will hold five years from now? What is the sanctity of a contract? How are legal disputes to be resolved? What standing will foreign firms have? Will domestic firms that operated these facilities prior to World War II be given preferential treatment?

Personal Allegations. How much in the millions of raw intelligence reports is to be believed? How can one clear his or her name of allegations? When will this be done? Until it is done, who prominent in these societies can rest assured that they will not shortly be smeared with a leak, no matter how unfounded? In Russia how did a certain individual conduct himself or herself during the attempted coup in August 1991?

Entrepreneurial Talent. Where is one to find or train potential business leaders with a host of skills never needed under communism? How long will it take to create a critical mass of such skills in each country? What happens to the existing cadre of managers?

Conversion of Currency. How do foreign firms repatriate their earnings? At what exchange rates? With what level of taxation? Is this likely to change dramatically?

Environmental Liability. What happens if a newly purchased facility is later found to have a major environmental problem? Is the answer the German approach, where officials simply indicate that indemnification will be provided?

Political Stability. With whom within a government does one negotiate? (In Czechoslovakia there are three foreign ministers; in the former U.S.S.R., fifteen.) With what government? For how long? Should commercial agreements be made with the central government, the republics, the cities’ mayors or the factory managers?

The dearth of answers to those questions represents the greatest deterrent to foreign investment and provides what may be the last great refuge of the established bureaucrat.

Problems of defense conversion naturally ease as the economy improves. Prosperity, or even relative improvement, is a catalyst to transition. That, in turn, depends on a measure of stability. Money is a coward; few risk great sums in periods of great uncertainty—especially when the world is rich with opportunities from Malaysia to Mexico for risk capital. Reports indicate some 3,400 foreign partnerships have been established with firms in the former Soviet Union, but in reality only a few have left the drawing board.

In a grand sense Britain prospered in the nineteenth century because of four factors: a clear, simple and dependable legal system, which assured both property rights and the sanctity of contracts; real, fully convertible money; relatively low taxes; and an absence of corruption (whose existence prevents any political system from encouraging economic growth). These four elements remain key to prosperity today.

For conversion to work best, capital must flow into private enterprises led by a new class of entrepreneurs sensitive to consumer needs. It will not work when production is assigned to existing defense facilities commanded by the military elite. Nor will it work well if it consists of simply answering the question posed to a Western visitor touring a Ukrainian plant, “How do we sell AK-47s abroad?”

Fortunately the critical step for conversion—privatization—is occurring in eastern Europe, as throughout much of the world. In 1990 some 25 governments worldwide sold state-owned enterprises—incidentally accruing some $30 bill lion in revenues. Such actions are frequently controversial, sparking demonstrations from India to Argentina when government-owned assets were put up for sale, but such actions are needed.

Privatization must come with greater incentives for workers and managers to engage in civilian projects rather than military programs. The traditional Soviet mania for secrecy must be lifted to open the way for joint ventures with foreign firms. Only justice is blindfolded; no worthy potential business partner will emerge so adorned.

Asking what to do leads to the Rosetta Stone of defense conversion—to wit, defense conversion should not be viewed as “conversion” at all. Rather it is the result of two independent and parallel actions: shedding many elements of the defense sector; and absorbing those assets into a new entrepreneurial consumer sector. The way to increase the production of sausage-making machines is to expand the sausage factory, letting it hire the employees of the defense firm and rent or buy its factories not to anoint the rocket makers as sausage makers. The first step is already being done rapidly throughout the world, especially in Russia and Ukraine, where defense shedding is happening much faster than was imaginable, even under Gorbachev.

Ex-military workers can be employed in similar civilian jobs; welding a tank resembles welding a truck. Even design engineers may be salvageable; designing a radar resembles designing a television. Some capital assets can be retained; factory buildings care little whether rifles or refrigerators are made within them. The bad news here is for the managers, most of whom become unsalvageable.

Hence our main message on defense conversion: bulldoze the management, not the factories. And, while they are at it, bulldoze the corporate culture. For every industrial organization, as every individual, has a “personality” or culture that is resistant to change. Buildings can be razed and replaced, machines moved in and out, workers hired and fired—but the culture lives on. It is established over considerable time by deed, not by word, and emanates from the top, only to seep through the layers of managers in an organization. Managers in those countries who stand to lose the most by change must therefore be replaced if the culture is to be fundamentally changed, as it must.

And as it can. Dramatic cultural changes have occurred, as when Japanese firms took over the operation of U.S.-based automotive or electronic manufacturing facilities and achieved remarkable improvements in quality and productivity with the same workers, plants and products—but new management cultures.

VII

Various models exist for transforming a defense industry into commercial pursuits. Many of them have been tried in past cycles of defense downturns in one country or another. None, however, has been fully tested during a shift of the entire economy from a managed to a free-market structure.

First is the “insertion model,” similar to what was unsuccessfully tried during the Soviet Union’s final years. Here commercial work and market share are assigned by the central government to defense manufacturers. A rocket plant is given responsibility for making refrigerators or perfume. This unworkable approach depends illogically upon a centrally managed economy, which is itself unworkable, and is not an attractive model.

Second is the “conversion model,” whereby defense contractors simply seek to use their technology and manufacturing capabilities to shove their way into the commercial sector. They launch major initiatives of new products, such as canoes, buses, coffins or beepers. This approach has been repeatedly tried—notably by U.S. defense manufacturers during the defense downturns of 1944, 1955 and 1969—and has regularly failed.

The third, unlike the first two not a proven failure, is the “evolution model.” This version is characterized by a gradual movement into selected commercial markets closely related to the basic skills of existing defense firms—endeavors marked by high-tech, systems engineering, “large” products, low-rate production and arrangements with a few large customers, whether governments or major corporations. This approach offers some promise. Yet it affords only limited opportunity to offset job losses in traditional defense activities since it excludes major market segments and does little for the consumer. Nonetheless this is the best model today for recasting the U.S. defense industry. It could work reasonably well in a controlled defense downturn, as opposed to a defense budget collapse. No model can manage a free-fall.

Fourth is the “substitution model,” which we recommend along with accompanying actions for the ex-communist states. This consists of providing government assistance and incentives to small start-up, entrepreneurial enterprises that then selectively hire away the employees of the existing defense firms and, in some cases, even buy or rent parts of existing defense factories. This approach helps assure that the existing management and culture are left behind eventually to wither away, residues of excessive government-imposed bureaucratic oversight attuned to a different era. Under this model technology is transferred the way it has always been transferred although seldom recognized as such in the minds and skills of the workers.

This substitution model can be facilitated by the leaders of these ex-communist states allowing joint ventures with foreign firms, on a company-to-company (not government-to-government) basis, to provide manufacturing expertise and capital in exchange for equity ownership. Start-up funds could also be raised from the sale of state-owned land and buildings. But to be effective the old management must be bulldozed aside and replaced with a cadre of fresh leaders, who make up for their lack of experience not only with a vision but also with a stake in that vision.

VIII

Decisive action is needed, and needed fast. The “muddle of the road” approach can only lead to economic failure, which invariably leads to political failure.

Leaders of these ex-communist states, now longing for capitalism, must realize that conversions of all kinds are endemic to that system. Joseph Schumpeter identified the essence of capitalism as “creative destruction” since companies, and even entire industries, constantly rise and fall. Manufacturers of buggy whips are down, while those of microchips are up. Employment in defense firms ebbs and flows as foreign threats rise and fall.

Any transition can be eased by enlightened government policy. In such an environment defense conversion largely “happens” rather than being directed or dictated. The U.S. government conversion policy is basically a hands-off policy. The Pentagon has only a minuscule office to help, the Office of Economic Adjustment, which uses its $4 million annual budget to assist some local communities.

Under capitalism the market redistributes whatever human and capital assets are displaced during defense downturns. After the INF treaty was signed in December 1987 American workers in Pershing II missile plants did not then start to make baby carriages in their factories. Rather some moved on to other projects in their companies while others moved on to other companies or other industries.

Defense conversion is a continual and natural part of change in Western economies. Downsizing leads to consolidation. During World War II, some 20 major contractors built fixed-wing aircraft in the United States; today only a half-dozen do. As U.S. defense spending continues to decline from a high of 6.3 percent of NP in 1986 to below an estimated 4 percent in 1995, the number of defense firms contracting with the Pentagon will continue to decline. Likewise in France and Britain; each had some ten manufacturers of military aircraft in the 1950s. They now have one or two.

Thus do people in free-market societies move on to other activities when a market recedes—not without pain, but with the knowledge that this is how it goes. Or how it should go, if alternatives exist, as with the U.S. economy, which typically generates some one to two million new jobs each year.

Sadly this is not how it goes in most ex-communist countries. Leaders there cannot delay defense conversion until their economies start to hum. They must begin now, and can begin, naturally, by building on their comparative advantages. Work forces in most east European countries are well educated and fairly well motivated. Their number of craftsmen is high and factory labor costs low.

Given appropriate tax and investment incentives in a stable situation, Western firms could use these comparative advantages to build new (or even modify existing) facilities for relatively low-cost production similar to what has happened in the Pacific Rim and Mexico.

How to accomplish such a transformation? We offer seven steps, none simple, but all clear.

The first task is to help assure political stability. Foreign investors shy away from committing assets if they are uncertain which government will hold power tomorrow—or, worse yet, which government holds power today. Likewise, layers of bureaucracy must be scraped away, for they do little else than impede productivity.

Second, a business-friendly infrastructure must be constructed with clear laws of property ownership, assuring the sanctity of a contract, environmental accountability and an encouraging tax policy. This entails a legal system for dispute resolution and protecting intellectual property, ways for foreign investors to repatriate earnings, insurance for bank deposits, an economic safety net for employees displaced during the transition period, and much more.

Third, privatization should be expedited with a generous stance toward foreign ownership, including special tax incentives to reward job creation. Only then can productive assets be taken from the hands of bureaucrats and passed to the entrepreneurs, while raising capital.

Fourth, conversion must be need-driven, not capacity-driven. To launch the defense conversion effort these new leaders should direct assets into the essentials of a society—medical care, food processing and distribution, housing and energy generation. This, of course, is not the path upon which many Russian or Ukrainian factories are embarked; they prefer instead more glamorous high-tech pursuits. What remains of the old Soviet army, or new republic armies, should use the military’s logistics system to help rebuild the infrastructure of highways, railroads, airports and telecommunications as well as for environmental clean-ups. The focus should be on internal markets since that need is greatest and today’s capabilities are generally inadequate to match worldwide competition in the export realm.

Surely the sole constructive measure taken by the former East German government occurred in its final gasping days, when it assigned those drafted into the army to spend only three months in basic training and then begin national service in construction work or health care for the duration of their time in uniform. A civilian conservation corps of people displaced from the military and defense projects could help avoid massive unemployment and actually build up the infrastructure.

Fifth, ex-communist countries must develop sources of hard currency by doing what in the nondefense realm they do best. Eastern Europe still produces agricultural goods, and tourism there and in Russia, Ukraine, Georgia and elsewhere can attract Westerners anxious to see once forbidden and foreboding sites. Officials could jump-start tourism as a potentially major source of foreign exchange.

Western firms could also be given equity stakes in developing oil resources in the Russian and other republics, whose resources are said to rival those in the Persian Gulf. This takes new approaches and firm decisions. Chevron’s attempts to develop the Tenghiz oil field in Kazakhstan, for instance, has been frustrated for more than four years by bureaucratic infighting among sundry Soviet authorities.

Sixth, civilian manufacturing capacity should be generated, not by converting defense plants to refrigerator factories, as is now done, but by permitting entrepreneurs outside those plants to create new businesses. Something similar to this happens in the black market; it can and should be legalized and encouraged. Then government authorities could offer the new entrepreneurs use of privatized defense plants, besides facilitating the construction of new plants as needed.

Seventh, as an interim measure to help them, Western efforts should be made to inhibit top-notch ex-Soviet scientists and engineers from peddling their expertise elsewhere. Libya, Iraq and other countries are reported to have offered scientists jobs at salaries of several thousand dollars a month—undoubtedly tempting for people now drawing the equivalent of $10 per month. For decades Washington paid American farmers not to farm. Over the next couple of years Washington should pay many Russian and Ukrainian nuclear workers not to work—or at least to work on less threatening projects.

Ideally the U.S. government should identify the top 20 or so nuclear engineers and scientists (those of potential Nobel Prize caliber) and recruit them for work in U.S. labs and universities. The next rung, the thousand or so skilled in this area and possessing the expertise to make nuclear weapons, could be employed to destroy, or at least defuse, existing nuclear weapons throughout the land, to participate on a new U.S.Russian cooperative Strategic Defense Initiative program, or they could be retrained for other high-tech but low-lethality projects. As for the tens of thousands of scientists at the bottom rung, they must cope with the new situation, much like their fellow citizens.

Overall we propose a policy of substitution rather than direct conversion through the two-step process of shedding defense assets and encouraging the absorption of such labor and capital by newly created companies.

IX

Training in free-market principles is sorely needed if a new corporate culture is to be created. Despite all the talk, knowledge of how to operate within a free market is scarce. After a tour of former Warsaw Pact countries on defense conversion, U.S. Deputy Secretary of Defense Donald Atwood reportedly said, “We found almost universal acceptance of what the problem is lack of understanding of how free enterprise works.”

An infusion of retired Western executives with proven track records could guide the new entrepreneurs. Such activities, dubbed the “paunch corps,” are already underway but need to be expanded both in numbers and in time of individual service (to a year or two). Launching a number of “how to” business courses in these countries would likewise help create a new cadre of entrepreneurs with a new corporate agenda. Corporate executive exchanges in both directions could assist as well, as could massive student exchange programs. Western aid to partially guarantee the seed capital for joint start-up businesses would be helpful.

Once on their way the ex-communist countries could model themselves on the step-by-step rise of postwar Japan, which deliberately proceeded from manufacturing baseball gloves to motorcycles to steel to automobiles to consumer electronics and now to aerospace.

International trade is also essential. Lowering, or better yet scrapping, the European Community’s protectionist wall against commerce with countries to the east remains the most critical contribution any outside governments can make. It is ironic that a formidable wall harming the peoples of eastern Europe today has been erected and maintained by the west Europeans.

Above all time and determination prove critical. While the newly liberated people of these nations fixate on defense conversion per se, they are actually embarked on a much grander and nobler conversion, into a system of freedom and free markets. Theirs is an effort certainly worthy of pursuit and strong support.