More Than We Want, Less Than We need

Steve Saideman on what Canada can expect if it pursues defence "industrial policy".
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August 1, 2013
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There is a temptation to think that the interests of the Canadian defence contractors and the preferences of the Canadian Forces always converge, but this is not always the case.  The Conservative government has become a big fan of defence “industrial” policy, where the defence procurement decisions are driven in part by what is best for Canadian firms and job creation at home.  The Canadian Forces are not entirely thrilled with this.  Why?  Basic economics and simple math.  The economics is all about competition and economies of scale, leading to higher production costs.  The basic math is this: if the Canadian Forces have to buy more expensive kit, then they will have to buy less or cut spending elsewhere.  This is all exacerbated by the Harper government’s austerity campaign.  Let me explain.

Whenever governments limit choices of where equipment can be produced, they are, by definition, reducing competition.  The defence sector already has enough problems with getting sufficient competition to lead to higher quality/less expensive equipment, but if you tilt the competition towards domestic producers, there will be less pressure to reduce costs.   To be clear, if Canadian producers were already producing the least expensive, high quality material, there would be no need for the government to favor domestic producers.  They would win in the competition.  But because they would otherwise lose, favoring them means buying more expensive stuff. 

A key challenge facing the Canadian defence industry is economies of scale—most of their competitors in the world serve larger markets.  As they produce and sell greater numbers of planes, ships, radar systems, whatever, the costs of the initial research and development per unit go down. Defence systems tend to have very expensive startup costs, so economies of scale are particularly important in this sector. Canada has a small military, so it will always be a limited market for Canadian producers.  Sure, some Canadian companies do well in international competition, which means that they can compete well at home. But many do not, and have not.

The best/worst example of this is ship-building.  The effort to re-capitalize the Royal Canadian Navy by building ships in Vancouver and Halifax is mighty good for those shipyards, but is awful from a budgetary standpoint.  There are other countries that could have sold Canada more capable, less expensive ships than what the Canadian shipyards will eventually produce.  Sure, the ship-building competition within Canada was lauded at the time for being fairly systematic, but it was gamed—the competition was only among Canadian shipyards.  Sure, the RCN learned not to buy used ships from the British due to the sub fiasco, but there are companies beyond Canadian shores that could provide excellent ships sooner and for less.

Why?  Because Canada is making a huge mistake—it is turning defence contracting into an exercise in domestic job creation.  Ask the Americans what happens when procurement is guided by job creation pressures.  You end up getting more than you want and less than you need.  Congress often forces the U.S. military to buy equipment it does not want, because such programs employ Americans.  This makes it very, very hard to kill under-performing programs.  The advantage Canada has over the U.S. is party discipline, which means that prime ministers are not beholden to individual members of parliament as they shape defence procurement policy.  But once you really emphasize the job creation part of defence procurement, the more politicized subsequent decisions will be.  What makes sense for the Harper government in the short-term, winning in 2015, is going to be very damaging to Canadian politics and to defence contracting in the long run.  The procurement system is already broken—turning it into industrial policy will only make things worse.

All defence procurement decisions are, of course, political.  All government decisions are political.  But playing favorites in defence procurement now will give today’s winners more incentive to pressure tomorrow’s politicians, and today’s losers will have to up their game in trying to exert influence the next time. 

Coming back to the present day, this is the worst time to be engaging in industrial policy.  If there was flexibility in the budget, if the Canadian government was spending more money rather than cutting back, then the government could afford the luxury of buying Canadian.  But we live in a time of austerity (well, government-induced austerity), so the government wants to cut military spending.  Which means now is the time when the military can least afford procurement as industrial policy. 

Thus, while we often think of the military-industrial complex as a single entity pushing in the same direction, it is very clear why the Canadian Forces and Canadian defence contractors do not see eye to eye on spending defence dollars in Canada to subsidize some companies and win some votes.