Competing Explanations of U.S. Defense Industry Consolidation in the 1990s and Their Policy Implications

I. INTRODUCTION In this article, we test for structural breaks in U.S. defense industry and spending data over the last five decades. The defense industry data, which include various measures of market concentration, capture trends in consolidation; the spending data, defined broadly to include measures of contract awards, budget authority, and expenditures and investment, capture trends in market size. We identify structural breaks in those data and compare them to structural breaks found in data relating to the rest of the economy to address a lingering debate among defense analysts, policy practitioners, and executives as to the forces behind the consolidation of the defense industry in the 1990s. Was the consolidation the result of an explicit directive of the U.S. Department of Defense (DOD) or was it driven by the same forces that led to consolidation in many sectors of the U.S. economy in the 1990s? In an era in which concerns about the future of the defense industry are again prominent, the answer bears directly on whether and how the DOD might choose to engage as a policymaking and procuring agency. If broader economic forces drive industry behavior, the DOD may face limitations in promoting competition, spurring innovation, or otherwise shaping the defense industry. We interpret structural breaks in the data as indicative of changes in defense spending, the defense industry at large, and the broader economy, which, in the context of two stylized narratives, provides a statistical approach to explaining defense-industry consolidation. The first stylized narrative, representing what we refer to as the "DOD-policy-centric" view, describes the DOD as the primary engineer of defense industry consolidation in the 1990s. The defense budget had been declining steadily since the mid-1980s and the DOD was seeking to reduce excess capacity and check rising costs. In response, at a 1993 dinner now referred to as the "Last Supper," the DOD asserted its support for industry-wide consolidation [see Augustine (1997, 2006) for an eyewitness account]. The DOD backed its assertion by agreeing to reimburse firms for some merger-related costs and, later, through antitrust oversight [for discussions see Gholz and Sapolsky (1999-2000), Markusen and Costigan (1999), and Markusen (1997)]. Without explicitly denying the relevance of economy-wide factors, this narrative claims DOD policy as the dominant factor in the consolidation process. For example, the former chairman of the Lockheed Martin Corporation, Norman R. Augustine, characterizes the Last Supper as perhaps "the most critical moment in the defense industry's consolidation" (Augustine, 1997). His comments suggest that the defense industry was hesitant to consolidate, even when faced with a declining budget, without encouragement from its largest purchaser, the DOD. (1) In contrast, a stylized "economy-centric" view places economy-wide phenomenon at the center of a story in which the same forces that drove the large number of mergers in the rest of U.S. economy also drove the consolidation of the defense industry in the 1990s. Such forces included developments in capital markets, innovation in technology, and deregulation [see Holmstrom and Kaplan (2001) and Andrade, Mitchell, and Stafford (2001) for details on merger activity in the U.S. economy]. Although the economy-centric view does not dismiss the impact of the decline in the defense budget, or the response of the DOD to that decline, it suggests that other forces provide a more telling explanation of defense-industry consolidation. Hensel (2007), for example, offers evidence that defense industry mergers in the 1990s are more correlated with economy-wide mergers than with DOD spending [see also Flamm (1998) and Oden (1998) for relevant discussions of evidence that is supportive of an economy-wide perspective]. We use the methods of Bai and Perron (1998, 2003) to estimate structural breaks in data that measure defense industry consolidation, defense spending, and economy-wide trends. …