Are defense offsets economically efficient?

Defense offsets refer to a wide range of industrial and commercial benefits often demanded by the nation’s government from a foreign defense contactor as a condition of purchase of military goods or services by that government from that defense contractor (Defense Offsets Disclosure Act of 1999).

Offset transactions are classified into two types: direct and indirect. Direct offsets include those industrial and commercial benefits directly related to the military goods or services the purchaser is buying. One example, which falls into the category of Co-production, is when the purchasing government chooses one or more of its local companies to manufacture some components of the purchased equipment (Brauer, J. & Dunne, J. P., 2005). On the other hand, indirect offsets are those industrial and commercial benefits, to the purchasing country, which are not related to the military goods or services that country is buying; hence they can be either of military or civilian type (Brauer, J. & Dunne, J. P., 2005). One example of indirect offsets, which happens to fall into the category of Overseas Investment, is when the defense contractor makes investments into one or more (defense or non-defense) companies within the purchasing country.

As alluded to in the examples for direct and indirect offsets, offset transactions can also be split into various categories, which give a more specific description of the involved arrangement or exchange. These categories include Purchases, Technology Transfers, Training, Co-production, Licensed Production, Subcontracts, Overseas Investment, and Credit Assistance (Offsets in Defense Trade, 2007, 2-3).

As far as the efficiency of defense offsets goes, it appears that there is a consensus in the academic community that offsets are inefficient. According to some, the damage from defense offsets to the national security of exporting nations, together with weak security oversights, is underestimated, severe, and increasing (Report of the Interagency Team on Consultation with Foreign Nations on Limiting the Adverse Effects of Offsets in Defense Procurement, 2006, appx. A). Offsets redistribute component production away from top producers to less efficient producers in other countries, and thus enhance trade-distorting international patterns of production. Offsets, also, undermine the world security and the national security of exporting nations by increase the possibility for leakage of information regarding the design and production of leading edge weapons (Report of the Interagency Team on Consultation with Foreign Nations on Limiting the Adverse Effects of Offsets in Defense Procurement, 2006, appx. A).

Offsets create distortions in the structure of firms and industries, while also distorting the composition of national spending in the buying and selling countries. Also, as already suggested, the long term effects of offsets that fall into the Technology Transfer category are particularly damaging (Report of the Interagency Team on Consultation with Foreign Nations on Limiting the Adverse Effects of Offsets in Defense Procurement, 2007, appx. A). Aside from damaging the exporting nation in a number of, already mentioned, ways; in some cases Technology Transfers lead to commercial disasters for their recipients. In other cases, the recipients stop producing soon after the end of the immediate technology transfer arrangements, citing lack of customers as the main reason (Report of the Interagency Team on Consultation with Foreign Nations on Limiting the Adverse Effects of Offsets in Defense Procurement, 2006, appx. A).

Offsets, like other forms of “countertrade,” are economically inefficient and trade distorting; in many ways because they substitute various forms of barter for monetary transactions. They undermine free world trade by introducing market rigidities, causing growing state intervention, and by perverting production effects. An example of the latter is when offsets lead to the financing of costly infrastructure for short production runs (Report of the Interagency Team on Consultation with Foreign Nations on Limiting the Adverse Effects of Offsets in Defense Procurement, 2006, appx. A). In a more specific case, the defense offsets demanded by Belgium, from foreign defense contractors, undermined the capacity of Belgian defense firms for international cooperation, and made them vulnerable to structural changes in the international defense industry, and overall, have been negative for the country (Report of the Interagency Team on Consultation with Foreign Nations on Limiting the Adverse Effects of Offsets in Defense Procurement, 2006, appx. A).

The capacity of defense contractors to win future business can be undermined by outstanding offset obligations that they carry. Moreover, offsets may force defense contractors to resort to sub-optimal, hasty solutions in fulfilling their offset requirements, because the latter are beginning to include deadlines, time penalties, and contractual liabilities (Report of the Interagency Team on Consultation with Foreign Nations on Limiting the Adverse Effects of Offsets in Defense Procurement, 2006, appx. A).

References

Brauer, J. and Dunne, J. P. (2005). Arms Trade Offsets and Development. Retrieved from http://carecon.org.uk/DPs/0504.pdf.

Defense Offsets Disclosure Act of 1999, Pub. L. 106-113, section 1243 (3).

Offsets in Defense Trade: Eleventh Report to Congress. (2007). U.S. Department of Commerce, Bureau of Industry and Security. Retrieved from https://www.bis.doc.gov/index.php/forms-documents/doc_view/258-eleventh-report-to-congress-2-07

Report of the Interagency Team on Consultation with Foreign Nations on Limiting the Adverse Effects of Offsets in Defense Procurement. (2006). In Offsets in Defense Trade: Eleventh Report to Congress (appx. H). (2007). U.S. Department of Commerce, Bureau of Industry and Security. Retrieved from https://www.bis.doc.gov/index.php/forms-documents/doc_view/258-eleventh-report-to-congress-2-07