Let's say you sell cars. It's a competitive market. You could try to attract customers by offering the lowest prices and highest quality in town-but that cuts your profit margin. Instead, you offer gimmicks to persuade your customers that they're getting a good deal, even if they're not: CD players, perhaps, or fancy upholstery. You might throw in things that have nothing to do with cars, like microwave ovens or discount airline tickets.

Now imagine that you sell tanks and guns and airplanes and bombs instead of cars. How far would you be willing to go to sweeten your deals? Well, in 1987 (the last year for which data is publicly available) U.S. arms manufacturers included a total of $2.987 billion worth of giveaways-called "offsets" in arms business parlance-on $3.037 billion worth of weapons sales.

Offsets may seem like an esoteric topic, but they offer a glimpse into the real world of billion-dollar corporate and government deal making on the international arms market. Moreover, the effects of these little-known side deals on domestic employment, international relations, and national security are profound.

Arms sales offsets come in two basic varieties. "Direct" offsets transfer military technology, typically by granting a license to the recipient country to produce a U.S. weapon system or its components or subcomponents. "Indirect" offsets-called that because they aren't directly military-related-may involve counter-importing some random product into the arms-selling country, investing in the buying country, or transferring commercial technology.

The direct offsets that clinched the $5.2 billion Korean Fighter Program (KFP) deal of 1991 are increasingly typical. South Korea bought 12 off-the-shelf F-16C/D fighters from General Dynamics (which was subsequently purchased by Lockheed) as well as 36 aircraft kits to be assembled in Korea. But South Korea wants to produce an indigenous fighter aircraft, and it held out for the right to manufacture an additional 72 F-16s under license (see "A License to Steal Jobs," page 32). Korean Air Lines and Daewoo Heavy Industries had already produced some F-16 parts, and Samsung Aerospace produced parts for the F/A-18 fighter. But that manufacturing capability was nothing "compared to the level of manufacture and production line management contemplated under the KFP," according to the General Amounting Of fire (GAO). On top of the transfer of manufacturing and assembly know-how, Korea received ~-30 percent of the contract value-more than $1.5 billion-in undisclosed indirect offsets.

Indirect offsets may be what Rep. Ron Wyden, an Oregon Democrat, had in mind when he called some deals "just bizarre" during a 1985 Congressional hearing. In order to clinch a $1.8 billion sale of F/A-18 fighters to Spain in 1982, McDonnell Douglas Corporation offered $1.5 billion in offsets. The aerospace company agreed to market a wide range of Spanish products in the United States, including steel coils, chemicals, sunflower seed oil, sailboats, paper products, zinc, and marble. The corporation helped publish and distribute a picture book on Spanish lifestyles designed to promote U.S. tourism in Spain. And in perhaps one of the oddest offsets ever recorded, McDonnell Douglas helped establish a Domino's Pizza franchise in Barcelona.

Offsets in Military Exports, a 1990 report by the Office of Management and Budget (OMB), said, "It is hard to conceive . . . a U.S. corporation that is an efficient producer of aircraft or aircraft engines being equally efficient in the selling of furniture, shoes, tourist packages, or education and training ser. vines."

Congress and the executive branch both recognize that offsets are mostly and that they subsidize foreign competition with U.S. manufacturers. Yet the government permits and even promotes such deals because, as Undersecretary of State Lynn Davis said in the summer of 1993, "the demand for offsets is growing, smith practically every arms purchaser demanding some form of offset." Industry, for its part, dislikes having to provide production technology offsets that may come back to haunt future balance sheets, but it feels trapped by the current system. If one company won't provide the technology transfer, another one will-and it will get the sale.

The U.S. government's longstanding policy of promoting, or at least ignoring, offsets was born out of a Cold War desire to build up allied industry. With economic competitiveness one of the Clinton administration's stated foreign policy priorities--and with the Pentagon citing regional instability and militarism as a primary threat to U.S. interests--it's time to east a cold eye on offset policies.

More, more, more

In the 1950s, in addition to supplying the European and Japanese militaries with U.S. equipment, the United States started to rebuild its allies' arms industries through licensed production and co-development of weapons systems. In the 1970s, as the allies began to shoulder more of the cost, they began to exact a fee for access to their markets. Offset agreements allowed buyers to tell their citizens about all the non-defense perks they got when they purchased weapons from abroad: new technologies, jobs, investment, a foothold in a new market. Camouflaging top-dollar weapons purchases with side deals "makers] the monetary outlays on military equipment appear lower than they actually are and therefore more acceptable to both politicians and the public," according to the OMB.

Prime contractors have been willing to play along. With offset agreements, their products can be sold at high prices. The real losers are the subcontractors who lose business to producers in recipient countries, and companies in unrelated industries who must compete with the foreign items defense contractors agree to sell in the United States.

In the late 1970s and 1980s, many developing nations began to follow the industrialized countries' lead and routinely require that some raw percentage of their arms purchase be reinvested in their own economies through offsets. Some congressional observers describe today's offsets as a massive foreign aid program being run by defense contractors. Kuwait, Saudi Arabia, South Korea, and Turkey, to name a few, have established offset "guidelines" for arms imports. As American and other developed nations' weapons industries vie for sales, countries that were once grateful for the opportunity to buy sophisticated weapons are now demanding offsets as well.

The Taiwanese legislature, for example, retroactively demanded Taiwan's first-ever offset from a U.S. firm in exchange for buying 150 F-16 combat aircraft in September 1992. After the U.S. and Taiwanese governments completed the $6 billion deal, the Taiwanese legislature blocked payments until the plane's manufacture, Lockheed, gave Taiwan technology and production contracts related to the aircraft. In July 1993, Lockheed signed a 10 year "Industrial Cooperation Agreement" worth $1.1 billion. It guarantees that some F-16 parts will be made in Taiwan and creates depot maintenance centers there.

U.S. manufacturers engage in offset bidding wars with each other and with European competitors. This past January, Israel finalized a $2 billion purchase of combat aircraft. Two U.S. arms manufacturing giants-McDonnell Douglas and Lockheed-fought fiercely for the deal, each trying to outbid the other in terms of price, technology, and offset packages. To cinch the sale, McDonnell Douglas agreed to offsets that may total 100 percent of the sale's value. Israel will "pay" for the 20-25 F-15Es with U.S. military aid, which is restricted to purchases from the United States. In this way, U.S. taxpayers will have paid for the McDonnell Douglas sale twice: first with taxes and then with lost jobs.

In a June 1994 report requested by Cong. Cardiss Collins, the GAO found that U.S. defense contractors undertook $4.7 billion worth of offsets on $11.G billion of arms exports paid for with military aid.

On some occasions, the value of offset agreements exceeds the value of the weapons sold. The $2.3 billion sale of F/A-18 fighters to Canada in 1982, for instance, included offsets that could total 150 percent of the contract value, according to the OMB. Brazil, France, Luxembourg, and Spain also receive 100 percent or greater offset obligations on U.S. arms sales during 1980-87.

Laissez-faire policy

Since they generally involve the transfer of military capabilities, direct offsets by U.S. vendors must be approved by-and usually are negotiated by--government official. Sometimes Congress is notified, if a deal exceeds a certain amount of money. Indigent offsets, however, are not enrolled or even routinely monitored. As a matter of policy--enumerated by President George Bush in April 1990--the government leaves these deals entirely up to industry's judgment.

The Clinton administration has continued the Bush policy. "We view decisions regarding offsets as matters best left to U.S. industry to negotiate and implement as part of their ongoing business activities," said then-Deputy Secretary of Defense William Perry in an April 15, 1993, letter to Sen. Russell Feingold, a Wisconsin Democrat. "The principal objective of the current policy is to give U.S. companies the flexibility to structure an arrangements that allow them to compete effectively for foreign sales. If U.S. defense manufacturers were unable to provide offsets, foreign government would often be unable to raise domestic political support for defense purchases from the U.S., and U.S. industry would lose sales to foreign competitors willing to provide offsets."

Every now and then Congress get upset about the damaging effect of offsets on the economy, generating what limited information and government oversight does exist. At Congress's direction, the government surveyed the U.S. arms industry's offset commitments in 1985 and again in 1987. The 1988 data shows that for 1980-87, nearly $35 billion in arms exports entailed $20.1 billion in offset obligations. If Under Secretary Davis's assertion that offsets are increasing is true, that they probably now amount for more than 60 percent of total arms sales contracts. It's impossible to know for sure, because the data does not exist.

Protected from the public eye

Congress decided in 1989 that the government should regularly collect information on indigent offsets. The National Defense Authorization Act mandated that contractors notify the Pentagon of indigent offsets exceeding $50 million. But more than two years later, the Pentagon had not yet implemented the requirement and had received only three voluntary notifications from industry. As an excuse, the Pentagon claimed that new reporting requirements then being pursued in Congress would displace the Defense Department one.

The Defense Production Act Amendments of 1992, signed into law that October, said that any firm offering $5 million or more in indigent offsets on an arms sale must notify the Commerce Department. Two years later, Commerce is still waiting for an executive order to implement the reporting requirement. Guidelines on what information is required or how it is to be reported were finally drafted and published for comment in April 1994.

Although the 1992 law was not fully fleshed out, it was clear on one point regarding offsets: "Such regulations shall provide protection from public disclosure for such information, unless public disclosure is subsequently specifically authorized by the firms furnishing the information." Even with that secrecy provision, industry representatives-prime contractors, anyway-fiercely oppose the law on the grounds that "confidential business information" will be disclosed. Industry lobbyists argue that if country X sees that country Y got a better deal, then country X will up its offset demands. But purchasing countries usually disclose what parentage of a contract they require in offsets, and this information by itself has not stimulated rising demands. Moreover, the whole point of offsets-from a foreign government's perspective-requires spilling the beans in some detail. How else would the public know what a great buy its leaders got? In fact, this is currently the only source of public information on specific offset deals.

Industry is probably more concerned that notification will lead to regulation. "No one believes this is just notification," groused an unidentified industry source to Inside the Pentagon, a military trade paper (March 16, 1990). "Once the offset is reported, they're going to want to know much more. It will be notification and justification." And industry certainly doesn't want to have to justify its actions. "Those things need to be business deals among businessmen.... Government has no business overseeing offsets," said James MeInerney, Jr., then executive vine president of the American League for Exporting Security Assistance, at a government-industry conference in 1991.

Senator Feingold didn't like the amount of secrecy surrounding offset deals, so he sponsored a "real time" notification provision in this year's State Department Authorization Act. In April, the provision-Public Law 103- 5 236-passed. It requires companies to tell Congress if any indigent offset agreements are being negotiated as part of the sale of | weapons or services subject to congressional approval. Specific information on offsets can now be requested along with the notifications required under the Arms Export Control Act, which provides Congress with 30 days in most eases to consider a pending sale. Unfortunately, even with this step forward, information on offsets will not be released to the public.

Smoke and mirrors

Feingold became interested in offsets when a Wisconsin heavy machine manufacturer nearly lost a contract for paper-making equipment in an offset connected to the 1992 sale of F/A-18 fighters to Finland. Northrop Corporation, a subcontractor who would benefit from the fighter deal, offered an "incentive payment" to a U.S. firm to purchase a paper-making machine from Valet Corporation, a Finnish company.

If U.S. workers realized that U.S. arms firms were underwriting their foreign competition, public opposition to arms sales would boom. In 1990 the Office of Management and Budget studied F/A-18 aircraft sales to Australia, Canada, and Spain to assess the economic impacts of both direct and indigent offsets. "Certainly, a substantial short term gain in business was achieved through direct offsets.... Canadian firms were particularly successful in turning what was originally offset work into long term business opportunities," the OMB concluded. "The total impact that offsets have on U.S. industry is complex and intertwined with other economic factors. However, it appears that offsets have contributed to the strengthening of foreign competitors in Australia, Canada, and Spain."

Industry lobbyists contend that offsets are essential to making foreign sales, and they have masterfully argued that arms exports support U.S. jobs and the defense industrial base. The arms-sales-for jobs frenzy peaked in 1992, when McDonnell Douglas claimed that if the United States did not sell 72 F-15E fighter-bombers to Saudi Arabia, 40,000 jobs would be lost. The highly controversial sale was pushed through Congress largely on the strength of this claim. McDonnell Douglas did not advertise the fact that Saudi Arabia requires a 30 percent offset on all major contracts. Accordingly, the U.S. economy lost $2.7 billion of business that was channeled to Saudi workers and the Saudi economy.

Providing that Congress oversees it-and this is far from assured-real-time reporting of offsets would help torpedo false or exaggerated claims of employment benefits. "Foreign military sales are often justified on the basis of the employment produced for the defense industry by such sales," said Feingold in a July 1993 fact sheet on his proposed amendment. "If, however, such sales are accompanied by offset agreements that result in the loss of American jobs and business in defense and other sectors, that information ought to be made available to Congress at the time the sale is being considered." But if workers and subcontractors who stand to lose are not alerted of offsets before arms sales are finalized, the deck remains stacked in the contractors' favor.

Exporting military know-how

Industrially advance countries prefer technology transfers to indirect offsets. Arms sales are now routinely accompanied by arrangements for foreign buyers to produce weapon systems or their components. If a buyer cannot rope with technology transfer, a service and maintenance depot for the weapon system might be established.

Currently, U.S. law actually encourages the transfer of production technology to NATO and "major non-NATO allies." This law treats the transfer of technology no differently than the sale of armaments, merely requiring that Congress be notified of contracts worth $14 million or more. Congress is then given 30 days within which to contest the arrangement (15 days for NATO members).

The result is a different kind of proliferation-proliferation of military-industrial complexes around the world. In the 1950s, only five developing countries made small arms, ammunition, or major military equipment (aircraft, armored vehicles, missiles, or naval craft). By the early 1980s this number had skyrocketed to 54, with 36 countries producing major military equipment. The developing countries of Brazil, India, Israel, Singapore, South Africa, South Korea, Taiwan, and Turkey all have a significant arms industry today.

In 1991 the Congressional Of See of Technology Assessment (ETA) chronicled this co-production phenomenon in a seminal study, Global Arms Trade. "In 1988 the United States was engaged in transferring the production technology for approximately 70 major weapons systems to foreign countries, about the same number as its NATO allies and the former Soviet Union combined," the report noted. Even top-of-the-line equipment-U.S. MlA1 tanks, Russian MiG-31 fighters, and advance French, Dutch, British, and Swedish diesel submarines-are now licensed for production. In fact, U.S. licensing has, over the past two decades, "contributed to the emergence of new centers of advance defense industry and technology, first in Europe, next in the Western Pacific, and increasingly in developing nations around the globe," the OTA testified in June 1993.

Glenn Rudd, deputy director of the Defense Security Assistance Agency (DSAA)-the Pentagon's sales department-defended the direct offset policy in a 1989 House Armed Services Committee hearing. "Selective use of co-production has facilitated the achievement of U.S. goals of enhanced cooperative defense," he said. "It's helped to rebuild NATO and Japan.... It has helped standardization of equipment with friends and allies and promoted regional stability through the improvement of industrial capabilities of certain countries."

But co-production isn't a free ride. There's the cost of building the necessary infrastructure, as well as licensing, royalty, and technical assistance fees. Licensed production or co-production costs the buyer more than weapons bought off the shelf-but the ability to manufacture high-tech weapons is alluring. To recoup their investment costs and to reduce the unit cost, the buyer frequently seeks to market the weapon, undercutting the U.S. firm from which it was originally purchased-as well as undermining the interests of the selling government.

The decision to help establish a new military industry in another country is strictly a business decision. Little attention is paid to national security, although arms exports by U.S. allies are increasingly viewed as a security threat. The chief of Naval Intelligence, Rear Adm. Edward Sheafer, Jr., testified before Congress in February 1992 that "Western Europe, our closest military partner and one of our largest economic partners, poses no military threat to the United States except through export of arms that are roughly equal to ours in overall lethality and technical sophistication."

Arms control implications

The burgeoning number of arms suppliers profoundly complicates efforts to limit international arms transfers through negotiations or embargoes. A frequent justification for U.S. arms transfers has been that, by withholding parts, servicing, or ammunition, the United States can control the recipients' use of the weaponry.

However, the increasing number of licensed suppliers of weapons and components has eroded any such leverage. Sixteen countries, for example, now assemble or produce parts for F-16 fighters. It was no surprise when the Pakistani defense minister said in February 1993 that, although the U.S. government had cut off sales of spare parts for Pakistan's F16s (because of concerns about Pakistan's nuclear weapons program), "no plane has been grounded." Pakistan, he said, was "acquiring necessary spare parts from the open market," though they were quite expensive. (Pakistan even acquired spares directly from U.S. manufacturer.)

Perhaps the most important security implication of co-production deals is the irrevocable transfer of industrial technology and manufacturing know-how needed not only for conventional weapons production, but also for the possible development of long-range missiles and weapons of mass destruction. U.S. sales of production technology to the Shah formed the basis of Iran's current military industry, and licensed production from the Soviet Union, China, Brazil, and others provided the foundation of Iraq's weapons industry.

Violations common

U.S. co-production contracts usually limit production levels and prohibit sales or transfers to third countries without U.S. government consent. But overproduction and illegal transfer is common.

Japan Aviation Electronics Industry (JAR) was fined $10 million in 1992 for illegally selling weapons components produced under a U.S. license. JAE was authorized to manufacture gyroscopes and accelerometers for the Japanese military's F-4 fighter jets, but from 1984 to 1987 JAE transferred more than $7 million of the navigational components to Iran-in defiance of the U.S. policy prohibiting arms sales to that country.

In 1988 the GAO disclosed that South Korea had violated the terms of a license for the manufacture of M-16A1 submachine guns, producing many more than they were supposed to and exporting them without U.S. approval. The State Department classified the names of the recipients, but Tong. Larry Hopkins, a Kentucky Republican, disclosed that they were "hostile countries." The Pentagon maintained it had been unaware of any violation. The DSAA's Glenn Rudd claims that the K-2 rifle is a "Koreanized" version of the M-16, "different enough according to our Army people that it could not be considered the same rifle."

"Indigenous" production is often based on licensed designs. Allegations have long persisted that Israeli arms manufacturers have illegally incorporated U.S. designs and technology into their weapons and exported them to countries the United States would not sell to for human rights or foreign policy reasons, such as China, South Asia, Chile, and Ethiopia.

In a 1989 report, the GAO examined 18 co-production programs and found at least five eases of unauthorized transfers. In addition, the GAO examined five programs that were supposed to have closed down. Four continued some production.

These examples and others illustrate a lack of enforcement of licensing terms. The Defense Department is responsible for negotiating most major co-production agreements and managing their implementation, although military technology transfers are licensed under the State Department's Direct Commercial Sales program as well. The State Department is responsible for oversight of resale of U.S. supplied defense equipment, including all co-production output, and for resolving issues of non-complacence.

However, former congressman Nicholas Mavroules stated at a 1989 House Armed Services Committee hearing that "there is virtually no ability of our government to monitor or enforce compliance." At the same hearing, the GAO reported that "with few exceptions, no co-production programs were directly monitored to ensure compliance."

Time for a change

After World War II, liberal co-production and licensed production of weapons was justified in order to rebuild the European arms industry and standardize allied forces. But today the United States is rightfully more worried about regional instability than the spread of communism. Co-production deals spread not only weapons, but weapon-makers. Creating new sources of competition simply insures that there will be less and less discriminate sales in the future.

Indirect offsets are just as damaging. By assisting foreign industries with commercial technology and giving them access to the U.S. market, indirect offsets export jobs. In effect, U.S. arms firms are subsidizing foreign competitors, both military and commercial.

It's impossible to calculate how much total economic damage has been caused by offsets. But you can be sure that the lack of data is intentional.

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Sidebar: A License to Steal Jobs

When Congress was considering the Korean Fighter Program in August 1991, the GAO was unable to calculate whether the sale would mean more or fewer U.S. jobs. U.S. production would be limited, and South Korea would manufacture most of the the airframe for 72 of 120 aircraft. Of the remaining 48 planes, European partners in the F-16 program were entitled to a 15 percent work-share from a previous offset. Only 12 planes were to be wholly U.S.-made; the other 36 would be exported in kits to be assembled in Korea.

On June 25, 1992, thousands of F-16 production line workers gathered at the gates of General Dynamics' Fort Worth, Texas factory for a "Fairness Rally" to protest the deal. George Kourpias, international president of the Machinists and Aerospace Workers union, told them, "GD originally wanted to bring 500 Korean workers here.... Our union put a stop to that scheme. At least for now. But the state of mind of the company hs not changed. They still see no merit in working with us to convert to become a part of the post-Cold War era.

"Right here in Fort Worth, 3,000 of our brothers and sisters have been laid off in the past two years.... This week, another 500.... And the company wanted those of you left to teach Koreans how to do your jobs." The Samsung Aerospace workeres were later trained in Turkey, where General Dynamics has another F-16 co-production facility.

Members of Congress had pushed for South Korea to purchase planes manufactured in the United States. Cong. Richard Gephardt, a Missouri Democrat, said, "General Dynamics, not unlike McDonnell Douglas in my district, has had to ... lay off a large number of U.S. workers in the past year. These workers are capable of manufacturing a majority of the parts to be used in the F-16 and the KFP, and they should be re-employed for this purpose."