Panel 3
The Effect of Offsets, Outsourcing, and Foreign Competition on Output and Employment in the U.S. Aerospace Industry

Robert E. Scott

Economic Policy Institute

Dr. Scott stated that, although his paper looks at the employment effects of offsets and other types of trade, his comments will focus on issues raised earlier during the symposium and on policy options for dealing with offsets and other factors affecting employment in the commercial sector.

He began by noting that the future of the industry may differ significantly from its past, particularly regarding employment. Over the past seven to eight years, the industry has gone through a massive downsizing driven by declines in defense expenditure. Offsets were a relatively small contributor to employment loss in the past, as pointed out by earlier speakers. Dr. Scott suggested, however, that as downsizing approaches its conclusion, trade in general, and offsets in particular, are likely to be bigger factors in employment loss in the future.

There has been a lack of concern by many analysts over the impact of trade on job loss in the aerospace industry. In part, this is based on the general presumption within the economics profession that over the long run trade will be balanced. The assumption is that if we do not sell aircraft, we will sell something else to the rest of the world. However, the U.S. has been running a sustained trade deficit for almost 20 years. In light of the developments in East Asia, trade deficits are likely to increase dramatically in the future, not decrease. One consequence of continuing trade deficits and increased competition, particularly with developing countries, is increasing downward pressure on wages. The loss of jobs in a high-wage sector such as aerospace is of particular concern, especially for labor unions.

Dr. Scott took exception to earlier statements that globalization has generated sustained levels of growth and higher levels of income. Production workers, who make up three-fourths of the labor force, have seen their real incomes fall



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--> Panel 3 The Effect of Offsets, Outsourcing, and Foreign Competition on Output and Employment in the U.S. Aerospace Industry Robert E. Scott Economic Policy Institute Dr. Scott stated that, although his paper looks at the employment effects of offsets and other types of trade, his comments will focus on issues raised earlier during the symposium and on policy options for dealing with offsets and other factors affecting employment in the commercial sector. He began by noting that the future of the industry may differ significantly from its past, particularly regarding employment. Over the past seven to eight years, the industry has gone through a massive downsizing driven by declines in defense expenditure. Offsets were a relatively small contributor to employment loss in the past, as pointed out by earlier speakers. Dr. Scott suggested, however, that as downsizing approaches its conclusion, trade in general, and offsets in particular, are likely to be bigger factors in employment loss in the future. There has been a lack of concern by many analysts over the impact of trade on job loss in the aerospace industry. In part, this is based on the general presumption within the economics profession that over the long run trade will be balanced. The assumption is that if we do not sell aircraft, we will sell something else to the rest of the world. However, the U.S. has been running a sustained trade deficit for almost 20 years. In light of the developments in East Asia, trade deficits are likely to increase dramatically in the future, not decrease. One consequence of continuing trade deficits and increased competition, particularly with developing countries, is increasing downward pressure on wages. The loss of jobs in a high-wage sector such as aerospace is of particular concern, especially for labor unions. Dr. Scott took exception to earlier statements that globalization has generated sustained levels of growth and higher levels of income. Production workers, who make up three-fourths of the labor force, have seen their real incomes fall

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--> substantially over the past 20 years. Income inequality has increased between production and non-production workers. Most economists believe that trade is responsible for at least 20-25 percent of this increasing gap between production and non-production workers' incomes. Thus, there is a significant question in the minds of production workers, who constitute the bulk of the work force and the electorate, as to the benefits of globalization. This is the reason for the growing public opposition to globalization, as expressed in the fast-track debate last fall and current debate over the International Monetary Fund (IMF). New Developments Dr. Scott pointed out that it is also important to look at how the Asian crisis will affect the economics and the politics of aerospace industry. There is some analysis that suggests that the U.S. trade deficit will grow from $200 billion today to $300 billion within the next 18-24 months. Dr. Scott's preliminary analysis is that this $100 billion increase in the trade deficit will result in the loss of approximately 1 million jobs, mainly concentrated in manufacturing. The total unemployment may not rise if the Federal Reserve lowers interest rates, but massive sectoral shifts in employment could still occur. The transportation sector, for example, is likely to lose 5-6 percent of current employment. The result will be a very different political environment. Already there has been a large number of cancellations of commercial aircraft orders. This will create something of a crisis within the aerospace industry, which may present an opportunity for some of the changes talked about during this symposium. Employment Impacts Turning specifically to the employment impacts of offsets, Dr. Scott pointed out that employment in aerospace peaked in 1989, as shown in Table 1 of his paper. Since that time employment has dropped from approximately 1.3 million workers to a low in 1995 of about 780,000 workers, before recovering in the past few years. Employment in civil aircraft followed the same general trend. The paper dissects that employment decline into three causes: a decline in sales, dominated by the declines in defense, but also in the commercial sector, which is responsible for approximately one-half of the job loss; outsourcing, meaning increasing imports of parts and components, which accounts for 6-10 percent of the job loss; and rapid productivity growth, which accounts for the remainder of the job loss. Thus, Dr. Scott agrees with the earlier analysis by Dr. Mowery that in the past offsets played a relatively small role in explaining the decline in employment. However, the coming two decades will see a sharply different environment. Defense spending is going to be, at best, constant. The commercial sector will

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--> grow in importance. Table 6 in his paper presents a revised version of the analysis of the future impact on unemployment of offsets presented earlier in Jobs on the Wing.5 The analysis breaks the causes of job loss into two factors. The first factor is offsets—where the effect is the loss of about 45,000 direct jobs by the year 2013. The second factor affecting employment in the industry is the continued loss of market share in the commercial sector to Airbus. Extrapolating the trend in the decline of Boeing's market share over the past decade or so, the projection is for a loss of approximately 77,000 direct jobs by 2013. Thus, the decline due to market share loss is twice as large as that due to offsets. The total job loss in the aerospace industry, therefore, is approximately 123,000. Indirect job loss in supplier sectors such as steel and rubber brings the total loss to over 200,000 jobs. This is a drop in employment in the total aerospace industry of roughly 15-20 percent. Because the losses will be concentrated in the civil aircraft sector with a current job base of about 300,000, this will have a significant impact on employment. Employment decline will also have a significant political impact. Current concern over globalization has been based on a loss of 2-3 percentage points in relative wages for production workers. Future job losses of this magnitude are likely to attract political attention, especially because the losses are in a high-technology, high-wage industry in which the United States should retain competitive advantage. Dr. Scott pointed out that he believes that these projections are conservative. For example, Airbus may gain market share even faster than assumed in the analysis, as shown in Figure 3 in his paper. Given that the industry is at great competitive risk, it is important to craft a coherent policy that goes beyond simply offsets. Although it may be difficult to negotiate a deal on offsets, it is clear that we are in a "prisoners' dilemma" with respect to subsidies. This raises the question as to whether we should consider applying an "inner-circle" approach to the commercial sector, as was suggested earlier for the military sector. This would mean looking for leverage points coming out of the crisis in the industry that will emerge in the next few years to negotiate a market share agreement with the European Union. Notwithstanding the negotiating difficulties referred to earlier by Dr. Robyn, Dr. Scott reiterated his recommendation from his paper for some form of bilateral agreement with the European Union to eliminate the use of offsets as a marketing tool, possibly as an extension of the Foreign Corrupt Practices Act. Dr. Scott concluded with the recommendation for continued dialog among industry, government, and labor as exemplified by this symposium, to build support for the development of a policy dealing with both offsets and the larger competitive threats to the aerospace industry. 5   R. Barber, and R. E. Scott, Jobs on the Wing: Trading Away the Future of the U.S. Aerospace Industry (Economic Policy Institute, Washington, D.C. 1995).

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--> Discussants Howard Rosen Joint Economic Committee Dr. Rosen began by stating that he agreed with the premise in Dr. Scott's paper as to the severity of the problem and the devastation caused by the economic dislocation. His comments, however, focused on two broader and possibly provocative points. The first is the fact that the economy has been going through significant structural changes in the past 25 years. It is therefore important to look at longer-term trends. The U.S. economy today is very different than it was 25 years ago—and changes in the industry need to be seen in that context. The second point concerns the importance of trying to quantify economic impacts. As someone who was previously involved in building models of employment effects, Dr. Rosen commended Dr. Scott's efforts at analysis. Especially important is the use of the analysis to understand the magnitude of the issue. However, he reminded participants that these numbers are the beginning of the discussion, not the end. He cautioned against crafting policy using numbers that may only be strong enough to disaggregate the causes of job loss and help understand what happened in the past, not necessarily predict what will happen in the future. He also expressed concern over the specificity of the numbers and suggested using percentages instead. Dr. Rosen went on to note that the trade debate over the past decade has tended to focus on two separate issues: free trade versus protection, and how to trade, for example, fair trade. Now comes the Asian crisis, which no one saw coming, that overwhelms all other issues. This shows that for too long we have been ignoring major changes in exchange rates and other factors, which have the possibility of overshadowing all other effects. Employment Policy, Not Offsets Seeking to broaden the discussion, Dr. Rosen suggested that the central issue is not offsets, but employment policy. He raised the question as to whether the United States is using its trade policy to create an employment policy. Looking back over the past few years, there seem to be two forces at work on the industry: the end of the Cold War and a dramatic increase in competition. Both of these are positive developments, even if some of their consequences are negative. Thus, it is important to think the issue through clearly. Dr. Rosen further commented that, although he appreciates the concern over the dislocation within the economy, he is concerned with the connotation that all unemployment is bad. As Dr. Scott's analysis shows, the employment effect of productivity gains—which is generally viewed as an economic positive—is double that of offsets. This suggests that the topic is more complicated than just the employment effects.

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--> He then raised the question of the importance of the aircraft industry. The answer, he suggested, is that the industry is big; however, the size can cause a distortion in the data. Other industries are being hit proportionately much harder. But because of the size of the aircraft industry, the aggregate numbers look much larger. Thus, the question must be asked as to what is the goal of policy: save an industry, regulate trade, or create an employment policy to improve living standards for all Americans? If the goal is raising living standards, it is not clear that focusing on offsets tells us how to do this. Interest rates, for example, have a larger impact on unemployment in the industry than do offsets. Policy makers, businessmen, and labor leaders need a broader perspective to incorporate these other factors, such as currency and exchange rate policy. He pointed out the core finding of Dr. Scott's paper that productivity gains contributed to most of the job loss and the declines in sales may reflect a positive development, namely the end of the Cold War. In addition, Dr. Rosen expressed concern about the focus in the paper on gross employment changes rather than net employment changes. The analysis should include job creation by exports and attempt to look at whether offsets contributed to those exports. The paper also needs to address the benefits of productivity to the industry. Dr. Rosen concluded by noting that the most important finding in the paper is that 62 percent of production is in the United States, yet 75 percent of the job loss is also in the United States. This suggests to him that the United States is absorbing more of the job loss than other countries. U.S. employment policy is to put adjustment costs on the backs of individuals. This calls for a serious policy response, similar to a pilot program that is being conducted in New Mexico to help coordinate economic development and assistance programs to meet specific local needs. Dr. Rosen complimented Dr. Robyn in her role in helping to bring about this innovative pilot program. Gordon Healey Defense Industry Offsets Association and Bell Helicopter Mr. Healey began by describing the Defense Industry Offset Association as an organization of 65 aerospace prime contractors who meet regularly to discuss and exchange information on offsets. He stressed that, in the defense industry, there is no such thing as a voluntary offset. There are offset agreements that may not be dictated by law or government regulation, but that are dictated by the competitive environment. Offsets are an inevitable part of marketing defense products overseas. Companies only have the option of either engaging in offsets or walking away from the deal. Concerning the employment impacts of offsets, Mr. Healey stressed the importance of offsets in maintaining jobs. Total sales of the industry are approxi-

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--> mately $130 billion-$80 billion domestic, $50 billion international. If the industry chose not to do offsets, that $50 billion in international sales would disappear. Those $50 billion in sales translates into approximately 300,000 jobs. As an element of the international marketing process, offsets are one of the greatest factors contributing to aerospace employment. Disagreeing with Dr. Scott's conclusion that offsets are an important threat to domestic production, Mr. Healey affirmed that offsets are in fact an important key to domestic production. As an inevitable part of the international sales process, offsets are a contributor to those 300,000 jobs. At this point, a question was raised by Brad Botwin, U.S. Commerce Department, concerning the data. Industry data supplied to the government show $3 billion in offsets, not the $1.5 billion shown on Mr. Healey's chart. Mr. Healey responded that in 1997 the industry did engage in approximately $3 billion in total offset agreements. Half of that, about $1.5 billion, were direct offsets in the aerospace sector. That translates into 10,000 jobs directly affected by offsets. Mr. Healey went on to stress that offset managers try very hard to mitigate the effects of offset requirements. Companies have many ways to minimize the impact of offsets on their work force and supplier base. These include negotiating down the percentage of the offset required; extending as far forward as possible the period of performance for the offset, obtaining the most favorable mechanism for offset credits in the contracts such as high multipliers, and ensuring the longest possible list of parties eligible to perform the offset. As noted above, multipliers inflate the actual value of offsets. For example, multipliers are offered as incentives by customer countries to place offset projects in certain areas. The value of the multiplier credit can be from two to ten times greater than the actual value of the work performed. Another mechanism to satisfy offset requirements includes sending personnel to the customer country to provide technical assistance and training. Such assistance is also often associated with multipliers. In addition, offset credits can be gained by offering assistance with financing and in marketing customer-country products in the United States. Joint ventures and investments in customer countries is another way of gaining offset credits, and they often show up as indirect offsets. In some cases, these arrangements can be very beneficial to other U.S. firms. Mr. Healey gave the example of one joint venture with a small U.S. firm with environmental technologies that helped that company expand into foreign markets. The defense contractor received offset credits for the amount of business done by that joint venture and for the investment made by the joint venture in the customer country. This form of indirect offsets is becoming more common.

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--> Policy Recommendations Mr. Healey concluded with a discussion of policy recommendations. He stressed the industry's belief that the United States must refrain from taking unilateral action on offsets. This would be tantamount to walking away from international sales. Second, the data collection process needs to be improved. Industry representatives have met with Commerce Department officials and have made suggestions on how to make these improvements. Third, multilateral discussions on the issue should continue. It is up to our trading partners to help restrain the use of offsets. Fourth, the dialog within the United States must continue so that all interested parties better understand one another. Finally, Mr. Healey reiterated the findings of earlier speakers that offsets are not the largest problem facing the industry, nor are offsets exporting large numbers of jobs. In today's competitive global market, companies simply cannot walk away from offset obligations. If there are problems with offsets, they should be fixed. But he urged that the issue be kept in context. General Discussion Page Hoeper, U.S. Department of Defense: Mr. Hoeper suggested that the demise of the defense industry may be overstated. He quoted from George Bernard Shaw's Major Barbara where the concern over the business impact of peace is answered when the armaments officer states, "Fear not, I have faith in human nature." General Discussion on Data: Mr. Shaw noted that the $1.5 billion used in Mr. Healey's presentation does not take into account offsets work in the pipeline, which would raise the figure considerably. Mr. Healey replied that this was simply offset performance in one year, and solely in the aerospace industry. Mr. Botwin observed that the $130 billion in Mr. Healey's presentation is total aerospace sales. Commerce Department's figures (and Mr. Healey's $1.5 billion figure) cover only defense offsets, with no data as to the size of offsets in the commercial sector. Using the Commerce Department's figures and excluding those defense sales with no offsets, offsets make up 80 percent of the value of the sales. A number of participants pointed out that this figure is for new agreements announced in 1997. Mr. Healey argued that this does not mean that 80 percent of the production is shipped overseas. The industry works hard to minimize the impact of offsets through a variety of ways. Companies try to create for the customer what to them has a certain level of value, but which actually costs the company only a fraction of that number. A number of participants questioned whether the 80 percent figure included the multipliers given by foreign governments when calculating offset credits. It was pointed out that $1.5 billion is the value that is actually being transferred due to the offset, which is only a fraction of the offset credit reported

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--> in dollars. The 80 percent figure uses the actual amount of offsets credited by the customer. It was suggested that this discussion illustrates why the data collection effort needs to be improved—and why the industry does not want to have the data released to other customers so that they can compare the multipliers. Data on offsets reported to the Commerce Department are offset credits as measured in dollars. Because of multipliers and other factors, these dollars do not represent the true impact of the offsets in United States, but represent the value to the customer. For example, $1 of production transferred overseas may earn $100 of offset credits from the customer. That does not mean that the cost to the United States was $100; the cost was only $1. In 1997, $15 billion in overseas defense sales was accompanied by $1.5 billion in offset credits; that is the value calculated by the customers of the fulfillment of the offset requirements. Mr. Healey again affirmed that many people are employed through the offset process—not in doing offsets but benefiting from the international sales that are made possible through this very small amount of offsets. John Tucker, Commerce Department, attempted one last bid to clarify the numbers. According to data given to the Commerce Department, offset transactions for fulfillment of previous agreements in 1996 were $2.9 billion, whereas the credit value was $3.1 billion. New agreements in 1996 were $3 billion in sales and $2.4 billion in offset agreements, which is about 80 percent. Lawrence Bertino, Boeing Space Systems, pointed out that the obligations for these new agreements are likely to be spread out over 10-15 years. Better Rules of the Game Robert Scott, Economic Policy Institute: Dr. Scott responded to earlier comments by stating that his numbers are not very far apart from those of other speakers. His estimate is that less than 10 percent of the job loss is due to offsets. Including commercial production with military production, and looking at U.S. production as opposed to world production, his figures are not that far apart from Mr. Healey's. The critical issue is whether offsets buy foreign sales. Industry representatives rightfully speak from the point of view of an individual company trying to make the sale. However, if the rules of the game could be changed to reduce the incentive to engage in offsets, then all firms would benefit. What is in the interest of any one producer in any individual transaction must be distinguished from how the market is performing. Policy must focus on how to change the rules of the game to improve the performance for both the firms and the country. John Sandford, Rolls-Royce, N.A.: Mr. Sandford commented that the model could be improved by looking at the impact of airline consolidation. Such consolidation may result in the emergence of buying groups that would have a greater ability to

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--> demand offsets. He also stated that the increasing need for access to capital will make it more difficult to distinguish what is an offset. Companies make arrangements with risk-sharing subcontractors to gain access to capital. That capital is needed not only because of the risk, but also because of the need to return value to the shareholder. In response to a question from Dr. Wessner as to whether all major players in the industry need to satisfy shareholders, Mr. Sandford stated that there was a large imbalance. It is mainly, but not exclusively, the American companies who have to satisfy short-term shareholders. It is his opinion that in today's environment, you could not launch a new engine program without significant risk capital from overseas. That capital would only flow for reasons of increased jobs.