America’s First Dual-Use Technology (Part II)
The Real Origin Story of the Modern Military-Industrial Complex
This is Part II of a two-part series on America’s First Dual-Use Technology: aircrafts. Part I explored the government’s disastrous policy of separately competing design and manufacturing contracts and how this birthed the myth of the fungible engineer. Part II explores Congress’s decision to paint industry as Merchants of Death, and how this formed the foundation for the DoD’s counterproductive fixation on profit margins.
1934 was a bad year to be an aviation executive. Industry leaders were hauled before Congress multiple times to stand trial as Big Business villains and Merchants of Death. William Boeing was banned from the industry. New legislation capped aircraft manufacturers’ profits at 10 percent.
First, it’s worth understanding the atmosphere that enabled these events. Against the backdrop of the Great Depression, agrarian populism, and war clouds in Europe, Congress campaigns to prove industry incited World War I and is on track to start World War II. Supported by FDR, Senator Gerald Nye (R-ND) launches the Special Committee on Investigation of the Munitions Industry, informally known as the Nye Committee, whose ambitions are nothing short of nationalization of the entire defense industry. Underpinning the Senate investigation is the Marxian question, “Should industry be allowed to profit when providing goods and services to the government?”
Senator Nye’s hearings lasted from 1934 to 1936. The most famous hearings see the Du Pont brothers on trial for “excess profits” – their company supplied 40% of the gun powder used by the Allies – and J.P. Morgan on trial for advocating for U.S. entry into the war so banks could be made whole on their massive loans to the Allies. The hearings produce thousands of pages of reports but fall short of producing evidence that a conspiracy among arms makers and their financiers fomented World War I. The Nye Committee’s final report weakly concludes:
While the evidence before this committee does not show that wars have been started solely because of the activities of munitions makers and their agents, it is also true that wars rarely have one single cause, and the committee finds it to be against the peace of the world for selfishly interested organizations to be left free to goad and frighten nations into military activity.
The hearings lead to no new legislation and fail in their goals to nationalize industry. In other words, they’re a waste of time and taxpayer money.
Alger Hiss is the assistant counsel to Senator Nye for the hearings. Hiss is notorious for a 1950 perjury conviction in connection with accusations of Soviet espionage in the 1930s, but I think Hiss – in partnership with Nye – engaged in an equally treasonous activity in plain sight. If I wanted to neuter America, it’s hard to think of what would be more effective than launching a campaign to nationalize the most productive sectors of its economy. It’s always difficult to speculate on the counterfactual, but I feel good making the statement that had the Nye Committee succeeded, there would have been no arsenal of democracy and no Freedom’s Forge to speak of. We’d be speaking German, as the saying goes.
The sensationalist but influential book Merchants of Death (Engelbrecht and Hanighen, 1934) fans the flames of the Nye Committee with quotes like “On April 6, 1917, the U.S. entered the conflict and the heart beats of the war traffickers became normal again (Engelbrecht et al., 176).” The authors engage in intellectually lazy arguments, regurgitating the financials of the successful “arms dealers” and expecting the reader to accept the conclusion that profiteering (i.e., corporate prosperity) is equivalent to at best, greed, and at worst, moral bankruptcy.
“The profits reported were simply colossal. Du Pont paid a dividend of 100 percent on its common stock in 1916. The earnings of the United States Steel Corporation for 1917 exceeded by many millions the face value of its common stock, which was largely water. In 1916, this same company reported earnings greater by $470,000,000 than the combined earnings of 1911, 1912, and 1913. Bethlehem Steel paid a stock dividend of 200 percent in 1917…. Winchester Repeating Arms Company, manufacturer of rifles, bayonets, and ammunition, could hardly complain of bad business. During the war period it sold almost 2,000,000,000 separate units (ibid., 178, 180).”
“A few years later a Congressional Committee showed that the government had paid about 49 cents a pound for powder while the cost of production was estimated at 36 cents. No wonder Du Pont stock increased 5,000 percent in the war period (ibid., 180).”
Missing from the above is any acknowledgement that services were rendered. Products were sold. A war was fought and won. While the terminology “Merchants of Death,” and the push to nationalize industries may be outdated, the ideology is not. If you squint, cost-regulated margins ensure our defense primes are functionally state-owned enterprises. A continued aversion to awarding contracts to firms with high profit margins serves as an effective barrier to entry to innovative companies capable of delivering a superior product at a lower price point.
Aviation on Trial
Unlike Du Pont, aircraft manufacturers were not awash in “excess profits” during World War I, and their business fundamentals remained poor throughout the 1930s. Nonetheless, in 1934 they’re subjected to several high profile Congressional hearings, including the Nye Committee. The industry drew the short straw of Girardian scapegoat largely thanks to the stock market boom.
From 1926-1929, the public invested $300 million in aviation stocks. “By March 1929, aircraft, air transport, and related stocks… represented 11.2 percent of all new corporate issues to that point in the Wall Street Boom (Vander Meulen, 92).” This capital buoyed the industry through the Depression years when the government was barely buying aircraft, and the promise of the commercial market remained unfulfilled. It also allowed the government to continue to buy aircraft below cost despite its ongoing and destructive policy of not recognizing the design rights of manufacturers (described in Part I). But this influx of private capital also put a target on the aviation industry. Already wealthy individuals like William Boeing unapologetically grew richer, and they lacked the savviness of Salesforce’s Marc Benioff to wage a public relations campaign that would convince the public they were but a simple billionaire-turned-socialist.
Boeing in particular paid for his shortsightedness. In partnership with Pratt & Whitney president Fred Rentscheler, he formed United Aircraft and Transport (UATC) in 1929, a holding company that pursued a vertically integrated strategy by acquiring airlines and military aircraft manufacturers. UATC won an airmail contract with the Post Office to exclusively serve the northern airmail route. This contract was distributed in 1930 by Postmaster Brown at what was later deemed the “Spoils Conference,” so called because Brown divided up the country into three airmail routes and directly awarded the contracts to the largest airlines in an attempt to impose efficiencies and force the smaller airlines to merge with the larger.
The distribution of lucrative contracts to only the largest airlines was considered corrupt and drew the ire of President Roosevelt in 1934. He abruptly canceled private airmail contracts, turning the mission over to the Army Air Corps. But the Army wasn’t prepared to absorb the responsibility. Ten pilots died in two weeks, creating a scandal for FDR that was much worse than the Spoils Conference. In the ultimate irony, the airmail routes were quickly re-privatized, and the contracts were redistributed in an almost identical way to the Spoils Conference. Of the three companies, everyone is re-awarded their route except UATC.
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Although the government was the monopsonistic buyer of airmail contracts, the blame for the Spoils Conference is laid largely at the feet of industry. The subsequent Air Mail Act of 1934 forbids aircraft manufacturers from also operating airlines, which forces UATC to break up into United Air Lines, Boeing, and United Aircraft Manufacturing. Airline executives alleged to have colluded in monopolistic practices are banned from working for airlines. In response, Boeing exits aviation entirely, sells all stock in his companies, and takes an early retirement to his horse farm.
Overlapping with these events are the aircraft industry’s first public Congressional hearings. In addition to the Wall Street Boom, news that engine manufacturers like Liberty had made 45 percent profit provided the perfect impetus to flagellate aircraft manufacturers. Comedy ensued. In the 1934 hearings, Congress went in with an agenda to show how rich industry was getting, but aviation – specifically airframe manufacture – was generally a terrible business to be in (engine manufacture was more profitable because those producers were allowed to keep the rights to their proprietary designs). As one anonymous Navy financial analyst put it – and this was after WWII, when business had done well – “no business man in his right mind, with a free choice, would make a career of aircraft manufacture (Vander Meulen, 192).”
The Navy, to its credit, at least had the self-awareness to recognize it was exploiting industry and wanted to continue to be able to do so. In response to Congress’s questioning about excess profits, Admiral King, the new Chief of the Bureau of Aeronautics following Admiral Moffett’s untimely death in an airship crash, proudly educated Congress that Navy audits revealed “industry averaged only 4.3 percent returns on its total naval business and that many contractors, particularly airframe manufacturers, regularly absorbed substantial losses (ibid., 135).” He opposed nationalizing aircraft manufacture at the Naval Aircraft Factory because “contractors always bear the losses,” and “the navy would always be able to take advantage of aircraft manufacturers who had an endless supply of motivation to build aircraft (ibid., 106, 136).”
Navy Secretary H.L. Roosevelt amplified this point by explaining the government was getting the best of both worlds: it did not have to provide any “tangible consideration” to the aircraft manufacturer, but it received the full benefits of the latest innovations in private design. “Without further compensation to the designer, [the government] has the right to make, to have made for its use, and to use any number of aircraft embodying the design (ibid., 136).” The Nye Committee rounded out the proceedings a few months later with a special emphasis on linking aircraft exports with war fever – never mind that the European export market in large part kept the aircraft manufacturers alive during the 1930s.
Unfortunately for industry, the 1934 hearings were not the nadir of their suffering. An inability to prove aircraft manufacturers were Merchants of Death did not prevent passage of the 1934 Vinson-Trammel Act, which exacerbated the already punitive legislative landscape. It required 10% of aircraft work to be filled at government plants, and it placed a 10 percent profit limit on all Navy contracts above $10,000. Profits were computed before federal taxes, so actual profit limitations were 7 to 8 percent. And these were profit caps on firm fixed price contracts!
The IRS was responsible for auditing contracts and collecting excess profits, but they would not specify in advance what counted as acceptable costs. This imposed a huge amount of uncertainty on industry, leading Donald Brown, President of Pratt & Whitney, to comment “This of course means only one thing. The contractor will not know his profit or loss until the contract is audited by the IRS (ibid., 143).” Contractors could not apply the losses from one contract to the profits on another in the hope of evening out profits and losses over time. And most painfully, “losses on development contracts could not be recovered in production contracts because the Treasury had simply decided that that was forbidden (ibid., 195).”
Of course, auditing enforcement required massive expansion in government resources and the amount of time firms spent on documentation and cost itemization. Leroy Grumman’s complaint that Vinson-Trammel was transforming his aircraft business into a compliance shop is reminiscent of Skunkworks’ Ben Rich enumerating how onerous classification and auditing measures were hampering Lockheed’s ability to actually deliver an airplane.
As it turns out, legislation imposing profit limitations was redundant – the industry was perfectly capable of losing money on its own. During a three year period from 1934-1936, manufacturers’ losses on Navy work averaged 71 percent on development contracts and profits of 2.8 percent on production work. Martin consistently lost money on military contracts during the 1930s, and Curtiss Wright earned only $5.8 million in contracts off of $25.6 million spent on aircraft development from 1937-1941. Boeing lost 27.7 percent on only $2.2 million in sales in 1938 and produced the B-17 at a loss well into WWII (ibid., 190, 213).
Almost 100 years later, Congress and the DoD’s fixation with industry’s profit margins persists. In a recent
post, and provide the hypothetical of two companies responding to a DoD Request for Proposal: Company A is a traditional defense prime that bids $1B with an 8-10% profit margin, and Company B is a non-traditional defense company that bids $500M with a 50% margin:It should be a no-brainer for the government to go with Company B at half the cost yet there are significant process barriers given the perception of excessive profits. There is currently little chance that a Contracting Officer could justify going with Company B to its business clearance board. There would be fear of an article in the Washington Post that “Company B is Price Gouging the DoD at 5X the Profits of Established Primes”. Certain senators would call for hearings and GAO audits to unpack what must be fraud, waste, and abuse and seek to void the contract.
The 1934 aircraft industry hearings were the early Indications & Warnings that much of the DoD would continue to reject market forces.
Innovation in Time for World War II
In a macabre way, we know this story has a (mostly) happy ending. The U.S. forges the arsenal of democracy during World War II, succeeding in a vision of mass production of aircraft that was unrealized during World War I. American bombers, and eventually some fighters too, are superior to our adversaries, something that was not true during World War I. How does this happen despite the poor policies described?
First, buying dynamics became more competitive and less monopsonistic for U.S. aircraft manufacturers during the 1930s. Foreign exports of combat aircraft to Europe helped buoy the industry from the Depression years through entry to WWII, a period of time when Army and Navy dollars for aircraft remained small and laws remained counterproductive. The export market didn’t directly spur innovation because until 1938, the military and State department limited firms to selling only their obsolescent designs abroad. But it did help keep companies solvent: “In 1937, for example, Martin sold abroad flying boats and obsolete two-engine B-10 bombers worth $15 million, while his combined business with the Army and Navy totaled less than $500k (ibid., 197).” While the Nye Committee continued to peddle the unfounded claim that foreign sales incited World War I and the aircraft industry was on track to repeat history, other parts of Congress embraced the role of aircraft as a useful instrument of foreign policy (e.g., exporting aircraft to certain Latin American countries as part of the Good Neighbor policy).
Second, rapid innovation occurs during the 1930s as the industry transitions from the promise of dual-use markets to actually being dual-use. Cargo transport and commercial passenger transport precipitate the U.S.-led bomber revolution. During the late 1920s, the government began subsidizing private airlines for transporting airmail; this market was too small to drive a step-change in aircraft design, and the subsidies were so generous that they disincentivized passenger transport. In 1930, the Watres Act reduced the subsidies for airmail. This had the effect of spurring innovation in larger and more efficient transport aircraft because airlines were now incentivized to find profitable ways of also transporting passengers.
Fortuitously, the performance envelope and dimensions of passenger and cargo transport overlapped with bombers, and so bomber aircraft had the first dual-use area for commercial application. In fact, the monoplane revolution started with commercial aircraft. Lockheed’s Vega and Alpha (both designed by Jack Northrop) and Boeing’s Monomail 200 were moderately successful passenger planes. The Monomail 200 heavily influenced Boeing’s B-9, “widely considered to have revolutionized bomber design in the United States, if not the world. It was an all-metal, two engine, semi-monocoque, cantilever low-wing monoplane with retractable landing gear.” Martin soon followed up with the superior B-10, which the Army procured over Boeing’s bomber.
The dual-use learnings were bi-directional. Boeing incorporated its B-9 innovations into the Boeing Model 247, “the world’s first truly successful modern passenger transport.” Douglas, which built Navy torpedo bombers and Army utility aircraft, employed Jack Northrop in the design of DC-3, “the most successful and most famous commercial transport of the prop era.”
Both Martin’s B-10 and Boeing’s B-9 were developed with company venture capital. In military-industrial complex parlance, this is called “internal research and development (IRAD)” dollars. I don’t like using that term here because Martin and Boeing ventured their capital in a way much closer to how commercial companies make product investments than anything that resembles what their 21st century successors do today. IRAD today is largely dictated by the government customer, and the expense is reimbursable because the primes can allocate the cost to existing customer contracts as part of general and administrative overhead.1 So much for nothing ventured, nothing gained.
But a very different type of “IRAD” happened in the early days. Companies were truly taking a gamble on novel designs. The government was not force-feeding companies a perhaps well-intentioned but misguided vision of innovation. Nowhere is this more evident than with Boeing’s B-17 Flying Fortress, developed at private expense in 1935. The Army’s requirement was for a multi-engine aircraft, but the assumption was this would follow the norm of two engines. Boeing instead developed a four-engine bomber, and the rest is history a popular TV show.
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Too much government R&D can be perilous for an innovative company.
writes of how powerful it is when “companies can treat government as customers for their products rather than as the boss of their R&D.” Bob Noyce, then co-founder/CEO of Fairchild and future co-founder/CEO of Intel “declined most military R&D contracts (despite these customers representing 95% of his revenue) so he could stay in control of his R&D roadmap. He never let more than 4% of this R&D budget come from Govt contracts. So 96% of his R&D was self-financed from investors and profits.” The commercial world intuitively understands that you do not let the customer dictate how the product is developed, but people get confused once the government is involved.And the final push to getting good aircraft into production was, of course, World War II. FDR unshackles industry, and Congress is forced to concede that the time for own goals has passed. Following FDR’s May 1940 call for annual output of 50,000 aircraft, Congress finally repeals Vinson-Trammel and gives the Navy discretionary power to negotiate directly with aircraft manufacturers rather than hold price competitions for production. A $2.9 billion appropriation quickly follows, along with the use of cost-plus contracting and authorization to make 30% advanced payments to manufacturers. These authorities are soon extended to the entire War Department — an explicit acknowledgment that bad policy was a peacetime luxury.
Boys and Their Toys
The heroes in this story are the mostly nameless pilots and soldiers who went to fight with whatever was available. I can’t say for certain, but they probably cared a lot more about flying the best airplane than flying the plane that was made with a 7 percent profit margin.
The other heroes are the aviation founders who woke up each day to battle the U.S. government. Aviation is exciting, and a good thing too, because the government benefited enormously from the inherent appeal of airplanes. Between forfeiting the design rights to their aircraft, subsidizing the military for decades during the interwar years, and being accused of instigating global conflict, aviation entrepreneurs could have found an easier way to make a profit.
By providing the only market for many years, the military expedited aviation development. It is also clear that the government uniquely hamstrung the industry for decades. These days, it’s hard to elicit sympathy for a Boeing executive, but William Boeing’s story is a tragedy of Shakespearean proportions. I’m deeply appreciative of individuals with a passion for building highly regulated and speculative but promising technology whose commercial market has not yet been proven. Today, that’s a lot of commercial space, hypersonics, nuclear reactors, etc. These individuals should be celebrated as they notch successes, and they certainly shouldn’t be mocked when they fail. I’ll even go so far as to say we should be more appreciative when the founders are already wealthy and could retire on an island but instead choose to build something hard (see the denigration of “rich boys and their toys”).
I, for one, would rather see billionaire fortunes blowing up on launch pads than being lit on fire in the form of donations to the Democratic party or Harvard’s under-performing hedge fund. But that’s just me ¯\_(ツ)_/¯
From Lockheed Martin’s 2022 annual report: “Company-funded R&D costs are allocated to customer contracts as part of the general and administrative overhead costs and are generally recoverable to the extent allocable to our cost-reimbursable customer contracts with the U.S. Government.”
References
Engelbrecht, H.C., Hanighen; F.C., Merchants of Death (1934)
Lorell, Mark, The U.S. Combat Aircraft Industry, 1909-2000 (2003). Vander Meulen, Jacob. The Politics of Aircraft (1991)
I would have to agree with the sentiment embodied in the last line here. Remember, Edison didn’t figure out how to build a lightbulb without first finding 2,000 ways not to build one.
Innovation of this kind is no different. It's high risk with unknown reward. Just because a rocket explodes does not mean it failed, far from it.
Risk and Progress always go together, hand in hand.
Just imagine the synergies that could have happened if the government had a less bone-headed view of industry. Great history lesson here Madeline - really helps to understand our past so we don't repeat it. The good news is that in general the view on the Hill is much more favorable and those in DoD are starting to get the message...even if we haven't yet changed the processes that view profit as something to control rather than value something to maximize. Well done!