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Date:07/08/2004
Session:108th Congress (Second Session)
Witness(es):Charles W. Wessner
Credentials:  Program Director, Board on Science, Technology, and Economic Policy, Policy and Global Affairs, National Research Council, The National Academies
Chamber:House
Committee:Armed Services Committee, U.S. House of Representatives
Subject:Economic, Technology, Vocational and Skills Implications of Defense Department Trade Offsets

OFFSETS: A STRATEGIC TOOL

Statement of

Charles W. Wessner, Ph.D.
Program Director
Board on Science, Technology, and Economic Policy
Policy and Global Affairs
National Research Council
The National Academies*

before the

Armed Services Committee
U.S. House of Representatives

July 8, 200

_______________________________________

*Please note: The views expressed here are the views of Dr. Wessner and do not necessarily represent the views of the National Research Council

Good morning, Chairman Hunter and members of the Committee. My name is Charles Wessner, and I serve the National Research Council’s Board on Science, Technology, and Economic Policy. The National Research Council is the operating arm of The National Academies, which consist of the National Academy of Sciences, National Academy of Engineering, and the Institute of Medicine. As you know, Congress chartered the National Academy of Sciences in 1863 to advise the government on matters of science and technology. My comments are based on work I directed for the Board on Science, Technology, and Economic Policy (STEP) at the National Research Council. I must emphasize, however, that the views I will express are my own.

My comments today do draw on two National Research Council reports. The first, Trends and Challenges in Aerospace Offsets1 was requested by the White House National Economic Council. This comprehensive study examined the impact of offsets on aerospace employment, the health of the sector and that of their suppliers, and their role in the global competition for aircraft sales. This study was exceptional in that every effort was made to provide a balanced view by including industry representatives, offsets practitioners, labor representatives, and expert economists.

Because the challenge is essentially the same in origin and nature, I also wish to draw to your attention the National Research Council’s recent report Securing the Future: Regional and National Programs to Support the Semiconductor Industry (See Chapter 2, Findings and Recommendations, included with the testimony as an Appendix) carried out under the leadership of Intel’s Chairman Emeritus, Gordon Moore. This report describes the technical hurdles and policy challenges facing the U.S. industry today. It describes the success of past cooperation between the government and industry, cooperation that fended off a major trade and technology challenge in the late 1980s and early 1990s to the U.S. semiconductor industry, and outlines the massive programs under way in Asian and European nations to support their national semiconductor industries. U.S. leadership in this critical technology cannot be taken for granted.2 As with aerospace, constructive cooperation with U.S. industry is essential to retain the benefits of this industry for the U.S. economy.

But first let me briefly address the offsets issue.

What are offsets?

But first, what are offsets? One of Berkeley’s outstanding economists, David Mowery, defines an offset as “a provision in an international export transaction that commits the seller firm to provide technology, to procure locally produced components, or to provide other forms of technical and other assistance to firms in the purchaser nation that go beyond those deemed economically necessary to support the sale.” 3

Offsets come in two forms. Through "direct" offsets, the purchaser receives work or technology directly related to the weapons sale, typically by producing the weapon system or its components under license. "Indirect" offsets involve barter and counter-trade deals, investment in the buying country, or the transfer of technology unrelated to the weapons being sold. Both types of offsets interfere in what might be called the “normal” operation of the market, but direct offsets send aerospace work overseas and sometimes help other nations move up the value chain in aerospace production.

Offsets are a Reality but not the Main One

It is important to keep in mind that offsets may not be desirable, but they are a fact of life. Shrinking military budgets around the world have reduced the demand for military equipment, creating a buyer's market. This increased international competition allows customers to extract very favorable deals from suppliers. In part, offsets are simply a means for foreign governments to justify large purchases of foreign equipment with taxpayer money. But offsets are also a symptom of a broader challenge mounted by foreign governments determined to support their aerospace industries – both their commercial and defense components – by whatever means possible. In a strategic sense, they are one tool from a tool kit of foreign industrial policies focused on the aerospace industry and its high-tech manufacturing.

Recognizing that private American companies are competing in an environment shaped by national governments’ industrial policies is the point of departure for clear analysis and for effective American policy making. If you believe, as I do, that the aerospace industry is a major asset for the American economy, a major exporter, a generator of well-paid, high value-added jobs, then you are in good company. Policy makers in many countries share your view. They see the aerospace industry as a potential source of high-paying jobs, export markets, and national technological competency.4 Offsets are one means of obtaining these benefits.

Citing this competitive environment, offset practitioners see themselves as responsible for making the sales that keep aerospace jobs in the U.S., and keep U.S. production lines hot. They argue that we have production capabilities that we would not have without the sales generated through offsets. This view is supported, in part, by the findings of the Presidential Offsets Commission which observe that offsets can contribute to U.S. national security by facilitating the export of U.S. defense products, maintaining production lines, and increasing interoperability.5

Some jobs are retained and maintained through sales facilitated by offsets. Basically, the industry argues that more jobs are retained than are lost through offsets-facilitated exports. On the other hand, the workers who make planes and the parts for planes are understandably concerned about the impact of offsets on their current and future work. There are also concerns about transfer of U.S. technology, the erosion of the U.S. supplier base, particularly at the second- and third-tier levels, and the increased dependence on foreign suppliers for U.S. defense products.

Impact on Employment

With respect to employment, there are two things to keep in mind. First, offsets are not responsible in themselves for the really large employment losses in this industry. The post-Cold War downsizing, the downturn in the commercial aircraft industry, and the applications of new technologies, such as CAD/CAM, and new IT-based procedures account for much of the employment loss.6 The second point is that offsets can and do cost jobs in some companies, and would appear to be reducing the capacity of the manufacturing base of the aerospace industry.7 Those analysts who, during the course of the Academy discussions and analysis, predicted declines in aerospace employment have been proven correct.

In addition to structural changes, it is important to emphasize that there are dynamic changes in the supplier base. There are always winners and losers as companies drop and acquire suppliers as part of the normal churning of the economy. However, offsets are seen as an artificial and therefore politically sensitive intervention. Indeed union representatives have argued cogently that the increasing use of offsets directly undercuts the precepts of free trade and comparative advantage.

Impact on the Supplier Base

Offsets can also impact the employment and sales in the supplier base of the aerospace industry—with long-term effects. As Todd Watkins of Lehigh University describes in his paper in Trends and Challenges in Aerospace Offsets, the supply base is increasingly squeezed between two forces. One is competitive demands to be ever leaner as suppliers respond to their customers in the aerospace manufacturing industry.8 The other force is foreign competition—companies that may have benefited from offset agreements and from home government subsidies—that now compete with U.S. firms. This places even greater demands on U.S. suppliers. These pressures may negatively impact the industries that supply critical components to the U.S. aerospace industry.

This conclusion reinforces that reached by the Presidential Commission on Offsets in International Trade.9 The Commission found that while quantitative levels of offsets have remained relatively steady, there has been a qualitative increase in the negotiated transactions. These qualitative increases refer to the transfer of often sensitive technologies to foreign defense industries, which improve the competitiveness of foreign firms and rarely result in the transfer of technology back to the U.S.

Good and Bad Offsets

This illustrates a key point about offsets. Offsets themselves are neither good nor bad, but there are good and bad offsets. If done well, they can keep U.S. production lines hot and help retain U.S. jobs and U.S. technological leadership. If done badly, they can cost jobs, disrupt other sectors of the economy, and transfer technologies that have been developed in part with taxpayer dollars. Better data would help us to make better judgments about the impact of offsets on the U.S. economy.

Initiatives to Curb Offsets

International agreements to limit offsets and other current practices in the trade area are necessarily long-term undertakings. Negotiations are likely to be most effective when accompanied by coherent national measures to support the U.S. industry. Unilateral measures are unlikely to succeed, and may have perverse effects. Measures curbing the use of offsets by U.S. firms could harm the prospects for U.S. sales and employment. Unilateral disarmament is not a policy many would advocate in military affairs. The ability of the U.S. to “lead by example” does not seem any more compelling in national commercial competition. This is particularly true of industries viewed as strategic by many governments around the world.

Whatever international effort is undertaken, we should heed the concerns of industry that has proposed that cures not be worse than the current situation, either in terms of employment or export sales or counterproductive technology restrictions. There is no simple fix to the offsets issue, not least because it is part of a broader challenge.

Policy Choices

The fundamental question for U.S. policy makers is how does the United States organize itself to focus on what everyone agrees are industrial sectors that are key to national security and major contributors to a robust economy?

With respect to offsets, the reality is that there are increasing demands on U.S. firms for offsets. We basically have three choices:

• The first is that we stay with the status quo, leaving private U.S. competitors to deal with the demands of foreign governments and subsidized competitors.

• The second is to seek bilateral arrangements at the government level and/or seek multilateral solutions. These are unlikely to succeed, particularly in the absence of other policy initiatives.

• The third, and most promising, is to concentrate on domestic measures to strengthen the industry, thus enhancing its competitiveness and providing leverage to work on bilateral understandings.

The real challenge in aerospace offsets is the need to recognize the challenge other countries’ aerospace policies pose for U.S. industry and to develop cost-effective public-private partnerships to retain and refurbish the design and manufacturing expertise necessary for the U.S. to remain a major supplier.

Immediate measures could focus on R&D tax credits, lower regulatory burdens, renewed support for aerospace R&D—where NASA seems to have diminished its expenditure and infrastructure. These would represent concrete measures to help the industry to compete. On a longer-term perspective, several commissions have researched industry needs. A common element, in my view, is the need to provide incentives that motivate government agencies to cooperate in achieving a common vision of the U.S. aerospace industry and a roadmap to get there. A forum bringing together the industry, the aerospace workforce, and the aerospace university research community to determine what needs to be done to keep the U.S. competitive might well be a positive step towards a constructive national strategy.

Challenges to the U.S. Semiconductor Industry

It is also important to recognize that the challenge to the U.S. aerospace industry is not an isolated phenomenon. In the time remaining I would like to raise the challenges facing the U.S. semiconductor industry. They are not facing offsets requirements. Instead they face requirements for direct investment for manufacturing and increasingly for the location of R&D facilities in their overseas markets.

As you know, the semiconductor industry is one of the most vibrant and productive U.S. industries. It is, of course, a supplier of critical components to the U.S. defense industrial base. This leading U.S. industry also faces challenges which will affect its U.S. manufacturing, its workforce, and its supplier base.

Semiconductors are pervasive and an important source of productivity in the modern economy. As the NRC’s report Securing the Future notes, their rapid technological evolution—characterized by continuously increasing productivity and contemporaneously decreasing cost—are a source of growth throughout the economy, both in emerging industries and in more traditional industrial sectors.10 A significant element of the strong performance of the U.S. economy in the last decades rooted in the investment and subsequent application of information technologies, which are ultimately driven by advances in semiconductor technology.11 Semiconductors also play a crucial role in ensuring our national security by allowing for advances in the capabilities of new devices and new applications for national defense. The pervasive impact of the microelectronics sector on the nation’s well-being—through improved communications, advances in health care, and better national security technologies—underscores the importance of the United States’ role as the world’s preeminent semiconductor producer.

The U.S. semiconductor industry is today, the largest value-added industry in manufacturing—larger than the Iron and Steel and the Motor Vehicles industries combined. And the electronics industry, based on semiconductors, is the largest US manufacturing industry.12 As of August 2001, the semiconductor industry employed some 284 thousand high skilled workers in the United States.

The NRC report, Securing the Future also highlighted the promotional policies of governments in every country in which the semiconductor industry has emerged. As Thomas Howell notes in his paper, Competing Programs; Government Support for Microelectronics’ “In a growing number of newly industrializing countries promoting an indigenous capability in microelectronics—Taiwan, Korea, Singapore, China, and Malaysia—government policies emphasize the acquisition and diffusion of advanced semiconductor technology from the industrialized countries rather than [by] pursuit of leading-edge R&D.” Countries such as Germany, France, and Belgium—yes, Belgium—also have major programs to support semiconductor industry R&D and investment. There is only one outlier, and that is the United States, where at the Federal level, we have no major cooperative R&D program, despite the success of SEMATECH.

With respect to semiconductors, a series of steps can be taken. The goal is not to restrict the industry with regard to its use of technologies or its investments overseas. That is likely to be counterproductive. What we can do is partner with industry to develop the technologies, encourage cutting-edge research, produce the students for the next generation, and provide incentives for investment in the United States. These incentives should seek to counterbalance the substantial subsidies of other countries while improving the business climate here in the U.S. Positive-sum environmental regulations and depreciation allowances attuned to industry investment cycles (i.e., depreciation over three, not five, years), major grants for new research facilities, and incentives for students and foreign talent, where required, can all help to retain and grow a vibrant U.S. industry.

As a concrete example, the recent Academy report on challenges facing the U.S. semiconductor industry recommended more support for the cooperative, university-based Focus Center Research Program. The financing for this program is relatively limited; the potential benefits are large, and the program already has a positive track record. Reinforcing this type of successful government-industry partnership is key.

Enhanced investments in nanotechnologies are another key step. It is important for the U.S. economy to build capacity in nanotechnologies, but commercialization is also essential. Programs such as SBIR and ATP, to encourage their commercialization, are key ingredients for a successful U.S. policy to anchor this tremendously promising technology in the U.S. economy. Support for research is not enough. Support for early-stage commercialization is also required.

A Broader View of the Challenge

In closing, let me just underscore the need for a broader view of the challenges facing the U.S. semiconductor and aerospace industries. In my view, government policies that support the sectors as a whole and provide sustained attention are the best means to maintain employment, encourage innovation, and ensure the future of these leading U.S. industries and a robust U.S. defense base. We have acted together to create and retain industries in the recent past, and with your help we can do so again.

**********

Endnotes

1. National Research Council, Trends and Challenges in Aerospace Offsets, C. Wessner, ed. Washington DC: National Academy Press, 1999

2. National Research Council, Securing the Future, Regional and National Programs to Support the Semiconductor Industry, C. Wessner, ed., Washington DC: The National Academies Press, 2003

3. David Mowery, "Offsets in Commercial and Military Aerospace: An Overview," in National Research Council, Trends and Challenges in Offsets, op cit., 1999.

4. National Research Council, Conflict and Cooperation in National Competition for High-Technology Industry. National Academy Press, Washington DC, 1996, p. 88. See Box H.

5. National Commission on the Use of Offsets in Defense Trade, Status Report of the Presidential Commission on Offsets in International Trade, Washington, DC: Executive Office of the President, 2001, p. 83.

6. See the paper by David Mowery, "Offsets in Commercial and Military Aerospace: An Overview" in C. Wessner, ed., Trends and Challenges in Aerospace Offsets. National Academy Press, Washington, DC, 1999, p. 85 - 114.

7. See the paper by Todd Watkins, "Dual-Use Supplier Management and Strategic International Sourcing in Aircraft Manufacturing" in C. Wessner, ed., op. cit., p. 167 - 196. See also the presentation by Kirk Bozdogan in C. Wessner, ed., op cit., p. 65 - 69.

8. Todd Watkins, "Dual Use Supplier Management and Strategic International Sourcing in Aircraft Manufacturing," in National Research Council, Trends and Challenges in Offsets, op cit., 1999.

9. The Status Report of the Presidential Commission on Offsets in International Trade can be accessed at http://www.clw.org/atop/offsets_commission.html.

10. Op cit. For an analysis of the role of new information technologies in the recent trends in high productivity growth, often described as the "New Economy," see Council of Economic Advisors, Economic Report of the President, H.Doc. 107-2, Washington, DC: USGPO, January 2001. See, National Research Council, Measuring and Sustaining the New Economy, Report of a Workshop, D. Jorgenson and C. Wessner, eds., Washington DC: National Academy Press, 2002.

11. See National Research Council, U.S. Industry in 2000: Studies in Competitive Performance, Washington, DC: National Academy Press, 2000.

12. Bureau of Economic Analysis, Statistical Abstract of the United States: 2001, Department of Commerce, Table 641, Washington, DC: US Government Printing Office, 1999, page 418.

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