America first learned the importance of an assured military industrial base during the Revolutionary War, a conflict whose success was far from an assured thing. The leaders of the new nation knew that success or failure depended neither on the worthiness of their cause, nor the personal bravery of the American revolutionaries — for those matters were assured. Rather, success depended ultimately on their ability to secure the arms and supplies needed to make war against England, then one of the world’s foremost military powers.

Theirs’ was an amazing gamble. The Revolutionary Leaders knew that if they declared independence, and thus war, and lost that they would be executed. But as Barbara Tuchman explains in The First Salute, the new nation -- long kept dependent on England for its military supplies -- had neither the domestic production of weapons and gunpowder, nor the raw materials, skills, and facilities for their manufacture.¹

Still, they declared independence. But to win the Revolution and to remain free, the new nation needed France and the Netherlands to supply them with the tools of war -- muskets, cannon, ships, ammunition, plus other manufactures, and do so largely on credit, actions that could easily bring those countries into war with England, as well. For sure, the Revolution was a risky undertaking.

In the first year, the Revolution was almost lost for the lack of ammunition. George Washington wrote that in "the whole American camp there were not ‘more than nine cartridges to a man.’"² In the fight for Bunker Hill, the Americans’ powder was quickly exhausted, forcing the Revolutionaries to use their muskets as clubs against the English.

In the fall of 1776, a desperate Congress sent Benjamin Franklin, the best-known American as head of a delegation to Paris where he sought French aid. The Franklin Delegation succeeded. But their inventory of purchases in 1777 illustrates just how dependent the new nation was on others for its most basic economic and military necessities.

Franklin bought eighty thousand blankets and eighty thousand shirts for the American troops. They also acquired one hundred tons of powder, one hundred tons of saltpeter, 8 ships of the line, muskets, and 100 field pieces. Congress paid the French with a promise to deliver 5,000 hogsheads of tobacco.³ Franklin also persuaded the French Government to give the USA a significant grant of monies, which helped finance the fight with France’s old adversary.

But buying the goods in Europe was only the first step. They then had to be transported across the Atlantic Ocean through a British naval blockage. Tuchman documents how in the first three years of the Revolutionary War, goods were transshipped from Europe in a 4,000-mile, six-week journey to a tiny Caribbean island then owned by Holland — St Eustatius. There, American smugglers would pick up the goods and take them on to the colonies, another journey of 1,400 miles and three weeks duration.⁴

Without the Dutch and French supplies and their transport, the Revolutionary War would have been lost because America lacked the means to defend itself. It was a hard lesson, but one learned well by America’s Founders.

Soon, the vagaries of European politics taught the Americans another lesson — today’s allies may well be tomorrow’s enemies — further reinforcing the benefits of not depending on others, of having a strong domestic industrial and military base. At the turn of the 18^th century, France fell into revolution, Napoleon seized the Netherlands, and John Adams, our second President, barely avoided war with France, our original arsenal.

After victory, the men and women who fought the Revolutionary War made industrial and military self-sufficiency U.S. policy. Never again would America be dependent on others for its prosperity and the means to defend itself. Alexander Hamilton, the first Secretary of the Treasury, articulated that policy in a white paper commissioned by President George Washington and the U.S. Congress and released on December 5, 1791. Hamilton’s Report on Manufactures says,

"Not only the wealth, but the independence and security of a Country, appear to be materially connected with the prosperity of manufactures. Every nation, with a view to those great objects, ought to endeavour to possess within itself all the essentials of national supply. These comprise the means of Subsistence, habitation, clothing, and defence.

The possession of these is necessary to the perfection of the body politic; to the safety as well as to the welfare of the society; the want of either is the want of an important Organ of political life and Motion; and in the various crises which await a state, it must severely feel the effects of any such deficiency. The extreme embarrassments of the United States during the late War, from an incapacity of supplying themselves, are still matter of keen recollection: A future war might be expected again to exemplify the mischiefs and dangers of a situation to which that incapacity is still in too great a degree applicable, unless changed by timely and vigorous exertion. To effect this change, as fast as shall be prudent, merits all the attention and all the Zeal of our Public Councils; 'tis the next great work to be accomplished."⁵

For two centuries, industrial and military self-sufficiency was America’s policy. It succeeded brilliantly. It protected against European adventurism in the 19^th century. It enabled the nation to become the richest, most industrialized country in the world. And it allowed America to be the arsenal of democracy in the 20^th century.

Even when America disarmed following World War I and again after World War II, it still had the industrial capacity -- the potential -- to re-arm quickly if a threat emerged. And when one did, America’s factories quickly converted to war production, allowing the Allied forces to out produce and ultimately overwhelm the Axis powers in the 1940s and hold off the enemy during the Korean War.

Following the Korean War, the U.S. defense industrial base was repeatedly modernized, again enabling the USA to cope with any foreign threat. And self-sufficiency was taken a step further during the Cold War as the United States actively led Europe, Japan and others in denying the Soviet Union the technologies, machinery, skills, and research they needed to keep apace — economically and militarily. That policy of strength and containment succeeded, too. The Soviet Union could not match the West, its people grew weary, and that empire broke into pieces.

But with the collapse of the Soviet Union, America seems to have quickly forgotten the older lessons and policies that long served it well. In a very real way, the mood of America in these first days of the 21^st century is akin to that of America in the 1920s. Then, the "war to end wars" had ended. The threat was gone. America could return to the business of America, which was perceived to be business.

With the collapse of the Soviet Union, America remains the sole super power. Americans are generally prosperous. And while as recently as the 1980s, the global competitiveness of domestic industries was a top concern of national leaders, their successors now focus on assuring stockholders higher share prices and American consumers a steady flow of inexpensively produced goods, regardless of where they are made. Once again, the business of America seems to be business.

Today, a smaller, simpler, more trusting, view dominates. Terrorists are seen as the principal threat to national security. The emergence of China -- a one-party, repressive, Communist state — as an economic and military power is mainly seen not as a danger, but as a business opportunity. And global economics is treated as something analogous to celestial mechanics -- a self-driven, self-correcting system in which markets balance supply and demand, assuring ever more growth and development.

But there is also something different about what America is doing now from what it did after World War I and World War II. Then, the United States shifted military production back to civilian uses and even though military expenditures were cut, the U.S. industrial base remained in America. The long-held policy of self-sufficiency was not disturbed.

Unlike in the past, however, now that the Cold War is over, the U.S. industrial base is being taken apart, piece-by-piece, and relocated to other nations. In the process, much of American’s industrial and military production base is being sold to foreign interests, and more important a significant portion of it is being physically relocated into other nations, including our most likely strategic rival — China.

This radical shift of policy of recent years, moreover, has come not as the result of some large, well-conceived, well-debated design. Rather it is more the unintended consequence of multiple smaller decisions -- some of which were relatively insignificant in themselves, but which in combination are steadily putting the United States on a very different, and potentially very dangerous, policy path that what it pursued for so long and so successfully.

The Five Shocks

America’s shift away from its two century long reliance on an assured industrial and military industrial base came about primarily in the last two decades of the 20^th century. The change of policy is largely an unplanned, unexamined cumulating reaction to five basic shocks to the US economic and political systems.

Perhaps of greater importance, US financial institutions mishandled — and very badly at that -- the recycling of the Petro-Dollars accumulated by OPEC. In the late 1970s and early 1980s, the US money center banks recycled those funds into massive, but dubious, loans to developing nations such as Mexico, Brazil, Argentina, and the Philippines. Soon, hundreds of billions of dollars were stolen and squandered. Repeatedly, the International Monetary Fund and World Bank were brought in to reorganize the economies of the nations defaulting on their loans. And repeatedly, worker sacrifice and a national export strategy were recommended as the means back to national solvency. The United States generally provided much of the foreign direct investment required to produce those goods, plus it opened the US market for their sale — all at the expense of domestic US production and workers.

Moreover, these foreign competitors, again particularly Japan, were targeting specific US industries, and then dumping goods, often subsidized by their governments, into the American market. At the same time, competitive US goods were excluded from the Japanese and other markets through a host of non-tariff barriers. Repeatedly, US trade and diplomatic authorities refused to confront these predatory practices sacrificing US industrial interests to foreign policy goals. When Congress attempted in the 1980s to enact laws that would force US Trade Officials to act against predatory trading practices, the legislation was bitterly opposed. And once that legislation became law, the new powers were not used.

Eventually, US companies came to understand that if they were targeted by other nations’ industrial strategies, they were on their own politically in the United States. Indeed, the US Government often took the side of foreign nations against domestic producers in Congress and the courts. More pernicious and more troubling for many industries, the United States entered into a series of trade agreements where it negotiated away some long successful U.S. industries, such as basic manufacturing, in exchange for concessions that would benefit others, such as business services. This is industrial policy set at the highest levels of government and for the highest possible stakes — the very survival of the "donor" industries.

Largely because of the policy indifference to mounting U.S. trade deficits, foreign imports surged to historic levels in the latter years of the 20^th century. While the United States had a trade surplus of almost $32 billion in the decade of the 1960s, for example, it had a trade deficit of more than $75 billion in the 1970s. In the 1980s, that deficit grew 11 fold to exceed $843 billion. And it doubled in the decade of the 1990s to more than $1.7 trillion.⁶

To pay for these deficits, the United States drew down its foreign holdings at first and by the mid-1980s it was forced into selling national assets, including control of thousands of US corporations, which are now held by foreign investors, and in many case, foreign governments. In the process, a long-standing bond between US corporations, the US Government, and US society was weakened.

Eventually, many U.S. corporations elected to meet the competition by shifting their operations offshore, where regulatory and labor costs were significantly lower. And many of these, went a step further — they chose to see themselves as global corporations with no allegiance to any nation. Not surprisingly, many of these companies shifted (on paper at least) their headquarters to places such as Bermuda and thus no longer pay corporate taxes to the US Government. The new attitude — this new allegiance -- was concisely summed by one well-known CEO who said, "It’s my job to take care of my stockholders. It’s the President’s and Congress’s job to take care of the United States."

Intuitively, it seems that buying 251 of something for $1 is better than buying only 123. But when it comes to national trade policy, the logic is just the opposite because arithmetic also works in reverse — that is, at 123 yen to the dollar it takes twice as many dollars to buy a Japanese import than a 251-1 ratio. At the same time, at this 123 to 1 ratio, it requires half as many yen for the Japanese to buy a US export. Thus, at that level, foreign imports are more costly and US exports are less costly.

The overvalued dollar of the 1980s did enormous damage to US industry for it alone translated into as much as a 50 percent price cut in price for imported foreign goods while doubling the cost of US made goods exported into foreign markets.

US exporters also faced a "trade tax" that still remains largely hidden from view and is rarely discussed. Europe, Japan, and many other nations use a Value Added Tax (VAT) that under global trade agreements permits tax refunds on exported goods. Thus, manufacturers operating out of those nations get a substantial VAT refund on every exported item, which in the European Union countries is a minimum of 15 percent of the goods’ value, but is often more.⁸ But these same trade treaties do not allow a refund of US corporate taxes on goods exported from the United States. Thus, most foreign imports arrive here paying no taxes in their country of manufacture, while US companies have to pay the full tax load -- here and abroad — on their goods.

Faced with a high dollar and hidden trade taxes, US companies, which also paid high social costs for their US operations, simply could not offset the resulting price differential through lower US wages, fewer benefits, greater investment, better technology or more worker productivity. And while most US manufacturers tried one or all of these things, most became increasingly uncompetitive with their principal foreign rivals. The economic burdens companies faced in their U.S. operations were simply too high.

The Cold War Shock — With the end of Cold War in the late 1980s, America’s 40-year policy of Soviet containment also ended, as did much that made up that policy. Where once the flow of technology and investment to communist nations was tightly restricted, it was soon encouraged. In the process, European, Japanese, and America companies rushed into those nations to gain future commercial advantage.

In the United States, the military industrial capacity was consolidated, as a handful of major arms makers bought up competitors and integrated their operations. Simultaneously, with America’s emergence as the sole remaining super power, the United States faced a world for the first time in its more than two centuries of existence, where no other nation represented a military threat. It was an extraordinary moment in history.

In the late 1980s and early 1990s, China’s industrial and military modernization was in its early stages. Then, China appeared more as a commercial opportunity than a potential future threat. And U.S. firms surged into China seeking their own commercial advantage for the future.

A decade ago, the big idea was that a long period of global peace was at hand — that the resources and attention of business could now be applied to production and economic development. Companies that were being pressed competitively saw limited risk to taking advantage of the vast new pools of penny-wage labor that suddenly became available and enormous profits. Thus, many corporations began slowly to shift their manufacturing to such nations, a process that quickly took on the qualities of the Oklahoma Land Rush of the late 19^th century.

And the U.S. Government saw little military threat to those companies moving their production capacity outside the United States, and thus did nothing to slow or qualify such moves. Nor did the U.S. Government see a threat to foreign purchases of U.S. companies that produced vital technology and components, even when the new owners closed U.S. production or shifted it abroad. Repeatedly, the U.S. Treasury, Commerce Department, and Department of Defense gave their official approval to such transfers.

Indeed, the U.S. Government actively encouraged American investors to seek out foreign investment opportunities even when that meant closing domestic factories and laying off U.S. workers. The presumption was the booming "information" economy would supply more than enough good-paying replacement jobs. Of course, we now know the U.S. economy in the late 1990s was an unsustainable bubble.

Together, these five shocks confronted US manufacturers with four basic choices — sell their business, outsource components from foreign factories, move manufacturing offshore, or struggle along until forced out of the business. Staying in America meant running the risk of bankruptcy. Shifting operations to other nations offered the promise of renewed growth and profits. And the U.S. Government made known that it did not care which choice business made. Indeed, companies were encouraged to invest in China and developing nations in order to spread the benefits of U.S.-style capitalism. A certain national hubris about victory in the Cold War was evident.

To make outsourcing and relocation politically viable — that is, the relocation of US production to other nations — major US financial organizations and the major US transnational corporations in the late 1980s and early 1990s pressed the US Government to join two major trade treaties — the North American Free Trade Agreement and the Uruguay GATT treaty. Both were significant, because each created new global protections for foreign direct investment and private ownership of intellectual property rights. The GATT treaty also created a new international regulatory body, the World Trade Organization, empowered to enforce the provisions of the GATT treaty and negotiate on its own initiative additional such protections.

Equally important, both the NAFTA and GATT reduced tariffs and other barriers to imports into Europe, Japan, and the United States from offshore manufacturing sites. With NAFTA and WTO in place, therefore, corporations could safely shift their factories and labs to low-wage, low-regulatory nations with little fear of expropriation. Moreover, they could then ship their production back into the US market -- often duty-free.

The Long Supply Line

Barry Lynn, the former Executive Editor of Global Business magazine, examined this growing dependence on foreign-based suppliers in the June issue of Harper’s.⁹ He reports that a large portion of America’s premiere corporations have transformed themselves into little more than "virtual companies" that rely on a complex and far flung network of suppliers spread throughout the world to make the goods they sell. To illustrate this disintegration of the integrated manufacturing process that so long characterized the U.S. economy, Lynn reports on Dell Computer, a leading U.S. computer manufacturer and defense contractor, that in reality is little more than an assembler of foreign made components. While the company assembles its computers in the United States, the 4,500 parts used in one of its finished products come from dozens of suppliers clustered in China, Taiwan, Korea, and Malaysia. And although the lack of a single component can slow or stop the entire manufacturing line, Dell maintains an inventory sufficient for only 4 days production. If a typhoon, fire, revolution, strike, war, or any other event interrupts that long supply line across the Pacific for more than 96 hours, and if alternative parts cannot be located within that period and delivered to Texas, production ceases on the 97th hour.

Now, corporations are even outsourcing their back office functions. Procter & Gamble Corporation, the giant consumer products company, announced earlier this year that it intends to outsource about 80 percent of its back office functions such as payroll, accounting, and travel services.¹⁰ Sabre Holdings, the travel-technology firm, completed a similar arrangement in 2001 when it sold those functions to EDS for $676 million and signed a $2.2 billion contract to have them manage those activities. As with manufacturing, those functions can be located virtually anywhere in the world.

The process of out-sourcing to get lower component prices, and just in time inventory management to lower inventory costs, is now the model used by most U.S. corporations. With the widespread use and implementation of this model, corporations have massively shifted their manufacturing activities to foreign locations or foreign suppliers. But lower price brings its own consequences. Any disturbance in the production or transport, even in the smallest way, will immediately translate into the stoppage of assembly lines and the flow of vital goods to the United States.

The unexamined assumption behind such practices, of course, is that the world is now safe and stable enough to depend on supply lines stretched so complexly, so far, and so widely. Geopolitical analyst William A. Hawkins says it is not. In a United Press International essay, Hawkins points out "Terrorism is only the tip of the geopolitical iceberg that threatens this titanic misconception. China threatens Taiwan. The Korean peninsula is still divided. India and Pakistan confront each over Kashmir. The Middle East remains on the brink of war, Drugs, insolvency and radicalism threaten the stability of Latin America, while Africa’s vast problems defy concise description."¹¹

And Lynn wonders what would happen, …"if just one of the still very sovereign nations that underlie this (supply) web were to grab hold of a few of the strands and start yanking." Both Lynn and Hawkins are concerned that China might make that grab.

The vital question they raise, of course, is this: Is the United States becoming vulnerable, both economically and strategically, as U.S. corporations outsource and relocate their functions, including manufacturing, across the globe? Obviously, the answer is yes.

Moreover, the vulnerability created by this hollowing out of American manufacturing is building at a fast pace. As recently as the 1970s, for instance, the United States had a manufacturing trade surplus in eight of those ten years, creating a cumulative trade gain of more than $75 billion. Beginning in 1983, however, US manufacturing trade slid into deficit, and it has remained there ever since. After NAFTA and the WTO agreements took effect in the early 1990s, the US manufacturing trade deficit soared to historic heights — leaping from $91 billion in 1993 to more than $308 billion in 2000 — a 338 percent gain within a period of only 7 years.¹²

Beyond the unprecedented size of these deficits, they are composed of goods vital to the U.S. economy -- things America recently produced for itself with U.S. workers in U.S. based factories. Consider this: U.S. imports of electric and electronic machinery surged from $55 billion in 1990 to more than $250 billion in 2000 — a 450 percent increase. Imports of transportation equipment leaped from $89 billion in 1990 to $213 billion in 2000 — a 239 percent gain. The import of instruments and related scientific goods grew from $16 billion to more than $40 billion.¹³

In substantial part, these imports come from US—owned factories in foreign countries, reflecting the large build up of U.S. investments in other nations. During the 1990s, U.S. foreign holdings almost tripled — surging from $430 billion in 1990 to $1.13 trillion in 1999. And of this $700 billion expansion, more than 41 percent — that is, $291 billion — was in the low-wage, low-regulatory nations of Asia, Latin and South America and Africa. ¹⁴

Consequently, almost a majority of all US imports now come from the foreign factories of U.S. companies or from foreign companies to their U.S. affiliates — something called "related party" trade. The Census Bureau reports that in 2001 such related trade amounted to $526 billion or 47 percent of all U.S. imports.¹⁵

Not surprisingly, such related trade originating in China is growing, as well. As recently as 1992, for instance, related trade constituted only 10.5 percent of U.S. imports from China. By 2001, this had grown to 18.1 percent.¹⁶ In the future, this related trade is sure to grow substantially larger¹⁷

America is becoming increasingly dependent on foreign factories and workers to supply its vital goods. Among those goods imported into the United States in 2001 where related trade constituted 50 percent or more of the value were:

• Resin, synt rubber & fibers (62 percent);
• Pharmaceuticals & medicine (72 percent);
• Chemical products — (66 percent);
• Rubber products — (61 percent);
• Alumina & alum processing (61 percent);
• Ag & construction mach, — (52 percent);
• Metalworking machinery — (51 percent);
• Engines, turbo, power eqpt. (56 percent);
• Computer equipment — (70 percent);
• Communications equipment (67 percent);
• Audio & video equipment (70 percent);
• Semiconductors & elect. (64 percent);
• Navix, measure, med instru.— (62 percent);
• Magnetic & optical media (56 percent);
• Electrical equipment (61 percent);
• Electrical equip & comp — (51 percent);
• Motor vehicles — (95 percent);
• Motor vehicle parts — (58 percent);
• Med equipment & supplies — (52 percent).

In addition, related trade accounts for 46 percent of all basic chemicals and 47 percent of all industrial machinery imported into the United States.¹⁸

The items in this list are essential to the U.S. defense industrial base. They are the things needed to make war. They include capital goods equipment needed to make the machines that produce the tools of war. Increasingly, the United States is rendering itself unable to shift production from consumer goods to military goods because neither the consumer nor the capital goods are being made here. Increasingly, there are few factories to convert, as was possible in World War II, and what factories that remain are capable of supplying only part of potential military demand.

The rapid and on-going hollowing out of the U.S. manufacturing base -- as documented by monthly trade data supplied by the U.S. Commerce Department -- is consequential for several reasons.

The US Department of Labor tracks what happens to workers "with 3 or more years of tenure who lose their job because of plant or company closings or moves, insufficient work, or the abolishment of their positions."¹⁹ Of the 1 million manufacturing workers who were displaced in the three years 1997, 1998, and 1999, only 72.9 percent had found replacement jobs by February 2000. And the US economy was booming then. Moreover, workers in some industries suffered even more. Only 41 percent of the displaced workers in apparel and other finished textile products, for instance, had found another job by early 2000. The other 59 percent were either still unemployed or dropped out of the work force altogether.

The shift of manufacturing to China is also putting hundreds of thousands of Mexicans out of work. Of the thousands of U.S. and foreign-based factories that went into Mexico’s maquiladoras during the 1980s and 1990s, more than 500 have closed since 2000. The Washington Post reports that most of these factories have moved to China, at a cost of 250,000 Mexican jobs, to get cheaper labor. The Post explains that an entry-level factory worker in Mexico "earns $1.50 to $2 an hour compared with 25 cents an hour in parts of China."²⁰

The problem is when people lose their job in Mexico, particularly in factories located just across the U.S.-Mexico border; many illegally immigrate into the United States, worsening an already bad problem for this nation.

When Mexico and Canadian imports are excluded, America depends on China and the surrounding Asian suppliers for more than 52 percent of all its merchandise imports. And as great as 52 percent is, that number only partially describes U.S. dependence on this cluster of factories in the China Sphere for many essential goods, particularly electronics, from produce almost all of many critical items America uses, such as LCD monitors.

Consider what is outsourced from Taiwan now, only one of the nations in this China cluster. Taiwan supplies 25 percent of the world’s personal computers, 58 percent of the Liquid crystal display monitors, 50 percent of computer networking hardware, 64 percent of network interface cards, 51 percent of DSL modems, and 65 percent of cable modems.²² And this, of course, does not include the production from factories making similar goods, located in the China sphere, such as Singapore or South Korea or Japan.

The unexamined question is what would happen to this long supply line across the Pacific if China moved to take Taiwan, as it has repeatedly threatened, and the United States intervened, as it has repeatedly promised?

Faced with China’s strong displeasure, would the other nations clustered around it in Asia allow the unimpeded export to the USA of goods that China considered essential to US economic and military purposes? Or, if China embargoed such exports to the USA would commercial carriers, who would not be insured in such a circumstance, take the risks associated with moving goods out of those countries across the Pacific? And does the U.S. Navy now or in the near future have the capacity to deal with both a military crisis in a place such as Taiwan and simultaneously protect convoys of goods from Asia to the United States. And does America even have the transport ships required for such a task? In sum, outsourcing may be profitable for a corporation, but it has basic policy implications for U.S. economic and military security.

This high technology deficit is particularly troublesome for it means that America is increasingly dependent upon China for goods — computer drives, semi-conductors, optical devices, and various other electronics that can be used for sabotage purposes in an information war. In a 1999 study for the National War College, (China’s Strategic Modernization: Implications for the United States), Major Mark A. Stokes, assistant air attaché in Beijing from 1992-1995, reports that China’s

"…highest priority for strategic modernization is in the realm of information. … A review of Sun Tzu’s Art of war reflects the Middle Kingdom’s traditional emphasis on information dominance. … Since the conclusion of the Gulf War, a growing chorus of PLA officials have strongly advocated the aggressive pursuit of information-based warfare doctrine and systems."²³

According to Stokes, China’s doctrine of war is to strike first and strike hardest at the opponent’s national command and control apparatus and then to disable key manufacturing, petroleum storage, transport and power generation facilities. As he also explains, this emerging doctrine also requires a high degree of secrecy and surprise. In such conflict, America’s unprotected electronics systems are its "Achilles heels."

The Rand Institute, in comments about information warfare, points out that

"Information war has no front line. Potential battlefields are anywhere networked systems, allow access, -- oil and gas pipelines, for example, electric power grids, telephone switching networks. In sum the U.S. homeland may no longer provide a sanctuary from such attack."

Beyond the obvious dangers created by a systematic electronic attack on U.S. information-dependent services, such as through the Internet, the use of Chinese components creates an even greater threat for sabotage — because electronic components can carry implanted "sleeper Trojan Horse viruses" that are exceedingly difficult to identify. Such sleepers can easily be hidden semiconductors and other components, where they wait for a command to awaken and do their damage. And because so many of the US information systems are interconnected only a relatively few such sabotaged components are required to close down most of the electronics systems on which the U.S. economy and military depend.

The U.S. Government’s Critical Infrastructure Protection R&D Interagency Working Group reported to the President and Congress in January 2001 on the lack of protection for critical infrastructures including telecommunications, electronic signaling, power generation, power lines, and transportation — systems whose interruption would ripple throughout the nation. Their report points out how the May 1998 failure of the Galaxy 4 telecommunications satellite created an outage of 90 percent of pagers nationwide, including those of doctors and emergency personnel, and how hundreds of thousands of other Americans were unable to use their credit cards for purchases or ATMs. Their report concludes that, "highly trained units in countries that are hostile to the U.S. could potentially inflict far more damage (than the Iloveyou and Melissa viruses) without ever leaving their homelands."

Imagine a leap backward in time 200 years to a nation without working radios, television, electricity, telephones, pipelines, air traffic controls, the internet, credit checks, among a host of basic services now dependent on networked electronics. And this is but one face of information warfare.

The policy question, of course, is this: Is it wise to rely on a potential rival for the supply and integrity of components, including electronics, that under gird U.S. economic and military security — particularly if that rival’s basic military doctrine includes information warfare?

Three Procurement Trends

First, the United States has steadily reduced the portion of national research and development devoted to defense studies. The National Science Foundation’s Science Indicators 2002 reports that in the 1950s, for instance, almost half of all US Research and Development was defense related, reflecting the enormous costs of developing technologies needed for military applications. By the end of the 1960s, that ratio had dropped to almost a third, and by the end of the 1990s was less than 14 percent of all US R&D.

Second, the United States, along with other nations, is increasingly relying on off-the-shelf commercial technologies in defense applications. Those commercial technologies, such as semiconductors and other electronics, are of such high quality and low cost that they can safely be used for national defense purposes.

But as the National Research Council points out, potential adversaries also have easy access to the same commercial technologies.²⁵ This will …"compel DOD and defense contractors to excel at being the first to integrate militarily relevant commercial technology into defense systems."²⁶ And the U.S. Government has chosen is to integrate commercial and military manufacturing to secure, so as to achieve …the optimal use of the commercial manufacturing base to meet defense needs over the life cycle of a (weapons) system."²⁷

The problem with this strategy is the third procurement trend. Corporations are shifting the commercial production of high-tech goods out of the United States and into either U.S.-owned factories located offshore or foreign-owned factories operating from their own homeland or some other foreign nation. As previously discussed, more than half of all merchandise the United States imports, other than from Mexico and Canada, and almost all of the imported electronics come from factories clustered in and around China.

In short, America is shifting to a "virtual" defense industrial base, one in which the basic contractors may be headquartered in the United States, but their subcontractors are spread across the world. The assumption is that all these suppliers will be able to get their components to the United States in time of crisis.

Worse, the United States Government does not know the source of many of the components used in its military equipment or where they are made. Since 1995, the Commerce Department has done fewer than a dozen defense industrial capability assessments. Publicly available information suggests that other federal agencies have also not devoted significant resources to such work.

In 1992, the Commerce Department did one of first contemporary studies of US reliance on foreign suppliers for critical components in weapon systems. It was released in March 1992. In that study, three representative Navy systems were chosen for analysis — the HARM (high-speed anti-radiation missile); the Mark-48 ADCAP (advanced capabilities) torpedo; and the Verdin communication system. Almost 12,000 companies participated in this study. What the Commerce Department researchers found is the supply matrix is not pyramid-shaped, but diamond-shaped. This means the Navy had a core group of sub-tier suppliers that were unknown and thus "could be bottlenecks during a surge in production." The study identified 115 distinct items where a foreign dependency existed, including high-tech items such as semiconductor ceramic packaging and needle roller bearing wire rod.

In October 2001, the Department of Defense released a "Study on the Impact of Foreign Sourcing of Systems."²⁸ To prepare this report, DoD collected and evaluated information on eight weapons systems. The study’s four conclusions are:

1. Foreign sources provide limited amounts of materiel;
2. Utilization of these foreign sources for these programs does not impact long-term readiness;
3. Utilization of these foreign sources does not impact the economic viability of the national technology and industrial base;
4. In most cases, domestic suppliers are available for the parts, components, and materials provided by foreign sources.

While reassuring, the response rates from the subcontractors cannot justify these conclusions.

Specifically, these responses were all voluntary. Second, the average response rate for first tier contractors was 58 percent. For third tier subcontractors, it was only 39 percent. And DoD sought no response from fourth, fifth and lower-level subcontractors. Yet, the diamond shaped supply matrix found in the Commerce study exists at those levels -- among those who supply low-cost, commodity items. This level of subcontractors depends on commodity technologies, much of which comes from factories in China and the countries that surround it.

The United States Government does not know where many of the key components used in its military systems are made, in part, because DoD does not generally mandate supplier selections to contractors. Nor does it systematically track the sources used by sub-tier suppliers. While this lack of information may once have been irrelevant since U.S. domestic producers supplied virtually all U.S. military components, this is no longer true.

The China Factor

China has moved much of its economy from the 19^th to the 21^st century in less than one generation. Consequently, China is now at an industrial and military take off point where development can expand even further, even faster in the future. The extent and pace of China’s recent development are captured by four basic facts.

First, China’s economy grew at an annual average rate of more than 10.3 percent between 1990 and 2000, making China the fastest growing major economy in the world.²⁹

Second, China’s trade surplus with the United States surged from less than $6 million in 1985 to more than $83 billion in 2001, evidencing China’s quick emergence as a competitive world manufacturing center.

Third, the USA now imports more Advanced Technology Products (ATP) from China than it exports, reflecting China’s emergence as a manufacturing platform for production of world-quality technology goods.³⁰

Fourth, China has acquired the information required to replicate the United States’ most sophisticated strategic thermonuclear weapons and various associated launch and reentry vehicles.³¹

The breadth, depth, and quality of China’s economic expansion have come so quickly and are so entwined with US trade, US foreign direct investment, and US technology transfers that several policy issues arise. Specifically,

1. Does the United States risk becoming dependent on Chinese manufacturing for products vital both to the basic functioning of the US economy and to US national security?
2. Are strategic technologies flowing into the Chinese military industrial base?

3. Are strategic skills and know how being transferred to China?

Yes is the answer to each of these questions.

As corporations from the United States, Europe, Japan and elsewhere have located their factories in China, they have also transferred vital technologies and know how to the Chinese.

Equally important, much of the commercial technology that China is acquiring and producing, often with US and other foreign assistance is also available for modernization of China’s military capacities. Moreover, every indicator suggests that China will be the recipient of far more foreign direct investment and foreign transfers of technology and know how, particularly from the United States, in this decade than in the last.

Strategic Drivers

Several strategic factors are driving the US-China economic relationship and are likely to continuing such.

China has the largest work force in the world, which according to the World Bank includes more than 750 million Chinese between the ages of 15-64. When compared to the US work force, which is approaching 150 million, China’s is five times larger, with more than 12 million new workers entering that labor force each year. Yet, the Chinese Government says it will only be able to create 8 million new jobs this year.

Not surprisingly, unemployment in China is high. The Chinese Government officially acknowledges that there are an estimated 150 million surplus rural laborers looking for jobs in cities. It also acknowledges China has at least another 6.8 million urban unemployed, a number expected to triple over the next four years. Other estimates place that urban unemployment as high as 100 million.

And China’s wages are low. The World Bank reports that as recently as 1999, the average annual cost of a manufacturing worker was only $729.³³ Put into context, the average annual manufacturing wage for an American worker was almost $29,000. That is a difference of 40 to 1.

In effect, China can provide foreign corporations an almost limitless pool of workers for semi-skilled manufacturing work at a wage whose compensation, in comparison to that in the advanced industrial nations, is virtually zero. It is as though China were providing free labor for semi-skilled work.

The resulting economics are striking. One major US headquartered chemical producer, for instance, has just purchased a protein plant in China, which will become a major global sourcing center. The plant is now being reorganized and upgraded to meet the standards of the US Food and Drug Administration (FDA). The company’s first step was to fire 10 percent of the Chinese workers, increase the pay of those remaining by 20 percent, put up safety posters throughout the plant, and increase the spending on workers’ free lunches from 10 cents per day to 50 cents. Still, the Chinese workers make a tiny fraction what their US counterparts do. To the company, the cost of the pay increase was effectively offset by the layoff of the 10 percent, the cost of posters was trivial, and the increased lunch cost is about $2,000 per month.

China offers more, however, than a pool of cheap workers for light manufacturing. It is creating a vast core of engineers and technicians for more advanced work. The Chinese Academy of Engineering reports that China has more than 2.1 million trained engineers, including 600,000 senior-level people. Even if some, even a majority of this pool, are not as well trained as their Western counterparts, they represent a significant reservoir of talent by any measure. And the competence of this pool is rapidly increasing in large part because of two decades of education exchange programs with the United States and Europe — exchanges that were supplemented in the 1990s by private training that accompanied massive foreign direct investment in China.

More significant for the future, China is rapidly expanding its cadres of high-knowledge workers. In 2001, for instance, Chinese leaders announced their goal to surpass India as a major source of software engineering. Most attractively for foreign investors, much of this high-tech talent is available for work at less than 10 percent the pay of their Western counterparts.

Beyond the size, skill, and low compensation of this work force, China offers an investment locale where unions do not exist, organizing is not permitted, and worker dissent is harshly discouraged.

The size, quality, structure, compensation, and compliance of China’s work force has been and will continue to be a major magnet for foreign direct investment long into the future.

Politically, the size of China’s work force, coupled with its continuing expansion, places a never-ending demographic imperative on China’s leaders to create more and better jobs. Those leaders are fully aware of how economic stagnation undermined one-party rule in the Soviet Union. They also know that China’s state enterprises cannot provide the job growth China needs. China’s leaders have concluded that foreign investment is required if China’s social stability is to be maintained.

From this dynamic, a relationship has been forged between China and foreign investors. China gets the technology, investment, and knowledge it needs to expand and modernize its industrial and military base, while creating new jobs needed to maintain the nation’s social stability. Foreign investors get some access to China’s markets and use of Chinese labor and resources to create a low-cost, high-quality, global sourcing center.

National Industrial Policy -- China’s ultimate strategy is to modernize all parts of its economy, though major parts, such as agriculture, are antiquated and deliberately kept labor intensive. Yet, key areas of that economy, particularly those associated with industrial expansion and military modernization, are being leapfrogged from the 19^th to the 21^st centuries now.

The absence of previous Chinese investment is actually a benefit in many sectors. Viewed historically, as Japan and Germany built most of their industrial infrastructure anew following the Second World War and gained significant economic benefits and advantage, so too is China today.

Accordingly, China’s leaders have identified those industrial sectors that are to be "pillars" for future growth and thus will receive special treatment. These pillar industries include machinery, electronics, petrochemicals, automobiles, and materials. These are areas where China is leap frogging national development.

To that end, the Chinese government targets foreign investment by explicitly defining which foreign investment is "encouraged," "permitted," "restricted," or "prohibited." Many of the resulting industrial policies are obvious. Since June 1995, for instance, China’s industrial policies on foreign investment have been codified in the form of laws and regulations and made public. These policies encourage investment in China’s Western and Central areas. They also identify 272 types of equipment that can be imported tariff free, generally equipment not yet produced domestically. Much of the "permitted" production is for goods that are 100 percent exported.

But much of China’s industrial policy is hidden, allowing Chinese leaders to bargain with foreigners over the size and location of their investments, technology transfers, and the donation of equipment, training, and education to China.

Beyond promoting specific industrial and regional development objectives, China’s targeting also provides special benefits to military modernization, allowing them to concentrate on those technologies and capabilities with multiple uses. While China’s targeting of dual-use technologies is well documented, China in fact is pursuing a "Quadra-Use" strategy. That is, China is targeting technologies that can simultaneously be used in four ways:

1. Create and improve production of goods for domestic consumption,
2. Develop an export capacity that can produce foreign capital,
3. Apply to military uses,
4. Establish a strategic and economic foreign dependence on Chinese production for key goods or components.

Thus, the movement of commercial technological capacity to China is also a shift of military technological capacity as well.

The longer-term concern is not that China is following a Quadra-use strategy, since that seems technologically and economically inevitable, but that China becomes the dominant, if not only, global source of some of these commercial technologies. That is now a likely prospect, as China becomes the world’s manufacturing workhouse. Put another way, the USA now faces a question it has not faced since the Revolutionary War — that is, what level of domestic production of which commercial technologies must it retain to assure an uninterrupted supply of high-quality items for both its domestic and military uses?

Foreign Direct Investment -- China is financing a major portion of its economic and technological development with foreign capital. In 2001, almost $47 billion of new foreign investment was made in China. The Chinese Government reports that 400 of the Fortune 500 global enterprises have invested in China. As of the beginning of 2002, the Chinese Government also reports that these companies had also established more than 100 major research and development centers, with US companies leading the creation of such centers and European nations following. Beginning in 2001, Japanese corporations also began to make similar large R&D commitments in China.

China is attractive for FDI for several basic reasons. For export-oriented operations, costs are low, workers are compliant, and government incentives exist in many sectors and regions. The cost differential of operating in China for most manufacturers, coupled with US open door trade policies for imports, gives these producers a definite cost advantage over competitors who retain US-based manufacturing. Indeed, few if any US manufacturers can compete with Chinese based factories operating with the most advanced technologies, the most modern equipment, and virtually free Chinese labor.

Equally important, China is viewed as a major emerging market where access often depends on domestic production. The promise is that by investing in China, foreign enterprises will have an opportunity to capture some part of that growing market, and sometimes this actually happens. Finally, companies that invest and produce in China, generally with partners acceptable to the Chinese Government, have the potential to be part of national production cartels, with all the benefits that creates. Expressed another way, foreign companies have limited prospects for competing in China through exports into that market. Domestic investment there is required for any meaningful penetration of China’s domestic market.

The massive FDI going into China has several implications. First, it is helping China build a state-of-the-art manufacturing base and helping China import state-of-the-art manufacturing know how, making China an advanced industrial state long before it could where it to rely on domestic capital and resources.

Second, the expansion of major corporate R&D centers in China is accelerating that nation’s technological development, which is being used both for industrial expansion and military modernization.

The shift of such work to China follows a two-decade trend of globalizing intellectual work. As recently as 1985, the value of the industrial R&D performed abroad by foreign affiliates of U.S. parent companies was less than $4 billion, and much of that by only a handful of companies such as IBM. The National Science Foundation Science Indicators 2002 reports that by 1999 such foreign-based R&D had increased more than 450 percent to almost $17 billion. Such R&D investment is a major means of transferring technology and skills. In the process, China is gaining technology it would require decades to develop on its own.

And with co-location of R&D and manufacturing, China is gaining unique skills since much of manufacturing improvement comes from the close coordination between R&D, design, engineering and manufacturing — all of which are increasingly been done there.

Correspondingly and to the extent that US production and R&D are shifted to China, vital manufacturing know how that now abounds in the United States will whither. This, of course, is significant for long-term US industrial and military capacities.

Finally, as FDI expands and corporations become increasingly invested in and dependent upon their Chinese production facilities, those foreign corporations are becoming increasingly vulnerable to China’s political desires. Ultimately, the control of production is determined not by who owns the share certificates of a corporation, but who can physically command the factories, labs, and workers. And despite years of liberalization, China remains a one-party, Communist government that exerts significant power over the foreign corporations that operate there.

Viewed in context, a long-term strength of the US has been the surge capacity of its domestically based defense industrial base. To the extent that such capacity is dependent on US-owned factories located in China, the reliability of that supply is vulnerable to the dictates of China’s political leaders.

In the final analysis, the issue is not whether the source of China’s economic and technological advances is foreign or domestic, but that it is under Chinese control.

A Changing Economic Structure -- While China remains a Communist State with one-party rule, it exhibits far greater flexibility in adapting its industrial and economic structure that other communist nations, such as the former Soviet Union, Cuba or North Korea. Beginning in the late 1970s, China initiated a process by which it began moving away from collectivization and a centrally planned economy to one that is more market-oriented. In the process, China allowed small-scale service and light manufacturing to develop, permitted some private ownership of the means of production, and reduced some of its inefficient state-owned operations. And China has encouraged foreign investment, but only on China’s terms.

What is emerging is a hybrid economic structure. It is no longer an old-style Soviet centrally planned economy dominated by state owned production. Yet, much central planning remains and perhaps as many as 60 million Chinese are still employed in state-owned enterprises. While China allows private ownership of companies, much of the most lucrative parts of that ownership are held by those closely connected to the political elites. Some market-oriented operations are permitted but state targeting still drives the most advanced sectors of the economy and many sectors are protected from outside competition.

What is emerging in China is less an American-style market-oriented capitalism but a quasi-market, quasi-capitalism model more reminiscent of the Italian and German economies in the 1930s. Those, too, had private ownership, but were tied closely to the goals dictated by the state. Some competition existed, but it was kept in control. This mix of government direction and increased private ownership, coupled with an increasing reliance on markets, seems to be the direction China’s economic structure is headed.

That structure, of course, has important implications for the United States. Foremost, it means that much of China’s domestic market is likely to remain an export illusion for producers located in the USA. China’s policy of modernization, coupled with its need to create ever more and better domestic jobs, dictates that it mandate that those who wish to sell in China, produce in China.

China’s political and industrial structure also means that China’s leaders are far better able to structure balanced economic arrangements with the European Union and Japan than the United States. They are experienced at managing trade. In turn, the EU and Japan are far more accepting, understanding and experienced in cartel-like trade arrangements than the USA, and far more willing to defend their domestic production and jobs. In such an environment, the inevitable result is the USA will be expected to serve as a major market for China’s exports — a role it has filled for more than 15 years.

Today, the United States is no better prepared to deal with China’s targeting, industrial strategies, and cartel operations than it was with Japan’s. And with China’s targeting of commodity manufacturing, a real and present threat exists for such US based manufacturing — production that is at the core of America’s defense industrial base.

World Trade Organization Accession -- In 2001, China was admitted into the World Trade Organization (WTO), the global trade regime. This has two principal effects.

First, China now has increased access to most of the world’s market. China’s vast competitive advantage in commodity manufacturing, created largely by its unlimited supply of talented, low-cost workers coupled with FDI, increasingly enables that nation to dominate such manufacturing, particularly when China can engage in head-to-head competition with few restrictions. Even India and Pakistan, with their vast numbers of talented but inexpensive workers, acknowledge that they cannot compete with China in most manufacturing, such as textiles, under unstructured conditions.

The problem is that much of the US defense industrial base is ultimately dependent upon the US domestic commodity-manufacturing base. The economics of manufacturing is such that commodity production provides the infrastructure, skills, and technologies required to make specialized military goods.

For the United States to finance special factories to make such specialized items is cost prohibitive. To rely on foreign supplies is strategically dangerous. Yet, the extinction of domestic commodity manufacturing in the United States, and the defense related production it makes possible, is almost inevitable under existing US trade policies and global agreements.

China’s competitive dominance in commodity manufacturing, coupled with its growing access to world markets provided by WTO membership, creates several basic policy questions for US leaders. Notably,

• Which US manufacturing capacities are essential to the overall economy;
• Which US manufacturing capacities are essential to the US defense industrial base;
• Which US manufacturing sectors are vulnerable to Chinese competition;
• What are the consequences of America losing much of its manufacturing base?
• What are the US alternatives?

Inevitably, China’s membership in the WTO will accelerate foreign direct investment there and the relocation of factories, jobs, and production out of the United States. One of the key features of WTO membership is the protection of foreign investment and intellectual property rights. In other words, WTO makes China — in theory -- a safer place for foreign companies to operate.

While 400 of the Fortune 500 corporations are already invested in China to some degree, this treaty-based safety of investment is already encouraging an expansion of their operations there, plus inducing smaller, investors to also shift operations into China.

While WTO membership requires China to adopt certain global rules and make its trade system transparent, it also requires the United States to deal with Chinese trade barriers through the WTO processes. Until now, the United States had great potential advantage with the Chinese Government, largely because of the vast trade surplus China enjoyed with the USA and on which it depends. Though never applied, such unilateral leverage was always available. Now, it is gone.

When US-China trade disputes arise now, a company must first seek the assistance of the US Government. And if US officials decide to take on the matter, and are unable to solve the problem informally, they must submit a formal complaint to the WTO in Switzerland. A WTO panel will be formed, a study undertaken and a judgment rendered. China can appeal a decision and even ignore a finding if it is willing to pay compensation to the United States or offset that finding with some other WTO claim and the finding of an improper US action.

Already, Chinese threats to file various WTO complaints suggest that China will aggressively use WTO procedures to their advantage.

Also, the WTO’s opening of China’s market for foreign producers will be agonizingly slow. Many of the political and structural reasons for this are outlined in the 2002 National Trade Estimate Report on Foreign Trade Barriers prepared by the Office of the United States Trade Representative (USTR).

Among the Chinese barriers the USTR identifies are:

• high import tariffs (even after a recent tariff lowering),
• tariff-rate quotas (a two-level set of tariffs, low for levels within quota, high for those over quota),
• Import licensing,
• Testing and standards,
• Local content requirements,
• Quarantine procedures,
• Sanitary and phytosanitary measures,
• Discriminatory administration of value added taxes,
• Quantitative quotas,
• Export licenses,
• Discriminatory anti-dumping procedures,
• Unpublished laws and regulations,
• State licensed trading rights (import and export),
• Required use of local agents to distribute imported goods,
• Import substitution measures,
• State certifications,
• Import quality licenses,
• Import commodity safety licenses,
• Labeling requirements,
• Hidden export subsidies,
• Weak enforcement of intellectual property laws,
• Distribution restricted to Chinese-owned firms,
• Highly regulated transport and logistics, and
• Unofficial local content requirements, among others.

Though China promises to reduce those barriers as part of its WTO accession, the transition will likely take many years and will be exceedingly difficult at best.

In the face of such import barriers, the most profitable route for most foreign investors is to use China as a low-cost, high-quality export platform, while seeking permission to make whatever local sales may be possible.

Conclusion

While industrial and military self-sufficiency was U.S. policy for more than two centuries, that policy no longer exists. Instead, the U.S. Government has elected, through many uncoordinated decisions made over a number of years, to globalize the U.S. economy and its defense industrial base.

Consequently, the U.S. manufacturing sector is rapidly hollowing out. Basic and high technology industries are shifting their production, research and development, and now back office functions to other nations. A host of U.S. policies are encouraging these shifts.

One consequence of this policy shift and the economic hollowing out is that a large and growing portion of the manufactured goods used in both the U.S. economy and the U.S. defense sectors are coming from factories based in other nations. More significant, more than half of all merchandise imported into the United States, other than from Canada and Mexico, now comes from factories located in China and the nations that immediately surround it.

Another result is that as the U.S. military increases its reliance on readily available commercial technologies, it is also relying on suppliers located in other nations. Moreover, many of these components, particularly electronics are coming from China and the nations clustered around it. The two key policy questions this raises are: Would that long supply line across the Pacific be secure in time of war and are reliable alternatives available?

Today, the United States Government does not know the source of many key components used in its weapons systems. Without that knowledge, the Department of Defense cannot assure the reliability of supply during a time of prolonged warfare.

Nor can the United States be assured of the integrity of many items it is using in its vast system of electronic networks that underpin both the domestic and military economies. Increasingly, these networks rely on imported components that are vulnerable to sabotage or being modified to carry "Trojan horse" programs and viruses that could be used against the United States in an information war. Moreover, a number of sources claim that China’s military doctrine is to make a first strike at an adversary’s information system. This is the U.S. "Achilles heel."

Ultimately, the key concern identified in this study is less that of the transfer of high technology capacities to China, which is inevitable, but the hollowing of the US defense industrial base, which is not.