Defense Reform 2016?

Congress again returns to a beloved topic, defense reform, and its policy lineup lacks any thought or imagination.

For now, let's examine the appeal of decentralization. Rep. Mac Thornberry believes that this is done by allowing the services to have more say in planning and programming through an increased role on the requirements generation and acquisition milestone processes. He also would like to break up his staff in OUSD(AT&L) by bringing back the Director of Defense Research and Engineering (DDR&E).

Note there are two "decentralizations" going on.

First, there is a decentralization of power from the OSD staff to the operating services. More decisions will be made by service executives than staff. The focal point of decision making on the services will resemble a weakened form of what had existed between 1949-58 and 1969-86.

Second, there is decentralization in the OSD staff itself. OUSD(AT&L), which is in the line of command but not an operating unit, was itself the product of a merger between DDR&E and manpower and installations functions from Goldwater-Nichols in 1986. Where decision making focuses on the OSD staff, they inevitably will come down to the detail of operations, requiring greater scale and specialization. This process grows staff into a hierarchy within a hierarchy.

The old myth of the staff had it that it that staff wasn't an operating unit, nor in the line of command. It collecting information, advised, and evaluated on behalf of the commander, and had no authority of its own.

However, with the 1958 Reorganization Act, DDR&E was created in order to bypass the long chain where lower echelons in the staff have to run up to the Secretary of Defense and then back down the appropriate chain in the services. The staff to the Secretary gained "legal" authority to exercise power over directing the services.

While the services are mission oriented with their own straight-line hierarchies, the staff is organized functionally. The functions, such as R&D, logistics, etc., are shared by all missions. Numerous lines of command in the staff have authority affecting operating decisions in the service hierarchy but no responsibility for the resulting outcomes.

This is how you get, as Admiral Rickover once lamented, a six month delay "just because one staff person with no responsibility but with authority had on his own decided that the policy was wrong."

What is ironic is that the second decentralization, fragmenting OUSD(AT&L), doesn't really appear to be reducing its overall power. While it reduces its authority in some aspects, which are devolved to the services, it appears that the strong mandate pursued by DDR&E will provide it new areas of authority which, by being out front of the acquisition process, might grow those areas.

Assisted Return

When I was in Oslo last week I noticed interesting government advertisements on their metro system. The same message was repeated in various languages, stating "Assisted return. Apply now. New rules from September 1." Not much else needed to be said by the Norwegian Directorate of Immigration (UDI) as the intent was clear -- we'll pay you to get out.

Euro-style American Colonization Society

Immigrants makes up 15.6% of the population in Norway as of the beginning of 2015, including children born in Norway to two immigrant parents. Roughly half (though quickly decreasing half) of these immigrants are from neighboring European countries, including Sweden, Estonia, and Poland.

In the abstract, I tend to like the idea of open boarders as a way of improving people's lives and economic productivity. But it is clear that even with many open minded people and state support, volatility and resentment will rear its ugly head.

The first thing that came to mind upon seeing the Oslo poster shown above was the similarities to the old American Colonization Society (ACS). The purpose of the ACS was to free black slaves and repatriate them to Africa, which help founded the colony (and modern day country) of Liberia in 1821.

"Enlightened" gentlemen such as Thomas Jefferson were major proponents of this movement, even going so far as to raid the Virginia Literary Fund to find money for such ventures. I will look for the citation, but this fact struck me hard as an undergraduate taking Virginia History. Jefferson was known, however, for using the Virginia Literary Fund for his own projects.

"On February 21, 1818, the Virginia legislature passed "An Act Appropriating Part of the Revenue of the Literary Fund, and for other Purposes," which set aside $45,000 annually to support elementary schools and $15,000 annually to support the University of Virginia[....] The annual amount appropriated under the Act was insufficient to meeting the University's construction costs."

  An act passed the following year gave UVA the power of the Literary Fund's purse, it:

"gave the Visitors [of UVA] the authority to draw money from the literary fund, and to regulate the tuition fees paid by students and the amount of rent charged for occupying the University's student dormitories. The Professors received a standing salary drawn from the Literary Fund endowment."

The Literary Fund originally had 25% of its budget siphoned off for UVA, which soon expanded so much as to effectively end Virginia's public elementary school system. The Literary 'Slush' Fund could then be used to support the American Colonization Society.

Paying to remove "less desirable" neighbors is the natural solution for the racist who finds himself conflicted with personal ideals about human rights. Germany's openness for refugees may be genuine, but I'm afraid such assisted return programs will be the first step in a degenerative bout of xenophobia.

The Good Job

"One theme that I found especially intriguing in the Mokyr, Vickers, and Ziebarth argument is how some of our social attitudes about what constitutes a "good job" have nearly gone full circle in the last couple of centuries. Back at the time of the Industrial Revolution in the late 18th and into the 19th century, it was common to hear arguments that the shift from farms, artisans, and home production into factories involved a reduction in the quality of work. But in recent decades, a shift away from factories and back toward decentralized production is sometimes viewed as a decline in the quality of work, too.

That was from the timeless Timothy Taylor. And this:

"There is clearly a kind of rosy-eyed nostalgia at work about the qualities of jobs of the past. Many of us tend to focus on a relatively small number of past jobs, not the jobs that most people did most of the time. In addition, we focus on a few characteristics of those jobs, not the way the jobs were actually experienced by workers of that time."

A Fiscal Scenario By Any Other Name

Paul Krugman: "I wrote Monday about the strange phenomenon of Republicans lining up to propose cuts to Social Security, a deeply unpopular policy that is, however, also a really bad idea. How unpopular? Lee Drutman has the data: only 6 percent of American voters support Social Security cuts, while a majority want it increased. I argued that this apparent act of political self-destructiveness probably reflected an attempt to curry favor with wealthy donors, who are very much at odds with the general public on this issue:..."

Regardless of whether the Republican cuts are ill-designed or voters overwhelmingly support increasing benefits, earned benefits have to be on the table for the U.S. to be able to meet its future obligations. The National Debt is over $18tn, but Laurence Kotlikoff states the true fiscal gap as measured by the present value of expected future taxes less expenditures is over $200tn. He goes on:

"[There is] irresponsible behavior on the parts of politicians of both sides who are trying to get the elderly's vote. When President Bush introduced Medicare Part D, which is prescription drug insurance for the elderly, [he added] another $15 trillion to the fiscal gap. He didn't ask a single old person, including Warren Buffett, to pay a penny for this extra form of social insurance.

...So a lot of people like to portray this as the Right vs. the Left, the poor vs. the rich, but it's really adults vs. children."

Like Kotlikoff, I believe in social safety nets. but something that can't go on won't. The Congressional Budget Office is apparently more concerned than they let on. The CBO produces two fiscal scenarios:

 "they put out what's called the 'Baseline Extended Budget Forecast,' based on forecast which is a complete fabrication of what they really think; and they also have put out, but rather quietly, this 'Alternative Fiscal Scenario,' which shows the official debt, as it's currently measured, exploding through time."

The nation's fiscal situation is similar to Detroit, but it has the benefit of the Federal Reserve to buy more time. One has to address the elephants in the room -- Social Security, Medicare, defense, tax policy (and of course Planned Parenthood).

One important item not often addressed is the Homeowner Tax Credit. Not only is it an expensive program (in foregone revenues), but it distorts the housing market. Yet it is a program with such momentum that pulling the plug will lead to foreclosures because those benefits are now priced into the market. Further, the Tax Credit subsidizes interest payments instead of down payments, and therefore households are incentivized to take on more debt.

The Homeowner Tax Credit was a political, not an economic, policy. This helps to create a vested interest with a broad base (both Republicans and Democrats own houses). 

The same is true for earned benefits. Now this doesn't mean that these policies don't attempt to achieve desirable ends or their principles should be abandoned. But we do need to recognize when one generation expects to get out far more than they put in. We need to recognize that what is prudence in the conduct of every private family can scarce be folly in that of a nation. No parent would leverage their children's future earnings to increase their own income with the understanding that it will be impossible for the child to recover by doing the same to the next generation.

Quality Choice and Net Neutrality

The net neutrality question is one that has been of particular interest of recent, and government policy in this area has many complex repercussions. In short, internet service providers (ISPs) can either provide the same quality service to all content providers at a flat rate (the status quo), or provide a range of qualities and corresponding prices. Much of that debate will not be discussed here. 

The purpose of this post is to evaluate the circumstances of net neutrality in one specific context: where the ISP is an assumed monopolist and can choose provide an array of service quality contracts at differing prices. The consumers then self-select and reveal their preferences based on the contract they choose. It will be assumed throughout that the profit maximizing monopolist has a marginal cost of zero for providing any quality service.

It is clear that should all consumers have the same preferences, the monopolist would choose the one quality/price pair that maximizes profits. If consumers had differing valuations but the monopolist had perfect information on this, then the monopolist would act as a perfect price discriminator (assuming no arbitrage). In either case, the monopolist would charge where the consumer’s marginal value for quality equals marginal cost (zero) and earn the total consumer value. 

             

More realistically, the monopolist does not know consumer valuations. Let’s start by assuming that there are two types of consumers: Low-Types and High-Types. Low-Types value may range from 0-100% of the High-Types and we assume that each group represents half the population. The general result is that when the Low-Types value a good at less than or equal to 50% of High-Types, the monopolist maximizes profits by driving the low-quality good down to zero, or taking classic monopoly profits on the High-Types alone.  

The pair of charts below depicts this situation. Left Chart: the monopolist would like to choose the low-end quality that maximizes their profits (choose X-coordinate at a function's peak). Right Chart: for a profit maximizing quality choice, how much of the total consumer value is being captured.
 

In instances where Low-Types value a good greater than 50% of the High-Types, it benefits the monopolist to keep a lower-quality good in the market. As Low-Types values converge on the High-Types, the optimal low-quality also converges on high-quality. Again, this is the case only when there are an equal number of Low- and High-Types.

We may also vary the distribution of each consumer-type to see how our answer changes. The chart below fixes the Low-Type value to half that of the High-Type, but changes the weighting of group size. The black line is where there are equal numbers of Low and High-Types. One can see that should there be a high proportion of Low-Types, the low-quality converges on the Low-Types value and it is optimal for the producer to attempt a monopoly in that market. 

Instead of charging the High-Types where their marginal benefit equals marginal cost, the preponderance of Low-Types makes it more profitable for the monopolist to extract all the welfare from the Low-Types. Should Low-Types have a value 30% or 70% that of the High-Types, the monopolist's optimal low-quality will be 30% and 70%, respectively, of the high-quality. Not surprisingly, relatively many High-Types tend to drive the low-quality good out of the market so the monopolist can extract the High-Types’ entire welfare. 

 

Within our context, these results help inform an opinion on the net neutrality debate. The types of quality provided depend on the distribution and intensities of consumer valuations. Where there are many High-Types, or Low-Types perceive the good/service to be far less valuable than the High-Types, the monopolist will tend to drive the low-end quality downwards and often out of the market. 

Large internet content providers, like Netflix, YouTube and Google, tend not only to demand high quality but use the ISP service more frequently as well. Their revenue generally depends on internet-user traffic. The faster the service, the more likely the website will retain or increase traffic relative to competitors. Therefore, these “High-Type” content providers would be keen on acquiring higher quality service if only to not lose market-share.   

Those who are “Low-Types,” perhaps because they cannot afford it, may see their traffic diminish due to low quality and find their relative market position worse than it was before. If low quality service is driven out, then the “Low-Type” content providers will simply leave. This outcome would appear most undesirable. More likely is that there will be a mandatory minimum quality; such a policy would alleviate the worst of these outcomes despite its distortions. On the other hand, if it turns out that Low-Types share of internet traffic is high, or that Low-Types value the service quite highly, then social welfare may be increased by abandoning net neutrality. 

I tend to believe that the vast majority of websites see very low traffic and have low willingness to pay for high quality service relative to the internet giants, suggesting net neutrality may benefit diversity and competition.

Navy Corruption Scandal

"Between September 2011 and June 2012, GDMA submitted 117 fake bids for incidentals to the Navy’s pricing database—for one port alone. But those 117 incidents comprised only 35 unique bids. GDMA would often just resubmit the same fraudulent pricing quotes over and over again.

And remember, those [117] quotes were just for one port for a short period of time. GDMA has been doing the same at dozens of ports for years.

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A typical example of this kind of corruption is what the GDMA did to the Navy in Thailand.

American ships require fuel with no biodiesel content. The DLA didn’t have any relationships with fuel vendors in Thailand, so the Navy asked GDMA to see if Bangkok could provide the fuel.

“[Fuel] is unavailable due to Thailand’s regulation that diesel in the country must have a biodiesel content mix which does not meet [Navy] requirements,” GDMA explained in forms provided to the Navy. “GDMA will provide [the Navy with fuel] from its own stocks which are imported and contain no biodisel.”

It was a lie. Bangkok had no regulations requiring a biodiesel mix. So GDMA bought the fuel from local suppliers, then sold it back to the Navy … and not at cost, as its contract required. GDMA overcharged for every gallon of fuel it sold to American ships.

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Any time ships from the Seventh Fleet docked in Thailand, GDMA would take care of the tariffs, then use a fake company to bill the Navy at exorbitant prices.

GDMA billed the Navy about $300,000 when a ship docked at the port of Laem Chabang in Thailand. Prosecutors in the case went back through the Thai port authority’s Website, cross referenced the tariffs charged at the time and got the real total.

The Navy only owed $35,000 for the Seventh Fleet ship."

That was from War is Boring. A Justice Department report is here. And this is how they got away with it for so long:

"Of all [the] cronies, NCIS supervisory agent John Bertrand Beliveau was [the] most important. Beliveau was [GMDA]'s man inside the criminal investigative wing of the Navy. Thanks to the agent’s efforts, [GMDA] was able to stay one step ahead of investigators for years."

Chinese Engineer Devaluation

"After recent data showing falling exports and a stalling manufacturing sector, the central bank said on Tuesday that it was allowing the yuan to weaken by nearly 2% in the hope of making China’s exports cheaper and pushing down borrowing costs."

From the Guardian. Chris Balding adds that "The trading rate was already near the new official rate almost 2% away from the old official rate prior to the devaluation." He goes on:

"The biggest currency risk here is that by resetting expectations on the RMB/$, it is creating future expectations of devaluations. The [People's Bank of China] PBOC can talk all day about market conditions and their models, but markets don’t like to be surprised and the PBOC has just created future expectations.  It will be very hard for the PBOC to put this genie back in the bottle.  The real risk is that China is going to be forced to release the RMB."

Two things to add:

1) Sweeping policies (even with forward guidance) inject uncertainty and volatility into markets which respond in complex ways.

2) China now has less than $4tn of reserves, which isn't a whole lot for a nation its size. If we consider the RMB 'backed' by foreign reserves (such as the US Dollar), then their position is precarious indeed. The devaluation helps reduce the value of China's liabilities (i.e. the RMB currency), and could perhaps stave off a liquidity crisis if a crunch comes.

"To supplement the liquidity outflows, economists expect the central bank to further reduce the amount of cash that is required to be held as reserves by financial institutions."

Further, there's this:

"Since March 2014, around the time China’s holdings of US Treasuries peaked at $1.65 trillion, through May 2015, China reduced its holdings by $180 billion, according to the US Treasury Department’s most recent data, reported Bloomberg."

This devaluation is likely part of a response to a broader crisis than a slump in exports.