DoD may be sick with Baumol's Cost Disease

I've had this post written as a draft for some time, but given the sad news that William Baumol has passed away, I thought it would be appropriate to post it today.

Baumol's cost disease occurs when sectors with low productivity are forced to raise wages. The Economist succinctly explains the repercussions:

Employers in such sectors face a problem: they also need to increase their wages so workers don’t defect. The result is that, although output per worker rises only slowly or not at all, wages go up as fast as they do in the rest of the economy. As the costs of production in stagnant sectors rise, firms are forced to raise prices. These increases are faster than those in sectors where productivity is improving, and faster than inflation (which blends together all the prices in the economy). So prices of goods from stagnant sectors must rise in real terms. Hence “cost disease”.

The Wall St. Journal had an article arguing that gains in productivity are more difficult in the services sector. This makes services more prone to cost disease. How susceptible is the military to this concern?

The Defense Department faces pressure to keep military salaries, which are based on experience and rank rather than achievement, comparable to civilian wages. And, while factors influencing military productivity have been studied in the past, more research is necessary to fully understand whether overall productivity is increasing in line with other sectors.

Some military innovations have led to increases in productivity. Examples include precision weapons, GPS, remotely piloted aircraft, operational support contracting, and online services. These savings are partially reflected in the decline in military endstrength. Nevertheless, the military is heavily reliant on manpower -- boots on the ground is a common measure of engagement -- to provide national security. And, the services are requesting increases in personnel to support perceived mission requirements.

Given that the cost of military personnel consumes over a third of the defense budget and that the department spends over $10 billion annually on recruiting and initial training, DoD should be aware of the impact that cost disease has on wages and attempt to link salaries to productivity to a greater extent by defining and measuring worker output.

Using tariffs to protect national security →

President Trump has directed the Secretary of Commerce to use authorities in the Trade Expansion Act of 1962 to determine if domestic steel production capacity is sufficient for national defense requirements. And:

Pursuant to section 232(b) of the Act (19 U.S.C. 1862(b)), if the Secretary finds that steel is being imported into the United States in such quantities or under such circumstances as to threaten to impair the national security, the Secretary shall, in the report submitted under subsection (a) of this section, recommend actions and steps that should be taken to adjust steel imports so that they will not threaten to impair the national security.

Adjusting steel imports suggests imposing tariffs (or quotas). Scott Summer provides an excellent breakdown of the inherent problems with imposing steel tariffs for national security reasons.

Though steel, along with many other commodities, is essential for national security, tariffs will hurt other manufacturers by driving up the cost of an important raw material.

Overall economic prosperity contributes more to national security than any particular industry.

Cultural Norms vs. Market Norms →

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U.S. Air Force 934th Airlift Wing leaders salute Airmen as their aircraft taxis on the runway for takeoff. (U.S. Air Force Photo by Tech Sgt. Bob Sommer)

The Air Force has replaced its cultural norms with market norms. And, it cannot compete with the airlines' market power.

Getting back to commitment

In watching the testimony on the pilot crisis, I noted that the Marines do not rely on bonus payments to the same extent as other services. The Air Force has paid a $25K annual bonus for decades that they would like to increase to $35K. In contrast, the Marines haven't offered a bonus since 2011 and plan to offer a temporary, targeted bonus to address its pilot retention concerns.

I recently participated in a conversation about pilot retention during which I learned that a pilot who leaves the service after their initial service commitment and flies for the airlines will make $1.3 million more than if they stayed in the Air Force until 20 years and then began a flying career. I have not verified this number; but, clearly, the Air Force cannot pay pilots a $1.3 million bonus.

After the conversation, I re-read Dan Ariely's book Payoff in which he addresses the long-term effect that bonuses have on worker behavior.

“The bonus, however, would put a numerical value on something that wasn’t countable to begin with: your commitment”

It seems the Marines understood long ago that commitment was not something they were willing to sacrifice by offering extrinsic rewards. They would rather see those who lack commitment leave. Now that the Air Force has established a bonus, pilots have come to expect these payments. Even when the airlines have been in periods of decline, the Air Force has been unable to curtail bonuses. Why? Perhaps, they are in a predicament where they cannot restore intrinsic rewards that build commitment. If this is the case, how does an organization shift from the transactional relationships that bonuses foment and return to a reward mechanism that builds commitment?

Handbook of Defense Economics →

Though dated, the two volume Handbook of Defense Economics (edited by Todd Sandler and Keith Hartley) is a good primer that covers a wide range of post-Cold War defense topics. The first volume was published in 1995 and the second is now 10 years old. Perhaps we'll see a third volume soon. I would like to see research on the principal-agent issues inherent in the Defense Iron Triangle, the implementation of contract theory in procurement, and use of market design in personnel policy.

What would you like to see?