McDonnell Douglas-Taiwan Deal Presents U.S. With a Pandora’s Box

Judged against almost any measure of performance--growth, exports, productivity or innovation--the civilian aerospace industry has for decades been a star performer in the American economy. But today, McDonnell Douglas, the nation’s second-largest aircraft producer, is in trouble.

Its newest aircraft, the MD-11, has not been as successful as anticipated, and the company’s commercial operations are teetering on the brink of bankruptcy. Exacerbating matters, the nation’s Cold War victory means substantial contractions in its military operations.

At the end of 1991, a white knight in the form of Taiwan Aerospace, a public-private company established to build a Taiwanese aerospace industry, negotiated a deal with McDonnell Douglas to revive its commercial business. Taiwan Aerospace offered to buy a 40% equity share in Douglas Aircraft, the commercial arm of McDonnell Douglas. Of this amount, at least 29% would be provided by the Taiwanese government.

For McDonnell Douglas, the proposed deal is a godsend. To remain a player in the commercial market, the company is seeking a substantial infusion of capital to retire its $2.7-billion debt and begin development of a new aircraft, the MD-12. Despite its energetic efforts, the company has been unable to find American partners for its MD-12 project. In addition to providing necessary capital, the deal with Taiwan Aerospace would all but guarantee McDonnell Douglas’ access to East Asia’s burgeoning markets for commercial aircraft.

The Taiwanese government has targeted the aerospace industry not because of its commercial profitability so much as the special economic benefits it can bestow on technology development, export promotion and high-wage job creation.

While the Taiwanese government has thought carefully about the proposed deal, the American government has paid scant attention. Behind the American attitude is the presumption that what is good for a private company such as McDonnell Douglas is good for the nation. Although ideologically soothing, this presumption is irrelevant to the case at hand.

McDonnell Douglas is no ordinary private company--it is the nation’s largest military contractor and the guardian of some of its most advanced military technologies. And the proposed deal with Taiwan Aerospace is no ordinary market transaction--it involves the active participation of the Taiwanese government, without which the deal would collapse. Considering these factors, we might ask what the American government should do to protect American interests.

At a minimum, it should negotiate directly with the Taiwanese on three issues: the protection of American military technology, subcontracting arrangements and subsidies.

On the first issue, the United States must make sure that the deal is structured so that sensitive military technology does not fall into foreign hands. This will require regular monitoring by the Department of Defense or some other oversight agency.

On the second issue, the American government should bargain with the Taiwanese government to realize an equitable sharing of subcontracting work for the production of commercial aircraft by McDonnell Douglas. Understandably, the development-minded Taiwanese government wants to shift employment and production opportunities to Taiwan to build a strong aerospace industry. Shouldn’t our government, concerned as it professes to be with the long-run competitiveness of American industry, try to keep as many of these opportunities at home as possible?

Finally, the United States must negotiate with the Taiwanese on the amount and kinds of government subsidies that will be allowed as part of their arrangement with McDonnell Douglas. The company will need several billion dollars to develop the MD-12. Where will this money come from?

In the unlikely event that private Asian investors supply the necessary funds, there is no public policy problem. But in the probable event that the Taiwanese and other East Asian governments offer the bulk of development financing on non-market terms, the deal will violate and derail a proposed American agreement with the Europeans to restrict government subsidies for the aircraft industry.

Without such an agreement, the Europeans are almost sure to provide massive subsidies for a new Airbus model to compete with the Boeing 747. Boeing will then find itself confronted with heavily subsidized competition from both Asia and Europe. Under these circumstances, the dangers of a trade or subsidy war among the United States, Europe and Asia will intensify, threatening to harm all sides and undermine the international trading system.

For these reasons, the United States must not allow the possibility of a substantive compromise with the Europeans to be jeopardized by the McDonnell Douglas deal. This requires an upfront understanding with the Taiwanese that the deal must adhere to current GATT regulations and to any future multilateral regulations on subsidies.

The active intervention of the American government in questions of technology transfer, subcontracting and allowable subsidies may itself derail the deal between McDonnell Douglas and Taiwan Aerospace. But perhaps this is as it should be. Indeed, a strategic analysis of aircraft competition suggests that the government should block the deal outright.

The slump in the global aircraft market is likely to continue several years. The entry of new capacity for the MD-12 will make matters worse, with ominous implications for prices, profits and trade conflict. Excess capacity will encourage cutthroat price discounting and aggressive sales campaigns that are likely to fuel further trade disputes between the United States and Europe.

Ironically, the MD-12 is likely to pose the greatest competitive challenge not to Airbus but to Boeing. If the MD-12 lives up to its billing--which, given recent performance shortfalls of the MD-11, should not be taken for granted--it will be about the same passenger size as the Boeing 747 but with a longer range. To meet the MD-12 competition, Boeing will be forced to offer substantial price discounts on its 747.

But while Boeing’s profits are likely to fall, McDonnell Douglas’ profits are not likely to increase. Even if the MD-12 attracts customers, it will be a high-cost aircraft for two reasons.

First, many of the people involved in its production will have little or no experience producing commercial aircraft. Second, because the MD-12 is not a major technological innovation over existing models, it will not command a healthy market share for very long.

A long-distance jumbo jet of the sort envisioned in the Airbus 350 proposal will probably make it obsolete by the decade’s end. Without a long production run, however, its costs will remain high.

To make matters worse, it is possible that the Europeans will respond to the deal between McDonnell Douglas and Taiwan Aerospace by launching the A350 immediately, rather than waiting until demand increases. If so, prices will decline still further, and trade friction between the United States and Europe will become even more pernicious.

If instead the Europeans wait to launch the A350 until the market is right, the American companies will engage in a free-for-all with each other, damaging their capacity for the next round of product launch. At a more propitious moment, Airbus, relatively unscathed by the previous battle, can waltz in and claim a more valuable market niche.

Given the likely adverse consequences of MD-12 development on the American industry, the U.S. government would be well advised to block its launch at this time. This implies opposing the deal between McDonnell-Douglas and Taiwan Aerospace in its current form. But active opposition is not enough.

The government must provide support for a forward-looking, domestically based rationalization plan for McDonnell Douglas’ commercial and military operations, as well as a complementary plan for the conversion and rationalization of the nation’s other military aircraft operations. American aircraft producers and their suppliers should help formulate these plans, which should be designed to reduce the adjustment costs of conversion and to guarantee that the American industry will have the financial and technological capacity to meet the inevitable Airbus 350 challenge.

Sadly, few of the strategic consequences of the McDonnell Douglas deal have been raised in the public debate. This reflects a woeful lack of vision in domestic policy circles about what is arguably the nation’s most strategically significant industry.

As the United States scales back its defense efforts, policy-makers must discard their ideological blinders and refashion the nation’s unwitting backdoor industrial policy into a commercially oriented economic strategy for its high-technology industries. Obviously, military and economic requirements dictate that the aircraft industry is the place to begin.