The brouhaha this month over the U.S. payment of $400 million plus interest to our enemy Iran over a long-forgotten defense contract offers lessons both in economics and history. It blew up in the second week in August, exactly 102 years after the German battlecruiser Goeben was handed over to the Young Turks ruling in Constantinople on the cusp of World War I. Economically, the two events are related, and old-timers who remember the heyday of the defense plant in Fridley should understand the Iran half of this pairing.
But Americans are not a very historical people and few will connect the dots. So let’s first look at the history to get to the economics involved.
The Ottoman monarchy in Turkey was overthrown by young reformists in 1908. As part of a modernization campaign, the new regime purchased two state-of-the-art Dreadnought-style battleships constructed in England. Funds were short and a popular drive raised coins from peasants, schoolchildren and even widows for the impoverished but proud nation to pay for these enormously expensive superweapons.
The ships were ready for acceptance and 500 Turkish sailors were already in England when World War I broke out. The “battleship race” between enemies Britain and Germany was a contributing factor to the outbreak of the war as the British feared their opponent’s burgeoning navy. One way to improve the odds was to seize the two new battleships just completed for the Turks. The British had some contractual right to do this, but they also refused to refund the money the Turks had so painfully accumulated.
The Turkish government and people were outraged, and Germany was already wooing them as an ally. On Aug.10, 1914, when the German battlecruiser Goeben and light cruiser Breslau arrived at the entrance to the Dardanelles near Constantinople seeking shelter, it forced the Turks to choose sides in a war they would have preferred to stay out of. The Germans cannily offered these two ships to the Turks as replacements for the two “stolen” by Britain. That helped bring the Turks in to aid the Central Powers.
Winston Churchill, who, as First Lord of the Admiralty, had decided to arrogantly stiff the Turks, later ruefully admitted that the upshot was “more slaughter, more misery, and more ruin than has ever before been borne within the compass of a ship.”
Fast-forward 60 years to the 1970s and another proud Mideastern nation with aspirations of modernity wanted to buy latest-technology warships. Iran, then ruled by Shah Reza Pahlavi, ordered four very large guided missile destroyers, an upgrade from a class being built for the U.S. Navy. Longer, heavier, with newer electronics, better anti-air armament and much more capable air conditioning, these Kouroush-class ships would be the most capable vessels of their type in the world.
The contract was highly welcomed in southern Mississippi, where Ingalls Shipbuilding of Pascagoula was the prime contractor. But it was also welcomed in a wide radius of Fridley as the Northern Ordnance division of FMC was chosen to build the guns, missile launchers and the fire control systems. This promised good salaries for hundreds of employees for years. Moreover, in contrast to cutting and welding in a Gulf of Mexico shipyard, most of the jobs in Minnesota were engineering and technical.
The big destroyers were well along in construction when the Iranian revolution broke out, the Shah was deposed, Americans were taken hostage at our Tehran embassy and the Ayatollah Khomeini came to power. Iran canceled its purchase as it became clear that our country would never deliver the ships anyway. The hundreds of millions already paid by the Shah’s regime were only part of an extensive set of Iranian funds frozen by the U.S. government.
Employees at Ingalls, FMC and many other contractors involved experienced panic, as did local governments. There was immediate political pressure for the U.S. Navy to acquire the ships. There was an ironic logic involved. Because we no longer had a loyal client state controlling the entrance to the Persian Gulf, we needed more ships, especially ones designed with air conditioning and a mix of missile launchers, to operate in those waters.
That is how we acquired four “Ayatollah-class” warships that served in our Navy for a quarter-century. The unreturned payment has been one thorn among many in U.S.-Iranian relations all the while, though one with far greater weight for the Iranian people than for the U.S., which rapidly forgot it. Forgotten at least, until after years of negotiations by four administrations, the Obama administration this past January paid back the $400 million (plus $1.3 billion in interest, it was reported Wednesday) timed to just after five U.S. citizens held prisoner in Iran were released. With regard to that last part, the prisoners, whether the payment was “ransom,” albeit it was payment of money owed, or “leverage,” as the Obama administration would prefer to call it, has become a political question in the current presidential election.
Interesting historical anecdotes, one might say, but what economics are involved?
One involves the size and role of fixed costs in the armaments industry. Designing and testing a new dreadnought battleship in 1911 was complex and expensive, but it paled in comparison to the overhead involved, before the first weld, on a guided missile destroyer 65 years later. And this pales in comparison to the costs of developing sophisticated military technology today.
When fixed costs are high, the way to lower average costs per ship or plane is to spread such overhead costs over greater output. Judiciously selling some private production in Mississippi and Minnesota to foreign buyers accomplishes that. The British Admiralty of the early 20th century was pleased to see its private defense contractors sell ships to Turkey, Brazil and Japan because such foreign sales helped keep skilled workers employed and maintained a ship-building base larger than the country needed in time of peace. And it lowered the price of ships that Britain wanted to buy. Ditto for the Pentagon in the 1970s when the Shah wanted ships or in the 1980s when Pakistan wanted and paid for F-16 fighters that it never got.
Second, such foreign sales can spur research. The Admiralty in 1911 was too stodgy to try new gun layouts such as seven in-line turrets; but these were fine in the ships designated for sale to Turkey that ironically ended up in the British fleet instead. Similarly, the Shah was willing to invest in new radars and missile-launching configurations not yet adopted by the U.S. Navy. Military bling may represent a net loss to world society as a whole, but it historically has advanced technology, whether in metallurgy a century ago or integrated circuits in the 1970s.
Incidents like the sudden coalescing of political pressure for the U.S. Navy to buy the Iranian ships bear out the idea of a “military-industrial establishment,” coined for president Dwight Eisenhower by speechwriter Malcolm Moos, who later became president of the University of Minnesota. When it comes to local employment, there are no defense-spending cutters in Congress and there is broad support of foreign military sales.
The story also illustrates a long process of structural change in armaments industries. The big British shipbuilders like Vickers and Armstrong that sold worldwide, together with specialists like Elswick, Dreyer or Barr & Stroud, whose equipment was used by nearly every navy in the world, eventually all were absorbed into British Aerospace, which is now BAE Systems. What Twin Cities old-timers still refer to as the “Navy gun factory” in Fridley went from Northern Pump to Northern Ordnance to FMC to United Technology to, surprise, BAE Systems. Such consolidation may be inevitable, but it reduces competition, slows innovation and increases costs. This, however, is another economics lesson that we’ll have to revisit in a later column.