Even the Pentagon now realizes that Wall Street’s insatiable appetite for easy profits and love of monopoly has become a clear and present danger to the national security of the United States.
On May 17, 2017, in a little-noticed House Armed Services Committee hearing on defense procurement, members of Congress received a shocking warning about the biggest vulnerability in our national security architecture—and it wasn’t China or Russia.
About fifteen minutes into the hearing, former Vice Admiral Joseph Dyer, with a respectful southern accent and peppering his speech with “sir,” spoke about his company, iRobot. While today iRobot makes a popular automated vacuum cleaner, the Roomba, much of its earlier robotic technology wasn’t designed just to hoover crumbs and navigate corners but to carry out missions in warzones and outer space.
iRobot used to be everything that is best about the American corporate, academic, and public sectors, but then it sold off its defense business, offshored manufacturing, and radically cut its research. Changes that were dictated by an American hedge fund in an effort to squeeze out more money for the shareholders.
“In my trips to Wall Street,” Dyer told the panel, “one of my analyst friends took me to lunch one day and said, ‘Joe, you have to get iRobot out of the defense business. It’s killing your stock price.’ And I countered by saying ‘Well, what about the importance of DARPA and leading-edge technology? What about the stability that sometimes comes from the defense industry? What about patriotism?’ And his response was, ‘Joe, what is it about capitalism you don’t understand?’”
For years, hedge funds and private equity firms have been roiling our defense base. National security analysts finally noticed when the Pentagon released its annual report on defense industrial capabilities last month. For the first time in history, the report referenced the greatest threat to our national security industrial base: “a US business climate that has favored short-term shareholder earnings (versus long-term capital investment), deindustrialization, and an abstract, radical vision of ‘free trade,’ without fair trade enforcement” and the “self-defeating” “off-shoring and out-sourcing” that go along with it.
iRobot is a good illustration of how our financial system devastates our own national security. iRobot, which started in 1990 as a spinoff of MIT, was founded by three experts in robotics, artificial intelligence, and man-machine interface. In 1998, the company got a grant from the Defense Advanced Research Projects Agency (DARPA), the government agency that financed the creation of the internet, SIRI, the predecessor to GPS, and other conveniences of modern life. Their mission was to build an advanced robot that eventually came to be known as the PackBot. Packbot helped search the rubble after 9/11 and aided US troops in clearing mines in Iraq and Afghanistan. iRobot’s robotic technology has gone to Mars on rovers and was deployed in the Fukushima nuclear reactor meltdown to measure radioactivity. Its iRobot Seaglider was used to peer underwater after the Deepwater Horizon oil spill.
But iRobot no longer makes anything for the military. It now focuses, instead, on branding and manufacturing vacuum cleaners in China and Malaysia.
“What is It About Capitalism You Don’t Understand?”
In that same 2017 House hearing, Dyer explained what happened. An iRobot shareholder and former Goldman Sachs partner running a hedge fund called Red Mountain Capital, Willem Mesdag, sent a letter demanding that the company sell or shut down every part of its business that didn’t have to do with robots that clean things. He demanded that the company slash its research budget, use the excess cash for dividends, and focus on branding and extending its near-monopoly in automated vacuum cleaners (68 percent of the global market share, according to Mesdag’s letter). Mesdag engaged in a proxy fight to wrest control of the company from its engineering founders, accusing one of its founders and iRobot Chairman Colin Angle of engaging in “egregious and abusive use of shareholder capital” for investing in research. Research that, according to an iRobot spokesman, was intended “to spur innovation in robotics and robotics-related areas.” Mesdag argued that the money should have been used for share buybacks to boost the stock value instead of for research.
What Angle and Dyer did not understand about Wall Street’s current brand of capitalism, Mesdag did: the duty is to immediate short-term profit.
Angle was forced to cave. In 2016, iRobot divested its defense business, Endeavor Robotics, to a Washington, DC-based finance company called Arlington Capital Partners, a takeover shop that specializes in finding ways to consolidate companies in the government contracting space.
Some in the defense industry were hopeful that gaining freedom from the new version of iRobot would increase Endeavor’s ability to supply the warfighter. Since then, however, Endeavor lost its bid on the massive Common Robotic Soldier contract and has been purchased by FLIR systems for $385 million. It’s too soon to tell how this story ends, but the lesson is clear: iRobot no longer looks for ways to keep us and our service men and women safe, despite the appearance that its founders, its engineers, and its executives still wanted to. The potential mission of the company—even if it’s national security and safety of our service men and women— takes a backseat to shareholders’ desire for short-term profits.
During the iRobot hearing, then-Congressman Paul Cook (R-CA), an ex-Marine, put a fine point on the issue when he said that “the system we had right now, I swear to God, we would have lost World War II.”
This month’s Pentagon report comes to the same conclusion, noting that the system we have right now has “severely damaged” America’s ability to arm itself. For a “staggering” number of items in the supply chain, it notes, the US defense apparatus often has just “one—often fragile—supplier.” This is the result of Wall Street’s constant pressure to roll up and out-source our manufacturing capacity. Rare earth elements, telecommunications equipment like 5G, and pharmaceuticals are all vital national security industries that shifted overseas due to Wall Street short-term profit pressures. The rare earth industry was funded by Pentagon grants, similar to iRobot, and then sold to China by hedge fund investor Archibald Cox, Jr.
Rare earths were not the only industry out-sourced to China for short-term profit. Another Pentagon report from 2018 revealed that “China is the single or sole supplier for a number of specialty chemicals used in munitions and missiles…. A sudden and catastrophic loss of supply would disrupt DoD missile, satellite, space launch, and other defense manufacturing programs. In many cases, there are no substitutes readily available.”
Financiers profit off of national security the same way they profited off of the derivative market that led to the Great Recession: by increasing risk and converting that risk into profit.
And the Pentagon has finally taken notice. Wall Street’s insatiable appetite for easy profits and love of monopoly has become a clear and present danger to the national security of the United States.
How to Prevent Wall Street from Endangering Our National Security
It doesn’t have to be this way, and President Joe Biden has the chance to remake the system to stop this leakage of capacity. The financial sector, if properly incentivized and controlled, could provide the national security apparatus, and the country as a whole, a valuable service: allocating resources to profitable long-term investment in critical industries. Currently, however, as the Pentagon report indicates, the focus of our nation’s traders is not on long-term investment, but on short-term profit, stock manipulation, and creating monopoly power. It’s all about extraction rather than long-term production: A recent analysis by Thomas Philippon at NYU’s Stern School of Business concludes that Wall Street now siphons off an estimated 2 percent of GDP above and beyond the value of the services it provides. To put that into a national security perspective, finance firms rake in enough excess profit for themselves to fund the United States’ entire NATO defense spending obligation.
The good news is that we have faced this before and beaten it back, so we know it can be done. As President Franklin Roosevelt said in 1936:
“We had to struggle with the old enemies of peace—business and financial monopoly, speculation, reckless banking, class antagonism, sectionalism, war profiteering. They had begun to consider the Government of the United States as a mere appendage to their own affairs. We know now that Government by organized money is just as dangerous as Government by organized mob.”
But the “old enemies” are stronger than ever. Financial sector compensation has grown to an all-time high. When people think of big industry, they often think of the defense sector. The financial sector, however, dwarfs national defense, which is one reason why Wall Street has been able to get such control over it.
New rules and policies, or more forms for contractors to fill out, are not going to fix our national security crisis, and may in fact exacerbate it, if they do not focus on eliminating the financial sector’s stranglehold on the defense industry. Solutions must address Wall Street’s overwhelming power over defense contracting and marketplaces in general. The financial sector’s ability to create monopolies through consolidation and acquisitions, and its ability to control products and their innovators, like iRobot, must be broken.
There is ample precedent for the Pentagon breaking monopoly control over products in order to create redundancy in the supply chain. One historical method was the federal regulation that allowed the Department of Defense to take ownership of specialized tooling rights to create competition in cases with specialized spare part needs from World War II through Vietnam.
Another historical example: from World War I through the end of World War II, the Navy ran its own Naval Aircraft Factory “in order to assure a part of its aircraft supply” and “to obtain cost data for the Department’s guidance in its dealings with private manufacturers.” During World War II, the US government simply built the factories that it needed.
Former Undersecretary of Defense Frank Kendall’s idea for a Pentagon veto on mergers and acquisitions that affect national security is yet another method that could be employed to prevent monopoly consolidation.
If businesses are now beholden to the stockholder, the government could make itself a stockholder. For example, in situations like iRobot, where the government supplied initial funding, that funding could have been in exchange for stock or stock options. Willem Mesdag, the hedge fund manager who forced iRobot out of the defense business, didn’t take the original investment risk in iRobot’s R&D. In fact, Mesdag didn’t take a risk on any product innovation. The people taking risk were the founders and DARPA. Mesdag’s contribution was to pool enough money to buy 6 percent of the stock and then extract profit from the company at the expense of national security equities.
A significantly higher tax on short-term investment income and momentum trading could be helpful. Pairing that with an increase in the federal R&D tax credit could incentivize businesses to invest in research and development rather than short term gains.
Another way to get national security out from under the yoke of the shareholder could be to create a national Constituency (Stakeholder) statute, which 13 states already have. That would allow companies to consider the concerns of stakeholders like employees or the government when making decisions, not just shareholders. A study co-authored by London Business School professor Aleksandra Kacperczyk has shown that stakeholder statutes increase patents and innovation and reduce the type of hostile takeovers that lead to monopolies.
The “drastic consolidation” of our national security industrial base, as the Pentagon report describes it, is a national security emergency. It was created by short-term profit seeking and in order to control it, Congress and the Biden administration must go after the source of the problem before it’s too late.