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U.S. payment to Iran offers a window to history, economics

Ed Lotterman: Real World Economics
Ed Lotterman: Real World Economics

The brouhaha over a U.S. $400 million payment to Iran offers many lessons. It blew up exactly 102 years after the German battlecruiser Goeben was handed over to Turkey at the start of World War I. Economically, the two events are related, and old-timers in my hometown who remember the “Navy gun factory” in a nearby suburb of Fridley, Minn., may understand the Iran half of this pairing.

But Americans are not a historical people, and few will connect the dots. So let’s first look at history to get to the economics.

Turkey’s Ottoman monarchy was overthrown by young reformists in 1908. In modernizing, they purchased new two battleships from England. Funds were short and a drive raised coins from the populace to buy these enormously expensive superweapons.

The ships were ready, with 500 Turkish sailors already in England, when World War I broke out. The “battleship race” contributed to war fever as Britain feared a burgeoning German navy. Seizing two new battleships just completed for the Turks improved the odds. And Britain kept the money so painfully accumulated.

This outraged Turkish rulers and people alike. Germany wooed them as an ally. On Aug.10, 1914, the Goeben and light cruiser Breslau sought shelter at the Dardanelles, forcing the Turks to choose sides. The Germans cannily offered these to the Turks as replacements for those “stolen” by Britain. That helped bring the Turks in as allies.

Winston Churchill, who, as Admiralty head, had decided to stiff the Turks, ruefully admitted that this caused “more slaughter, more misery and more ruin than has ever before been borne within the compass of a ship.”

Fast-forward to the 1970s, when another Mideastern nation aspiring to modernity sought latest-technology warships. Iran ordered four large guided-missile destroyers, upgraded from those of our Navy. Longer, heavier, with newer electronics, better anti-air armament and more air conditioning, these ships would be the most capable of their type in the world.

The contract was welcomed in Mississippi, where Pascagoula’s Ingalls Shipbuilding was prime contractor, and in Minnesota, where the Northern Ordnance division of FMC was chosen to build the guns, missile launchers and fire-control systems. This meant good salaries for hundreds for years. Moreover, in contrast to shipyard cutting and welding, most of these jobs were engineering and technical.

The ships were near completion when Iran’s revolution broke out, the Shah was deposed, Americans were taken hostage and Ayatollah Ruhollah Khomeini came to power. Iran canceled its purchase as it became clear we would never deliver anyway. Hundreds of millions already paid were part of billions in Iranian funds frozen by the U.S. government.

Employees at Ingalls, FMC and other contractors panicked, as did local governments. There was immediate political pressure for the U.S. Navy to acquire the ships. An ironic logic prevailed. Because we no longer had a loyal client state controlling the Persian Gulf, we needed more ships, especially ones with big air conditioners and many missile launchers, to operate in those waters.

Thus we acquired four “Ayatollah-class” warships that served our Navy for a quarter-century. The unreturned payment had been one thorn among many in U.S.-Iranian relations, though one with far greater weight for Iranians than for U.S. citizens, who rapidly forgot it. Forgotten at least, until decades of negotiations by four administrations led the Obama administration this past January to pay back the $400 million. just after five U.S. citizens held in Iran were released.

Interesting anecdotes perhaps, but what economics are involved?

One is the role of fixed costs in armaments. Designing and testing a new battleship in 1911 was expensive, but it paled in comparison to the overhead involved on a guided missile destroyer in 1975. And this pales in comparison to the costs of developing military technology today.

When fixed costs are high, the way to lower average costs per ship or plane is to spread such overhead over greater output. Judiciously selling some private production from Mississippi and Minnesota to foreign buyers accomplishes that. The British Admiralty of the early 20th century was pleased when private defense contractors sold ships to Turkey and Japan, because foreign sales helped kept workers employed and maintained a large ship-building base. 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 paid for F-16 fighters that it never got.

Second, such foreign sales can spur research. The 1911 Admiralty was too stodgy to try innovative gun layouts, but this was fine with the Turks. Similarly, the Shah spent on radars and missile launchers 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.

Incidents like the sudden political pressure for us to buy the Iranian ships illustrate the “military-industrial complex” criticized by President Dwight Eisenhower. When it comes to local employment, Congress has no defense-spending cutters, and it broadly supports foreign sales.

The story also illustrates a long process of structural change in armaments industries. The big British shipbuilders like Vickers and Armstrong, together with specialists like Elswick, Dreyer or Barr & Stroud, that sold equipment to nearly every navy in the world, eventually all were absorbed into British Aerospace, now BAE Systems. Minnesota’s “Navy gun factory” 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.

St. Paul economist and writer Edward Lotterman can be reached at