(FORTUNE Magazine) – WHEN MILITARY historians look back on the 20th century, they may well call the war against Iraq the last big hurrah for America's awesome arms industry -- an all-stops-out, razzle-dazzle, techno-killer grand finale. Normally a performance like that would guarantee future engagements or at least a rousing encore. But -- for now -- this show is over. The world stage is changing. As the Cold War gives way to international economic competition, America's vaunted military-industrial machine is being forced to surrender the star billing it has enjoyed for nearly half a century. At the current rate of decline, by 1996 military spending will be down to a mere 3.6% of GNP, the lowest since before World War II. (The postwar high: 19.9% in 1946.) Once a primary engine for jobs, growth, and technology, the industry is becoming an economic sideshow. Not that the U.S. should start converting its armories into Ikea outlets. Far from it. If Saddam Hussein has done nothing else, he has reminded anyone tempted to euphoria by the end of the Cold War that the world remains a dangerous, unpredictable place. For all the nonproliferation treaties and export controls that are sure to crop up in the aftermath of the Gulf war, the electronic genie is out of the bottle. If the U.S. does not retain its technological edge on the battlefield, someone else will grab it. To keep that edge, American weapons of the 21st century will be not just smart but ''brilliant,'' ever more discriminating in their attacks on enemy targets, distancing combatants ever farther from the field of battle. The challenge for the defense industry is to envision tomorrow's weapons today -- and then figure out how to make them without breaking the bank. For | guidance, scientists, engineers, and strategists will be analyzing the lessons of the Gulf war for months, even years, to come. One sure thing: Saddam's trouncing will increase the salability of high-tech weaponry on Capitol Hill. Says Senator Jeff Bingaman, a New Mexico Democrat: ''It will be hard for anyone to argue that it wasn't good to have had those weapons on hand.'' What does all of this mean for the future of America's arsenal? On August 2, the day Iraq invaded Kuwait, President Bush gave a speech to the Aspen Institute laying out his vision of the military for the post-Cold War world. ''What we need are not merely reductions but restructuring,'' he said. That vision has not changed: His goal is to make America's arsenal smaller, smarter, swifter, and stronger. To achieve that, the arms industry and the government will have to do business a lot differently. The process is already under way: -- GETTING SMALLER. Even though the military has become everybody's new best friend, pressure on the defense budget will remain severe. The price of one $1.3 million Tomahawk could pay a lot of teachers' salaries. The budget agreement last October put a cap on defense spending that has forced Defense Secretary Richard Cheney to cut weapons programs sharply. His plan is to slash the Pentagon's budget to $283 billion a year by 1996 -- in real terms, a cumulative 34% decline since 1985. If the Pentagon acquires the newfangled stuff it wants, such as Northrop's B-2 stealth bomber, the Strategic Defense Initiative, and the Advanced Tactical Fighter for the Air Force, it will only be at the expense of a host of current-generation programs. Congress is likely to fight for some of them. Cheney is canceling the Bradley Fighting Vehicle, made by FMC; General Dynamics' F-16 Fighting Falcon; the Trident submarine, also made by General Dynamics; Martin Marietta's MX missile; and an upgrading of the F-14 Tomcat, which may end Grumman's six-decade tradition of building fighters for the Navy. Other prominent weapons zapped include three of the biggest stars of the Gulf war: General Dynamics' M-1 Abrams tank and two McDonnell Douglas aircraft -- the AH-64 Apache antitank helicopter and the F-15 Eagle. For contractors, this news is not quite as bad as it sounds. For one thing, Cheney will probably get from Congress $15 billion in supplemental funds to help pay for Desert Shield and Desert Storm. In some cases the Pentagon wants to replenish even more weapons than it used; apparently Cheney hopes to take the pressure off the defense budget by shoving some of them into the Desert Storm account. A request for 500 Patriots shows up in this year's supplemental budget, even though fewer than 200 have been fired in the Gulf. While the Patriot's success has increased public support for a limited antiballistic missile defense, Congress is likely to shoot down Cheney's bid to raise the SDI budget 60% in the next fiscal year, to $4.6 billion. Concludes Fred Ikle, a former Pentagon official now a senior policy analyst at the Center for Strategic and International Studies: ''The defense industry will continue to evolve in the direction it was going before the Gulf war, with the focus on research and development of advanced accurate weapon systems and on building forces suitable for a wide range of contingencies.'' -- GETTING SMARTER. How smart can weapons get? Smarter than Generals Colin Powell and Norman Schwarzkopf put together. The U.S. has long relied on its technological edge to offset its adversaries' strength in numbers. That strategy will continue; hence the Pentagon's emphasis on new programs over old. Contractors with forward vision are already working to design Tom Clancy-ish war toys for the 21st century. McDonnell Douglas and General Dynamics are well along in developing an advanced stealthy cruise missile. In December, McDonnell Douglas flew the prototype of a new family of ''stand-off'' smart bombs for the Navy that can be launched at a distance from low-flying attack planes, soar to higher altitudes, seek out the target, and dive down and destroy it. While few dispute the value of developing weapons like these that can save their users' lives, the debate continues over their cost and the pace at which they should be fielded. Many military experts think that with Saddam out of the way and no other likely near-term threats on the horizon, the rush to produce a new generation of weapons is a waste of billions. Instead, they say, the U.S. should take advantage of this window of opportunity to concentrate on research. Before the Senate Armed Services Committee in late February, Cheney acknowledged the need for a vigorous program of research to preserve the technological superiority of U.S. forces. The Pentagon is asking for a real increase of 11% in R&D money for the fiscal year starting this October. But after 1992, as new weapons move from research and development into production, the procurement budget starts to rise and R&D begins to drop. Complains Lawrence Korb, a senior fellow at the Brookings Institution: ''That is exactly the wrong way to go. There is no rush to put this stuff into production. The threat and missile gaps and bomber gaps and windows of vulnerability are not there anymore.'' William Kaufmann, who teaches defense planning at Harvard, agrees: ''Twenty years from now we could be facing Martians. We have scarce resources. Over the next five years, through weapons upgrades and good R&D, we will be in a strong position so that if things start looking menacing, we'll be in a position to go into production.'' Military contractors counter that it is impossible to keep technology on the shelf: You use it or you lose it. The solution, says Robert Cattoi, senior vice president of research and engineering at Rockwell International, is to concentrate on R&D that has wide applications. For example, he says, ''guided tactical missiles all use sensor seekers ((to spot targets with infrared or radar)). So let's work on seeker technology, without developing six different weapons that utilize it. Let's develop new engine capabilities for ground vehicles as well as air. Let's ensure we've developed good wing design. Let's look at the functional elements and prove we have the pieces. Then if we have to put them all together in a weapons system, we don't have to start from scratch.'' -- GETTING SWIFTER. Military planners gleaned one key lesson from the Persian Gulf: Wars of the future may break out with little warning. That means maintaining a battle-ready expeditionary force that can be mobilized on a moment's notice to fight anywhere in the world. To ensure continuous readiness in an era of declining defense dollars and uncertain enemies, the Pentagon will place greater emphasis on intelligence, training, transportation, and ''surge planning'' -- the ability to gear up production lines quickly. Rapid mobilization depends on fast, efficient transportation -- a requirement that probably translates into dollars for McDonnell Douglas. The company is building the C-17, a military cargo plane meant to replace the aging Lockheed C-141 Starlifters that did yeoman duty in the Gulf crisis. Almost from the beginning, the C-17 has been under fire for delays and cost overruns. But because of deficiencies in sea and airlift capability exposed by the Desert Shield deployment, Cheney wants it more than ever. In his fiscal 1992 budget, Cheney asks for a 176% funding increase, to $2.8 billion, for six ! C-17s, to be followed by 12 more in 1993. It will probably survive in Congress. Yet another lesson from the Gulf is the importance of adequate training. To keep both reservists and those on active duty in a high state of readiness, the military will have to rely heavily on simulation devices. According to Aviation Week, the civilian and military simulation and training market is growing 20% a year and should reach $5 billion by 1992. Potential winners: Evans & Sutherland, GM Hughes, McDonnell Douglas, and Loral Corp. -- GETTING STRONGER. Long after Saddam's demise, defense contractors will go on fighting an enemy they have been battling for years: mismanagement. Since 1985, the peak of the Reagan buildup, budgets for procurement, research, testing, development, and evaluation have dropped on average 4.5% a year in real terms. Coming at a time of increased international competition and tougher government procurement policies, these cuts have forced contractors to take aim at waste. For some companies, the effort is paying off. Both Lockheed and Northrop reported sharply higher earnings in 1990, helped by drastic companywide cost cutting. Northrop earned $210.4 million in 1990, reversing an $80.5 million loss the year earlier. Lockheed did even better: Net income soared to $335 million, vs. $2 million in 1989. In the past year Lockheed Chairman Dan Tellep cut over 5,000 jobs and put $200 million of property in Burbank up for sale. Many weapons once plagued by problems performed superbly in the Gulf -- among them the Patriot, Martin Marietta's Lantirn night-vision system, and the Apache helicopter. Their rave reviews should gain contractors a little slack, though budget pressures will keep the room for error small. For its part, the Pentagon must accelerate its efforts to streamline the hopelessly bureaucratic procurement process. A tasty sample: Until recently the military specifications for chocolate chip cookies ran to some 20 pages. The Defense Department should also allow contractors to use more commercial components and practices, and it should abandon concurrent development and production of new weapons systems. The Pentagon rushed Rockwell's B-1 bomber into production, only to have it sit out most of the Gulf war in the repair shop. Cheney plans a more deliberate ''fly before you buy'' approach: New weapons prototypes will be tested extensively before they are fielded. And by limiting the number of new programs, Cheney hopes to be able to buy enough of each weapon to make them cost effective. Back in 1961, President Eisenhower warned against the ''unwarranted influence'' of the military-industrial complex, a term he coined for the unsettlingly potent combination of industry and government that stands sentry over the nation's security. Over the years the mighty military machine has grown, matured, and learned some painful lessons that could go a long way toward shaping it into the mobile, flexible, high-tech force that Bush and Cheney envision. After all, in middle age, smaller, smarter, swifter, and stronger is not such a bad thing to be.

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