When a small defense contractor in Florida was going broke two years ago, the Defense Department did what has been done in the name of national security more than 6,000 times since 1958: It bailed out the company.

The $1.8 million grant to the Wayne H. Coloney Co. of Tallahassee, a maker of ammunition cases for the A10 warplane, was pocket change by Pentagon standards.

But it provided a perfect symbol of the golden safety net the United States has woven beneath the nation's most controversial industry -- the defense business.

The bailout was bestowed under an act of Congress that has been used to pump out hundreds of millions of dollars over the last 27 years, while remaining nearly hidden from public view: the Extraordinary Contractual Relief Act.

The relief to Coloney, moreover, was not from an act of God or natural disaster or fickle shift of governmental policy.

The Air Force rescued Coloney despite concluding that the company had deliberately underbid on arms contracts.

What Coloney illuminates is how thoroughly Congress and the Pentagon insulate the defense industry from the normal rough-and-tumble risks of doing business.

From cradle to grave in the life of a weapon, the nation's defense giants are coddled in ways only dreamed about by most commercial companies, ensuring that few defense contractors fail and adding a hidden surcharge to every military budget.

The Pentagon soothes its contractors through the birth pangs of a new weapon by picking up the tab for even unsolicited and unsuccessful proposals.

It consoles the bereaved arms maker at the death of a weapon with hefty "termination" fees.

And along the way, the government again and again trusts the defense industry to tell it what to buy and how much to pay.

Again and again, the government pays for contractor mistakes.

Again and again, government underwrites industry's costs with what amount to interest-free loans.

"Somebody said that the Pentagon runs the world's second-largest planned economy after the Kremlin," said defense analyst Wolfgang Demisch. "I think that's a little harsh, but there's something to it."

This article is the first in an occasional series that will look at this and other aspects of the peculiar institution that President Dwight D. Eisenhower darkly dubbed "the military-industrial complex" and that President Reagan prefers to call "the arsenal of democracy."

Among the features of that American arsenal:

At the midpoint of Reagan's eight-year, $2.3 trillion defense buildup, the Pentagon is spending an average $28 million every hour -- 24 hours a day, seven days a week.

In the time it takes to read this paragraph aloud, the United States will spend $160,000 for defense.

The defense industry is racking up record profits, with many multinational corporations finding their military business two or three times more rewarding than commercial sales.

The top 13 contractors last year had combined sales, military and commercial, of more than $122 billion.

Few of the country's defense giants have paid any federal income taxes in the past three years.

General Dynamics Corp., the nation's largest defense contractor, has paid no federal taxes since 1972. The Grumman Corp. is paying federal taxes this year for the first time since 1976.

Because profits paradoxically increase as costs rise, in many cases there is no incentive for contractors to save taxpayers' money.

As Sen. William Proxmire (D-Wis.) put it, "The higher the cost, the higher the profit. It's all perfectly legal in the topsy-turvy world of defense contracting."

The industry has more than its share of patriots who have performed technological wonders in advancing the state of weaponry for American soldiers and sailors.

But persistent revelations of exorbitantly priced coffee pots, shoddy missiles and taxpayer subsidies for executives' high-rolling life styles also provoke questions about whether the industry has exploited -- and thus undermined -- the national consensus to rearm America.

The arsenal of democracy includes 20,000 prime contractors and 150,000 subcontractors and vendors. They labor under 154 accounting systems used by the Pentagon, as well as purchasing rules that fill more than 7,500 pages -- five times the length of Leo Tolstoy's "War and Peace."

Some inkling of the torrent of paper involved can be gleaned from Lockheed Corp.'s recently submitted proposal to build a new military transport jet: One copy of the plan weighed three tons and had to be delivered to the Air Force by cargo plane.

This year, the Defense Department will issue 15 million contracts for purchases of everything from socks to submarines, all supervised by 54,000 officials who do the Pentagon's shopping.

"Without question, it's the biggest thing that afflicts us . . . the vastness of this bureaucracy," said Navy Secretary John F. Lehman Jr., one of the most aggressive Pentagon advocates for competition and curbs on costs.

"Nobody really realizes how big this building is and how complex it has become," Lehman said. "It's really like an ant on an elephant's knee trying to describe it.

"The problem just gets worse and worse and worse every year. Unfortunately, what it creates is the ideal environment for monopoly relationships."

Or, as former Deputy Defense Secretary David Packard put it in 1970, "Frankly, gentlemen, in defense procurement we have a real mess on our hands." The Arms Bazaar

Before World War II, there was no defense industry as we know it today.

Weapons were simple enough that, with few exceptions, government arsenals could mass-produce the requisite rifles, cannons and other tools of battle.

When warfare took to the skies, however, government arms makers were incapable of building the increasingly sophisticated warplanes, and the industry was born.

By 1958, only 10 percent of the nation's munitions were made in U.S. arsenals.

Since then, captains of the defense industry have proclaimed themselves paragons of free enterprise.

But the arms bazaar remains a business like no other, part regulated utility, part national asset, part reaper of subsidized profit.

Under a broad and bipartisan policy, the United States has chosen to nurture an elaborate defense industrial base, ready to respond should the nation again be plunged into global war.

It is that fundamental manifesto that causes the Pentagon to go to extraordinary lengths to nurture the defense industry in peacetime.

"Either overtly or subconsciously, we don't let them go out of business because of concern about the defense industrial base," Maj. Gen. Bernard L. Weiss, chief of Air Force contracting policy, said in an interview. "We can drive the industry to survival of the fittest, but then we'll have even more sole-source contracts and no industrial base.

"Who should say whether that industrial base is worth the cost?" Weiss added. "I think it is."

The Reagan administration took office determined to stop what it viewed as the erosion of the military's industrial underpinnings.

Administration policy, best articulated by former deputy defense secretary Frank C. Carlucci, called for higher industry profits, lower risk and closer working ties between contractors and the Pentagon.

This attitude of partnership has leached much of the risk from the defense business, turning it into what author and Pentagon critic Gordon Adams calls "a funny form of capitalism."

In fact, industry and government often are so snugly intertwined that defense contractors help define the enemy threat, essentially creating their own market, and then design, build and test the weapons to meet that threat.

The Defense Nuclear Agency, for example, is responsible for doing much of the Pentagon's thinking about nuclear war.

When DNA wanted to think about "hardening" the electronics in U.S. weapons against the electromagnetic effects of an atomic explosion, it appointed a technical advisory group to study the issue.

Eleven of the 15 advisers, including the chairman and executive secretary, were defense contractors, according to a Defense inspector general's audit last fall.

Almost 90 percent of the millions of dollars subsequently spent on the program went to the same contractors, who had recommended themselves for the jobs.

In fact, the Defense Department frequently relies on contractors for everything from pricing data to the inspection of the contractors' own construction projects.

Federal law, for example, gives the government the right to review contractors' financial records to verify cost and pricing information.

But Woodrow Murphy, the Pentagon's chief watchdog at Texas Instruments for three years, was so effectively barred from doing his job that "today I don't even know where the accounting department is" at the company, according to the retired auditor's testimony to a Senate subcommittee last year.

A defense inspector general's audit team last year looked at 216 Pentagon contracts and found evidence of fraud in 10 percent of them, including 11 in which the contractor had refused to let the government look at the pertinent records.

And when the contractor is caught overcharging the Pentagon, cases may drag on for years. During an appeals process that can be glacial, the contractor gets free use of the taxpayers' money. And there are no penalties for the overcharge unless fraud is proved.

In April 1980, for example, Pentagon auditors found that General Dynamics had made a $2 million error in the company's favor on a contract for F16 warplanes. The contractor quickly agreed that it had made a mistake -- but managed to hold onto the money, interest free, for two years. 'Fish in a Barrel'

Lee Iacocca, chairman of Chrysler Corp., likes to ask his suppliers who also peddle to the military whether there's easy money in defense contracting.

"They start chuckling and they look around to see if the office is bugged," Iacocca said in an interview. "And they say, 'It's like shooting fish in a barrel.' "

Defense executives believe they should be compensated for the trials of serving a single customer -- the U.S. government -- which can be fickle, meddlesome and capricious.

The government has been so sympathetic to that argument that it has assumed many of the companies' ordinary business costs.

In the commercial world, for instance, companies must dip into profits to pay for product development and sales. The Pentagon, on the other hand, last year gave its 100 largest contractors $3 billion -- over and above profits -- for independent research and the cost of submitting proposals for new weapons.

In the commercial world, companies usually compete for business, with the losers coming away empty-handed. The Pentagon gives most of its dollars to monopoly or specially chosen producers, despite greater emphasis on competition under Defense Secretary Caspar W. Weinberger.

Even when the Pentagon orchestrates competition, the loser often wins. Two companies dueling for the Army's Hellfire missile business knew before the fight began that each would end up with at least 30 percent of the pot.

"You turn on two of the bull mooses," said Pentagon whistle blower A. Ernest Fitzgerald, "and you pay 'em both."

In the commercial world, a company snaring new business has to gear up with new tools and equipment. In the defense world, the Pentagon often antes up millions of dollars in special tooling that the contractor balks at buying.

In fact, contractors are given rent-free use of more than $10 billion in factories and equipment bought by the government. M1 tanks, F16 fighters, C5 cargo planes and Stealth bombers all are being built by private companies in publicly owned factories.

Businesses in the commercial world may have to borrow money to buy supplies and pay salaries. But the Reagan administration, as one of its first initiatives, agreed to pay large defense contractors up to 100 percent of their costs every month, compared to 80 percent elsewhere in government.

Consequently, Lockheed was able to boast in its 1984 annual report that it had amassed nearly $200 million in progress payments above actual costs.

In the commercial world, companies often have to pay expensive insurance premiums. They also may find themselves losing money to inflation. The Pentagon frequently insures its contractors -- even against their own negligence -- while picking up the tab for inflation, which in the defense business is assumed to run 30 percent higher than in the economy as a whole.

Finally, in the rare event that the Pentagon decides to kill a weapons program earlier than expected, generous "termination clauses" can cushion the contractor against any financial shock.

Thus, when the Army pulled out of a joint plan with the Marine Corps to buy light armored vehicles from General Motors of Canada, the Marines suddenly found themselves buying 758 vehicles instead of 586, paying $20,000 more for each and, for good measure, tossing in a $31 million surcharge, according to congressional testimony.

Defenders of the system contend that if eternal vigilance is the price of freedom, then this "funny form of capitalism" is the price of eternal vigilance. Critics respond that the system has bred precisely the military-industrial complex that Eisenhower fretted about a quarter century ago. Contract Nourishment

It was known simply as Change Order No. 173, a bureaucratic sleight-of-hand that demonstrated just how understanding a customer the Pentagon can be.

The Air Force had agreed to pay Hughes Aircraft Co. $230,000 apiece for 400 Maverick air-to-ground missiles.

But when Hughes ran into trouble developing the new weapon and threatened to bust its budget, the Air Force cut a new deal for only 290 missiles -- at about $500,000 apiece.

That modification, No. 173, was just one small example of a process known in the Pentagon as "contract nourishment."

It is a process that nurtured the Maverick's supposedly "fixed-price" contract from $90 million to $360 million in three years, thanks to almost 300 such change orders.

Over the decades, some large defense contractors have lost money. Others have been swallowed in mergers. But for the most part, the Defense Department has cushioned contractors from the impact of their slips and stumbles, at times even rewarding them for their own mistakes.

One emblem of Pentagon indulgence is the Extraordinary Contractual Relief Act, Public Law 85-804, which has allowed the government to bestow $1.4 billion on troubled contractors since 1958, including the hapless Coloney Co. of Tallahassee.

This law, enacted to protect companies deemed "essential to the national defense," is dormant except in times of national emergency. But because President Harry S Truman's declaration of emergency at the outbreak of the Korean war in 1950 never has been repealed, the law remains quite alive.

In 1982, for example, Gichner Mobile Systems of Old Forge, Pa., underbid two other firms to win a $1.3 million contract to build "transportable shelters" for the Army.

Gichner then disclosed that it had bid too low after relying on an obsolete tax schedule. The mistake was "so obvious," the company argued, that the Army contracting officer should have saved the company from its own arithmetic. The Army agreed and handed out $62,000.

Defenders of PL 85-804, such as Wayne H. Coloney, vice president of the Florida firm, contend that the government would have lost more money had his company been shut down.

"Obviously I'm biased, but it was a hell of a deal for the taxpayers," he said.

One of the law's most enthusiastic cheerleaders is an arcane legal journal called the Extraordinary Contractual Relief Reporter.

"The fact that a mismanaged company may occasionally benefit from its relief," the journal once said, "is insignificant when compared to the statute's ability to ensure that the government promptly obtains products and services essential to the national defense."

And in truth, most large contractors do not need PL 85-804. Instead, they rely on more informal methods of contract nourishment when things go sour.

As a result, some critics allege, companies that perform poorly earn as much or more than companies building first-rate weapons.

"It's for a very simple reason," said Michael R. Burns, legislative liaison for Business Executives for National Security. "Industry gets paid to fix its mistakes. It's like consumers paying Ford for fixing exploding gas tanks in their Pintos."

Thus, the Air Force paid Lockheed Corp. $1.5 billion to put new wings on its giant C5 airplanes after studies showed that the old wings -- which Lockheed had built -- were in danger of cracking. Lockheed blamed the government's original specifications for shortcomings in the C5 wings, a charge repeated by most contractors when problems emerge.

The government routinely pays for fixes on a smaller scale, too: Pratt & Whitney built a jet fighter engine that didn't work as well as the Air Force had hoped. As a result, the Air Force paid Pratt & Whitney nearly half a billion dollars in a multiyear Component Improvement Program -- aimed at "improving" the engine up to its original durability goal. In 77 cases of shoddy construction work reviewed by Pentagon auditors in 1982, only once was the contractor forced to pay for his mistakes. General Dynamics built a rapid-firing shipboard gun for the Navy that worked beautifully, when it worked. Unfortunately, it also leaked -- no small setback for a shipboard weapon -- and frequently broke down. It cost $5 million to make the guns watertight and $9 million to make them more reliable. Taxpayers paid for both.

A Navy spokesman explained, "It's part of the evolutionary improvement process common to most weapons and weapon systems."

When Deputy Defense Secretary Carlucci took office in 1981, he endorsed the relatively radical idea that past performance should be considered in awarding future jobs as a way to stop rewarding contractors who fail.

Carlucci, who has worked for Sears World Trade Inc. since leaving the Pentagon two years ago, admits that the idea never left the ground.

"There's a lot of feeling in the Defense Department that that would turn into a blacklist, and there's something pejorative about that," he mused. "I still think there's something valuable in an institutional memory."

Even Pentagon attempts to hold contractors responsible by offering incentives sometimes beget additional risk-free profit.

A construction contract for a naval base on the tiny Indian Ocean island of Diego Garcia, for example, allowed the contractor half of the maximum bonus even for work rejected by the Navy, the General Accounting Office found.

Despite a long litany of problems, the contractor pocketed $4.9 million out of a possible $6.8 million.

Pentagon officials argued that the $1.9 million the contractor didn't collect demonstrated "clear, positive actions taken to emphasize to the contractor the need for an efficient, cost-effective construction process."

Similarly, the Army established a $6 million award fee on a contract to engineer the Pershing II missile. By simply devising what was considered a good plan, the contractor qualified for three-quarters of the fee, while only one-quarter was tied to good performance.

"Breaking into the defense business is one of the most frustrating, time-consuming and difficult operations," Navy Secretary Lehman said. "But once you're in, you stay in."

NEXT: Good times in the arsenal