The Folly of Airline Deregulation

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By: Mark H. Goodrich – Copyright © 2012

The United States is 35 years into the experiment known as the economic deregulation of the airlines. Evidence of its devastating effects across the industry is now clear, but less evident is the breadth and depth of those effects. And, more puzzling is the absurd extent to which many still go in defending its premises, given the resulting carnage in the aviation industry, and similar failures of deregulation schemes in other industries.

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Like all deregulation efforts, allowing airlines to operate in a free market was a creature of corporate influence and politics. It was borne of presumptions that unfettered free markets are always preferred, and that a corporation will behave efficiently, logically, legally and honorably if left to its own devices. As yet another tribute to the failures of human beings to heed the lessons of even recent history, and the seemingly bottomless capacity of human nature to believe that lead can be turned into gold, the deregulation of the airline industry was a simply a bad idea whose time had come politically.

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Even at its inception, problems certain to result were known by many politicians who were to vote in its favor anyway. Its staunchest supporters were opportunists and political ideologues. Some were simply willing to experiment, and ignore the potential scope of the damage if they were wrong. To legislators sailing on political winds created by deregulation, adverse effects on safety were also ignored. Many assumed that quality would be factored by the public in making their ticket purchasing decision – free markets at work. But quality – too often defined as only meals and blankets – goes much deeper than superficial passenger comforts. In aviation, a major part of quality is safety. How crew are trained, airplanes are maintained, dispatch is conducted, and myriad other operating details, are fundamental parts of the quality and safety equation.

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Some airline managers knew that disaster was in the wings, but thought they could profiteer before the house of cards collapsed. Absent the requirement to justify their plans to regulatory overseers, and without a requirement for a regulator to consider the effects of those plans on the stability, dependability and efficiency of the industry generally, dollar signs danced in carpeted hallways of airline management. A few airline executives foresaw the certainty that the industry would be unable to survive economic deregulation, but they were shouted down by the tyranny of the majority view, and forced to acquiesce.

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Some legislators did understand the risks, but were unwilling to commit political suicide by trying to educate voters, rather than endorsing what the public already believed – they held their noses and voted for deregulation anyway. That political cowardice was to facilitate the dismantling of a vibrant air transportation industry, ruining many thousands of careers, leaving cities with bond and maintenance obligations for airports now without airline service, destroying investments of airline shareholders, bankrupting suppliers, and littering salvage yards with shop equipment and airplanes that still had years of service to give. It has also resulted in a redistribution of wealth to the banking and finance sector. Before deregulation, leased airplanes were a small fraction of the worldwide fleet. Since, an airplane leasing industry developed to allow leveraging and expansion on credit that has, with the aid of favorable tax-code provisions, progressively sucked the equity from the airline industry through increased debt service loads. In point of fact, this replacement of equity with debt still forms the most resilient block to any hope of a return to reasonable and sustained profitability through normal airline operations.

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By its supporters, the potential benefits of deregulation were described as certainties, and couched in a way that presented “free-market forces” as universally beneficial. The potential problems with economics, reliable commerce and safety were downplayed. The public was swayed by false assurances that, once government oversight was removed, the industry would flourish, fares would be lowered, and safety would be maintained, ostensibly because corporate executives would never risk safety in the interest of mere profits.

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Those who argued against deregulation were pilloried as “against free markets”, and “for socialism”, the kiss of political death in the United States, even if unsupported by the facts. Many in the industry who foresaw the trouble ahead were rightfully afraid of being blacklisted, and reluctantly stepped aboard the deregulation train as it left the station.

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While the particulars of how airline deregulation has been incorporated around the world have varied somewhat due to differences in cultures, governmental systems, and airline ownership, the direct and indirect problems addressed in this article have been remarkably universal, as has been the failure of airlines to establish long-term business plans, to operate rationally, to be profitable, and in many cases, to survive.

So, why was it so certain that economic deregulation was destined to fail? The reasons were many, but the following are several of the most significant.

An unregulated free market must have a sufficiently large number of participants to spread the risks and maintain a stable marketplace as the inevitable start-up and failure events take place. But most airline routes will only support one or two carriers, and too few flights to justify the costs inherent in serving those routes. Thus, such operations require a higher percentage of route operating costs be assigned to each ticket, including landing, gate, counter, handling, line maintenance and other expenses. When coupled with a desire to maximize profits to the extent allowed by the market, this means that service to low activity airports under a free-market system is always more expensive to the consumer. Under the prior regulated structure, a carrier was required to operate more and less lucrative routes, and often required to service a low activity route in order to obtain authorization to serve one that would be regularly profitable. When coupled with guarantees of a minimum return on investment for shareholders and a requirement to obtain fare approvals, this maintained a relationship between length of the flight and ticket costs, and recognized a public policy that air service should be fairly priced and reasonably available across the panoply of higher and lower population areas.

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Although many believe that serving large markets along high-activity routes would therefore be easily profitable, too much unrestrained competition is just as bad as too little. Such routes draw more service than can be profitably supported, and the price of admission is to rationalize lowering fares to an unprofitable level until competitors have left or failed. Then, just when the remaining carriers see an opportunity to raise fares and return to profitability, yet another start-up appears, with managers certain that they can weather the competitive storm with lower fares, using superior management and operating techniques. The industry is littered with the carcasses of airlines whose managers thought the wheel could be so re-invented. The bottom line is that the ticket prices to consumers for a coast-to-coast flight between major cities often totals less than the cost of fuel to make the flight, other consumers pay several times as much for short sector tickets, little or no profit is actually made anywhere, and the equity of all industry participants progressively shrinks.

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An unregulated free market must be subject to vigorous anti-trust enforcement, ensuring that all participants conform to legal requirements. Absent such oversight, airlines will conspire to fix prices (thus only pretending to compete), and engage in predatory pricing by which large carriers slash fares for the express purpose of driving smaller competitors out of business, while spreading the losses across their inherently larger market share. As the marketplace becomes more global, enforcing fair trade is ever more difficult, because coordinated action by more than one government is required. In addition, the enormous financial and political leverage brought to bear by large corporations – manufacturers, insurers, banks, lessors, airlines and others – is in natural tension with anti-trust laws. This is more so given the inexorable movement within free-market systems for concentration towards monopoly. That is, through merger and acquisition, there is an inherent trend for the surviving participants to become ever larger, and therefore to possess more economic and political influence, including over legislative and judicial functions of government. Justice departments around the world are increasingly unable to overcome the corporate and political forces in favor of economic deregulation and market concentration, most often reflected by a neutering of anti-trust enforcement. Indeed, a proliferation of so-called “anti-trust waivers” is the trend, essentially granting approval for airlines to conspire to fix prices on routes such as those across the North Atlantic, flying in the face of the “competitive free markets” that all of the involved governments pretend to believe is in the public interest. At the other end of the spectrum, legal challenges against large carriers for predatory pricing have been uniformly unsuccessful, and generally denied on procedural grounds, which is to say without an actual day in court. This reflects the degree to which judicial functions are ever more subject to political influence.

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An unregulated free market must not be polluted by hidden subsidies, because it skews the ability to analyze whether the deregulated environment is actually working. In addition to the favored treatment described above by anti-trust officials and the courts, legislatures worldwide have written highly incentivized provisions into their tax codes, so as make the leasing of airline transport aircraft financially lucrative, even if a lessee airline is essentially absent the equity and financial stability to otherwise qualify for a loan or lease. Despite that the most fundamental factors upon which airline profits depend is equity and ownership of the fleet, reflected by lower debt service costs over time, economic deregulation has eroded the equity base of most airlines to the point where airplanes must be leased. The worldwide fleet was about 5% leased thirty years ago, but is now just under 50%, and many airlines lease 100% of their airplanes. Allowing more leased airplanes through hidden subsidies to banks and lessors is a political maneuver intended to hide the dismal level of failure that deregulation has been. Thus, taxpayers end up footing the bill for hidden subsidies in the tax code, even as the airlines, governments, banks and lessors spin the facts to create the impression that deregulation has been successful.

If business plans for airlines in an unregulated free market are to work, they must be “long view” plans that extend for years into the future, with reasonable conservative assumptions on both sides of the projected income statements. And, if managerial salaries and bonuses are to work in conjunction with such plans, they must be based on profit and good business practices, rather than short-term swings in share value. Yet, the modern trend has been to focus on extremely myopic business plans that place share price movements above the long-term interests of shareholders, employees, communities or indeed, the corporation itself. Top managers with knowledge and experience in aviation have been replaced by professional balance sheet manipulators, whose assignment is not to build or improve the business, but to create and encourage share price movement. Motivation for them is in the form of outrageously inflated salaries, and bonuses calculated on share price, rather than development and execution of long-term business plans, and stable performance.

Inexperienced managers do not know the difference between fat and muscle. They do not know that much of the money spent for training and maintenance is not expense, but an investment in lower future costs for both. They do not know that delaying engine overhauls results in an exponential increase in wear during the extension period, dramatically increasing the downstream overhaul costs. They do not know that out-sourcing is always more expensive over the long-term. They care more about the appearance of short-term reductions in cash flow, its effect on share price and their bonuses due to the fundamental ignorance of the markets, than building a sound company producing profits over time.

A successful company in an unregulated marketplace must have accountability up the management chain, ending at the board of directors. In theory, shareholders select and vote for board members who will hire senior managers, oversee those managers and hold them accountable. In reciprocal fashion, the board members are then accountable to the shareholders. In practice, this theory has been turned on its head. Few shareholders pay attention to the performance of the board. And, senior management is often allowed to select prospective board members, putting them up for election using a variety of proxy mechanisms and other corporate tricks to ensure that the board is a lap dog of management, and not an overseer. To reward this evasion of board duty, management sees that board members receive handsome fees to attend meetings, and procures insurance to protect them from any personal liability for their evasion of responsibility to the company and its shareholders. In short, the “fix is in”. Why do incorporation laws allow this nonsensical behavior? Because individual states are competing for incorporation business, and in a race to the bottom by gutting their laws so as to reduce the potential for officers, directors or corporate entities themselves to be held accountable for anything. Even if lawsuits ensue by which shareholders or customers seek redress from a corporation, its management or its board, corporate-friendly states water down the standards by which liability is determined to prevent any real accountability. The bottom line to this charade is a near absence of corporate accountability, and management practices that run roughshod over the rights and interests of shareholders, employees, customers, and even the corporation itself, when measured over the long-term.

A free-market model requires rational behavior by all industry participants. In the case of the airline industry, some airlines sought to tie of up the markets for airplane orders using credit, and drove themselves to early failure. Others over-expanded in an irrational effort to seize control of routes and markets, only to discover that the fundamentals of capitalization and finance could not be defeated with high hopes and no cash. Even survivors of the first two decades mostly failed to operate their businesses as long-term endeavors, and most became merely cash machines for a never-ending stream of managers who knew very little about the airline business, but made outrageous promises, took ridiculously large salaries and bonuses, weakened the airline that had been entrusted to their managerial care, and moved on to inflict similar damage to other carriers.

A successful company in an unregulated marketplace must have a stable work force of career employees, well-trained and happy to be team members working in the best interests of the business. Weathering business transitions requires older employees who have institutional memory, and are able to mentor those who will follow. Reasonable salary levels, working conditions, and pensions are essential to stability. But deregulation has brought short-term cost cutting to a position of priority. Experienced employees are furloughed to slough off higher salaries and pension costs. Labor is out-sourced without regard to reductions in productivity and safety margins, or to collateral problems that follow when work is performed outside quality assurance functions of the business. When line maintenance at out-stations is farmed out to the local FBO, it may meet the minimum standards required by the regulator, but no one can knowledgeably argue it is a sound business practice. When heavy maintenance is out-sourced to an MRO without modern equipment or manuals, paying low wages and no benefits to a work force that has not been trained on the specific products, it is folly to pretend it is a sound business practice. When a carrier seeks protection under the bankruptcy laws to evade paying benefits it previously negotiated in exchange for reduced wages, no one can expect the labor force will see itself as part of the team. When management pays itself enormous salaries and benefits in the midst of losses, and then asks the bankruptcy court to approve additional bonuses as part of a restructuring package, it is clear beyond peradventure that senior management is focused on its own interests to the preclusion of its corporate responsibilities.

A successful company in an unregulated marketplace must have solid long-term business relationships with its suppliers. But deregulation has created just the opposite, where repeated bankruptcies have allowed airlines to evade hundreds of millions in legitimate billings by suppliers, bankrupting many of them, as well, and leaving the airline without the continuing assistance of the supporting businesses that are essential to the health and profitability of every commercial enterprise.

An unregulated air transportation system must have symbiotic relationships between its air carriers, airports and air traffic control providers. Stable growth and profits ensure that airports can be rationally expanded to meet demand, and that route expansions will respect air traffic control considerations. But in the wake of deregulation, many communities have been left with the bond payments undertaken to expand airport facilities in response to new air service, long after the service has failed. Likewise, air traffic control often finds itself overbuilt where airline service has failed, overloaded where new service has started, and unable to collect millions in fees from an ever-expanding list of bankrupt carriers.

A free-market model requires vigorous federal oversight, to ensure industry participants are held to the highest standards of regulatory compliance. But regulators are ever more subject to the political influence inherent when a handful of large corporations – airlines, maintenance and repair organizations, manufacturers, banks, insurers and lessors  – have enormous financial effects on national economies, international balances of payments, and levels of national employment. The political pressures that are brought to bear by these large and powerful corporate entities result in waivers, letters-of-agreement, special conditions, and other means to bypass regulatory oversight, facilitating blind corner and cost-cutting in areas of design, materials, manufacturing, training, maintenance, line operations and other safety-related industry components.

Most fundamentally, a free-market model requires that consumers be able to make quality judgments about products or services, such that the acceptable price-performance point can be determined by the marketplace, with lower-quality and higher-cost providers forced to meet consumer expectations. In the case of air transportation, quality is materially defined as safety, and yet consumers are without the knowledge or ability to make informed judgments about the safety of an airline operation. Instead, consumers make purchasing decisions based mostly on ticket price. The result is that fares become the primary focus of airline management, with all other facets of the operation relegated to lower levels of priority. The consumer cannot make judgments about the quality of internal airline operations, and safety is therefore not sufficiently valued in the cost-cutting calculus. This is especially true where senior managers are absent the experience themselves to know muscle from fat. In this skewed version of a free-market system, the survivors are carriers willing to sacrifice good operating practices, accept risks, and then be lucky enough to get away with it for a time, rather than those who operate efficiently, legally, and safely.

So, where has the failed experiment brought us? Hundreds of carriers have failed. Most surviving carriers have sold off their airplanes to giants in the banking, finance or insurance business, leasing them back for inflated prices, and increasing debt service costs forever. Office buildings, maintenance and training facilities, shop equipment and simulators, have been sold to create enough cash to survive a little longer. Although always more expensive in the long term, basic business functions – including reservations, accounting, maintenance and training – have been increasingly outsourced. Employee contracts have been renegotiated – often repeatedly – in order to reduce wages and benefits to mere subsistence levels. New-hire employees often work for wages that meet federal poverty standards for food assistance. Customers have been subjected to an ever more creative set of “bait and switch” marketing tactics, where low ticket prices are used to make the sale, followed by fare adjustments for such incidentals as early boarding, checked bags, and aisle seating. Some have even proposed pay toilets as a fare enhancement technique. At the same time, collusion to wink at laws against price fixing has resulted in ever higher fares. In short, the promises of deregulation were all temporary, and we are left with only the shell of an industry as the permanent result.

Corporate equity has been eroded to the point where many carriers are without the capital required to operate an airline well – even safely. Owning little and leasing or outsourcing much, many airlines have become little more than “corporate shells”. Balance sheets and financial reports have been increasingly jury-rigged so that carriers can report undefined “operating profits”, where losses were actually incurred. No investments in the long-term health of the airlines are made, with all liquidity dedicated to staying ahead of the monthly cash flow requirements. Costs are cut indiscriminately, with little attention to the long-term consequences. Press release gamesmanship has become the order of the day, creating false impressions about the health and future of the industry and its participants. Carriers, lessors and manufacturers report orders for new airplanes that none expects to honor. Most carriers know that a true return to profitability is not possible under existing business plans and the free-market model. Since a taxpayer funded bail-out of at least those deemed “too big to fail” seems to be an ultimate certainty, airlines with little in common, marginal equity, few prospects for synergism, and no cash, merge so as to hedge that the resulting larger carrier will be a survivor when the industry implodes. Knowledgeable insiders wonder at how the losses of assets and equity can ever be replaced by a mere bailout, when an overall recapitalization and reregulation of the industry would be required to ensure success. Some believe the air transportation industry is doomed to forever be the hand-to-mouth shell of its former status that it has become over the past three decades.

In the final analysis, there was no real prospect that the free-market model would succeed, and yet, as it was also with banking, thrifts, energy, and other examples, many were willing to believe the industry could provide a solid gold watch for only a dollar. The real tragedy is that so many were so easily fooled by empty promises that overshadowed the certain folly of airline deregulation.

Mark H. Goodrich – Copyright © 2012

The Folly of Airline Deregulation was first published in the November 2012 Issue (Vol 9 No 3) of Position Report magazine.