Deregulation gone rogue in airline industry

When FT or Economist writes about the harms inflicted by deregulation, it's a good time to start taking it seriously.

The deregulation of the US airline industry and the breaking of the US air traffic controllers strike by Ronald Reagan are considered seminal moments in the triumph of the free-market orthodoxy in the late seventies and early eighties. 

However, that wave of deregulation and privatisation has since played itself out with its problems and failings being exposed. I have blogged earlier on the roll-back of railways privatisation in UK, the problems with water privatisation, and the general reversal of the trend towards private participation and PPPs in infrastructure in Europe. 

The recent disruptions from mass cancellations in the US airline industry has drawn attention to the problems associated with excessive deregulation and the absence of adequate investments in capacity. In a recent article, the FT wrote thus,

Is this period of disruption for America’s air travel industry a short-term consequence of the pandemic or the culmination of long-term under-investment and shortcomings in regulatory scrutiny... A Gallup poll in August found that 37 per cent of Americans held a negative view of the airline industry, compared with 27 per cent who held a favourable impression... Despite widespread customer dissatisfaction, the three major companies — United Airlines, American Airlines and Delta Air Lines — reported combined fourth-quarter net profit of $2.47bn on revenues of $39bn... Passenger yield — the revenue from each person flying one mile — was higher in 2022 than in 2019... “The US [has] the largest, most complex air system in the world,” says Joe Rohlena, an airline analyst with Fitch Ratings. “Like it or not, when something goes wrong in one part of this system, it’s going to have relatively large effects. Without improvements that need to happen, it’s not going to run flawlessly.”

The roots of the current malaise can be traced back to the era of deregulation,

The roots of the current US aviation system spring from the 1978 Airline Deregulation Act. In the four decades prior, the US government was responsible for regulating the air service. Prices and routes were set by the Civil Aeronautics Board, which based fares on airline costs plus a 12 per cent profit. Republican President Gerald Ford began the push towards deregulating the industry, a mission later championed by Democratic Senator Ted Kennedy, who argued it would lower fares and allow more people to fly. Airlines themselves were among the most vocal opponents, saying the shift would destabilise the industry... When President Jimmy Carter signed the bill in 1978, it allowed airlines to fly any route they wanted, charging any price the market would bear. Dozens of new airlines formed, paying their crews lower wages than the established players. Labour unrest gripped the industry, and fares plummeted as airlines battled for market share. Many adopted the hub-and-spoke model, using major airports as a central hub for connecting flights, allowing airlines to maximise efficiency but eliminate many nonstop routes.

The new world order toppled titans Pan American World Airways and Trans World Airlines (TWA), which filed for bankruptcy in the 1990s. United Airlines filed in 2002, in the aftermath of the 9/11 terrorist attacks, and Delta Air Lines followed three years later. It has been reported that, years later, Kennedy cornered Phil Bakes, the man who persuaded him to champion deregulation, at a Democratic Party event and chastised him for misleading him about its effects. The bankruptcies led the airlines to fixate on cost-cutting and to avoid investing in their operations, including expensive but necessary IT infrastructure... In the next decade, airlines rewarded shareholders with stock buybacks instead of improving their services, resulting in the zero-slack system infuriating customers today. As airlines sought to increase revenue, they downsized seats and introduced fees for services previously included in the airfare. Planes have grown increasingly crowded, with the load factor inching upward from 72 per cent in 2002 to 83 per cent last year. 

The FAA, too, has struggled to invest in infrastructure and operations. The agency now has fewer employees to manage airspace that has grown more crowded from both commercial flights and the proliferation of drones. It also has suffered from precarious Congressional funding. Only once since 1982 has it received funding for a five-year period, making long-term planning difficult. Instead, the agency has been plagued by continuing resolutions on Capitol Hill that force it to plan how air traffic control will operate if federal employees are forced to stop working due to a government shutdown. The trend accelerated when a wave of candidates from the Tea Party, a one-time anti-government faction within the Republican Party, were elected to Congress in 2010. Temporary reauthorisation had been extended 23 times from 2007 until Congress voted in favour of the FAA Modernization and Reform Act of 2012.

The consequences of deregulation has not been benign,

The concerns raised by opponents of deregulation came to pass: the airline industry has increasingly consolidated. Between 2008 and 2013 there were a series of megamergers in which United, Delta and American Airlines each swallowed a similarly sized competitor. The four major US carriers and their affiliate regional airlines now control 80 per cent of the routes in the United States, says William McGee, senior fellow for aviation at the American Economic Liberties Project, an anti-monopoly think-tank. Unlike the glut of new competitors that flooded the market in the 1980s, only two new airlines have launched in the past 16 years. Average airfares adjusted for inflation have fallen since 1978, but the benefits are spread unequally among customers. Heavily trafficked routes or those where low-cost carriers operate do offer lower fares, while prices have risen on routes to smaller cities. Passengers also typically face extra costs, such as bringing luggage — a move that has paid off for carriers. US airlines derived less than three-quarters of their operating revenue from fares in the first nine months of 2022, compared to 89 per cent three decades ago.

The fundamental problem that needs to be highlighted is that deregulated free market competition invariably results in a race to enhance efficiencies primarily by cutting costs, limiting investments, and maximising profits. The incentives of private participants get distorted big time. The outcome in the medium term is higher prices, asset stripping, and reduced service quality. This is the iron law of deregulation.

It's important here to make two points. One, the baseline of regulation is important. The problem is less with deregulation per se, but with excessive deregulation of the kind mentioned above. It's the ideological belief, instead of practical choices, that's the problem. Unlike developed markets which are typically already deregulated for private participations in most sectors, many developing countries could do with greater deregulation. An example is that of power generation in Africa where the entire sector is government owned and heavily regulated. It could do with deregulation. 

Two, the success of deregulation depends on the capability to regulate. Given the innate incentives of the private sector, deregulation should be accompanied by strong capacity to monitor and enforce the existing regulations and private contracts. This depends on state capability, which is unfortunately acutely deficient in most developing countries. In its absence, deregulation is a recipe for state capture and crony capitalism.