Terminal Sickness

How a thirty-year-old policy of deregulation is slowly killing America’s airline system—and taking down Cincinnati, Memphis, and St. Louis with it.
March 12, 2012 |
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It was certainly one of the hardest choices that I’ve ever made,” explained Fernando Aguirre. He’d raised his family and built his career in Cincinnati, Ohio, rising through the ranks of the city’s business elite, first as an executive at Procter & Gamble’s headquarters and later as CEO and chairman of Chiquita Brands International. Along the way, he became a fanatical fan and part owner of the Cincinnati Reds baseball team, as well as a proud sponsor of the Chiquita Classic golf tournament, the proceeds from which he poured into local philanthropies.

But last fall, Aguirre confirmed Cincinnati’s worst fears by announcing that he and his company were—very reluctantly—skipping town, and for a reason that cast an even deeper shadow over the city’s economic future. Cincinnati has long been (and for now remains) a major business center, the headquarters of six Fortune 500 companies and fifteen Fortune 1000 companies, including not just household-name producers like Procter & Gamble and Chiquita but also retail giants like Macy’s and the Kroger grocery chain. With a population of 2.1 million, it’s the twenty-seventh-largest metro area in the United States. But running a national, much less international, business out of Cincinnati is becoming more and more problematic for a simple reason: inadequate air service.

As recently as 2004, the Cincinnati/North Kentucky Airport (CVG) was a major hub for Delta, and offered nonstop flights to 129 major cities, including Frankfurt, Amsterdam, London, and Paris. Today, the number of flights through CVG has fallen by two-thirds, and an entire concourse stands eerily empty. At the same time, flights out of the airport have the highest fares in the country. This means that if you live or do business in Cincinnati, it’s hard to fly anywhere without paying a fortune and having to cool your heels for hours while waiting to change planes in a city like Atlanta or Charlotte. And if you’re a global business like Chiquita, which operates in seventy countries and needs to be able to attract global talent, the situation is untenable.

So Aguirre is moving Chiquita’s headquarters to the NASCAR Plaza in uptown Charlotte, just a thirteen-minute drive from that city’s busy international airport. The move will be a boon to Charlotte, creating more than 400 jobs with an average wage of over $100,000. But it will be gut-wrenching for existing employees, as well as for Aguirre personally. He recently had to explain to Charlotte’s local press that he is no fan of NASCAR (“I have never gone to a NASCAR race. I’m sure I will end up going to a few from now on”), and that he still pines for his beloved Reds. But at least he and his employees have had time to prepare themselves mentally. “We’ve been dealing with the logistics of our business and the airport for so long now,” says Aguirre, “that everyone knew that the likelihood of moving was very high. It was just a matter of where and when.”

A generation ago, Aguirre and his employees at Chiquita would not have had to face such a difficult choice. Until 1978, the United States viewed airline service as a “public convenience and necessity,” and used a government agency—the Civil Aeronautics Board, or CAB—to assign routes and set fares. This regulation was designed to ensure that citizens in cities like Cincinnati received service roughly equal, in quality and price, to that provided to other comparably sized communities like Charlotte. The government also made sure that smaller cities maintained vital links to the national air network.

In 1978, however, a group of liberals including Ralph Nader, Ted Kennedy, Kennedy’s then Senate aide Stephen Breyer, and an economist named Alfred Kahn, whom President Jimmy Carter chose to run the CAB, conjured up a plan to drive down the cost of airline fares by fostering more price competition among airlines. Though they called it “deregulation,” the practical effect of eliminating the CAB, especially after subsequent administrations abandoned antitrust enforcement as well, was to shift control of the airline industry from experts answerable to the public to corporate boardrooms and Wall Street.

Over the years, most Americans have adopted a pretty standard line about the results. On the one hand, complaining about the indignities of flying—overbooked, late, or canceled flights; surly flight attendants; and, more recently, terrible in-flight food service and high fees for checked baggage— has become a staple of American life, much like complaining about Internet providers or health insurance companies. On the other hand, we’ve told ourselves, at least the increased competition has made air travel cheaper. And at least most of us can still get where we need to go by air.

But now we find ourselves at a moment when nearly all the promises of the airline deregulators have clearly proved false. If you’re a member of the creative class who rarely does business in the nation’s industrial heartland or visits relatives there, you might not notice the magnitude of economic disruption being caused by lost airline service and skyrocketing fares. But if you are in the business of making and trading stuff beyond derivatives and concepts, you probably have to go to places like Cincinnati, Pittsburgh, Memphis, St. Louis, or Minneapolis, and you know firsthand how hard it has become to do business these days in such major heartland cities, which are increasingly cut off from each other and from the global economy.

And it’s about to get worse. Despite a wave of mergers that is fast concentrating control in the hands of three giant carriers, the industry remains essentially insolvent. Absent any coherent outcry, the directors of these private corporations remain free to respond to the crisis in the manner of an electrical utility company that, when it runs short of money, simply cuts off power to the neighborhoods of its own choosing.

The loss of airline service to rural and remote areas is an old story; by the 1980s, even some state capitals— such as Olympia, Washington; Dover, Delaware; and Salem, Oregon—became places you could no longer fly to except in a private plane. But over the last five years, service to medium-sized airports fell by 18 percent. This latter trend is much more disruptive to the economy, reflecting lost service to important centers of commerce that until recently had major airports but are now isolated—most often due to the frantic pace of airline mergers and downsizing.

St. Louis, for example, has seen “available seat miles”— an industry measure of capacity—fall to a third of their 2000 level, following the American Airlines takeover of TWA and Lambert International Airport’s subsequent downgrading as a mid-continental hub. Two of Lambert’s five concourses are now virtually empty, and another, which housed the TWA hub, is only partially used. A third runway—the building of which required demolishing hundreds of homes and cost local taxpayers a billion dollars to finish in 2006—is now redundant. “This scenario,” notes Alex Marshall, a senior fellow at the Regional Plan Association, “can be likened to states building highways and then having General Motors, Ford, and other auto companies suddenly telling their drivers to use different roads.”

St. Louis’s loss of service comes despite the fact that the population of the St. Louis metropolitan area, the eighteenth largest in the U.S., grew by more than 4 percent between 2000 and 2010. The city is also the home of eight Fortune 500 companies and is a major center for such international players as Anheuser-Busch InBev, Monsanto, Boeing, Emerson Electric, Express Scripts, and Nestlé Purina. The GDP of the metro area, which is also propelled by such large research institutions as Washington University and a fast-growing medical sciences sector, rivals that of oil-rich Qatar. Yet like most other midsize American cities, St. Louis’s economic development is now hostage to the shifting, closed-door deals and mergers of a mere handful of airline executives and their financiers. The prevailing mood was captured by a St. Louis Post-Dispatch editorial that quoted “The Serenity Prayer” in advocating philosophical acceptance of the distant forces shaping the region.

Memphis International faces an even more urgent reason to pray. When it was designated a hub by Northwest in 1986, the airport undertook record-breaking expansion projects to house the airline and its regional carrier, Northwest Airlink. As in other cities, lack of competition at the airport led to record-high airfares. These high fares are still in place, but they haven’t been enough to preserve service. Delta’s acquisition of Northwest allowed the executives of that Atlanta- based airline to diminish the airport’s hub status. In March of 2011 the post-merger airline announced that it would cut 25 percent of its flights from the city. This loss of connectivity affects Memphis in ways both big and small. The Folk Alliance music conference, held annually in downtown Memphis, recently announced that it would move to Kansas City starting in 2014, due in part to airport hassles. The Church of God in Christ, too, recently decided to move its yearly convention out of Memphis, breaking 100 years of tradition. When Mayor A. C. Wharton visited church leaders to lure their 50,000 convention attendants back to the Bluff City, he learned of the material culprit that had pushed the spiritual gathering away: high airfares.

Pittsburgh is another example of a major city whose culture and economy is increasingly determined not by its underlying fundamentals but by the dictates of an ever more concentrated, yet failing, airline industry. After it lost most of its steel industry in the 1970s, the city did everything the apostles of the so-called new economy said must be done to compete in the emerging global economy. When the city played host to the G-20 Summit in 2009, President Obama hailed Pittsburgh’s transformation “from a city of steel to a center for high-tech innovation—including green technology, education and training, and research and development.” That same year Forbes named Pittsburgh one of America’s best cities for job growth, while the Economist lauded its cosmopolitan cultural amenities, such as the topflight Pittsburgh Symphony Orchestra and the Pittsburgh Opera.

But Pittsburgh’s renewal as a vibrant, creative, international city is now in doubt, due to the downscaling of its international airport, which now stands largely empty. Pittsburgh International was able to offer more than 600 daily nonstop flights after the city went deeply into debt to turn it into a showcase during the 1990s. But when US Airways merged with America West and concentrated its hub operations in Philadelphia and Charlotte, Pittsburgh service tumbled. US Airways’s daily flights have plunged from 542 to sixty-eight, causing the shuttering of half the gates at the airport as well as sections of two concourses.

K&L Gates, one of the country’s largest law firms, used to hold its firm-wide management meeting near its Pittsburgh headquarters, but after flying in and out of the city became too much trouble, the firm began hosting its meetings outside of New York City and Washington, D.C. The University of Pittsburgh Medical Center, the biggest employer in the region, reports that its researchers and physicians are increasingly choosing to drive to professional conferences whenever they can. Flying between Pittsburgh and New York or Washington can now easily take a whole day, since most flights have to route through Philadelphia or Charlotte. A recent check on Travelocity showed just two direct flights from Pittsburgh to D.C., each leaving shortly before six in the morning and costing (one week in advance) $498 each way, or approximately $2.62 per mile.

All these trends in the airline industry are bound to get much worse, and soon. Despite massive consolidation, steep cuts in wages and benefits, sharply rising fares, huge direct and indirect subsidies, and a slowly recovering economy, the industry remains unable to service its debt, and its executives—now serving at the whim of Wall Street— see no way out except to continue to merge and to cut capacity. U.S. airlines lost money in all but three years between 2001 and 2010, according to the industry’s trade group, for a cumulative net loss of $62.9 billion. Even before the recent bankruptcy of American Airlines, the value of all publicly traded U.S. airline stocks amounted to only $32.3 billion, less than that of Starbucks.

That number would be even lower were it not for the major subsidies the industry has extracted from Congress. These include not just the billions spent by state and local governments to construct and maintain airports, and the $15 billion in loan guarantees the industry received in the aftermath of 9/11. They also include tens of billions in unfunded pension liabilities that major airlines have shoved onto taxpayers by declaring bankruptcy, as United and US Airways did in the last decade and American Airlines is trying to do now. If American succeeds in its plan to shed its pension debts onto the federal government’s Pension Benefit Guaranty Corporation, that alone would amount to a bailout of more than $10 billion. Other U.S. airlines continue to benefit from special provisions passed by Congress in 2007 that allow them to underfund their pension plans, so in the future taxpayers are likely to be paying even more of the cost of flying yesterday’s planes.

Yet even though these and other public subsidies dwarf those provided to Amtrak or General Motors, only one U.S. airline, Southwest, still has an investment-grade credit rating. Since 1978, almost all new start-ups have either failed or been absorbed (remember People Express, ValuJet, and Air Florida?) and only one, JetBlue, remains as a national competitor. Meanwhile, all six of the major “legacy” carriers that were still flying in 2011 have gone through bankruptcy. When the final numbers come in for last year, the U.S. industry as a whole will probably show some net income, but as of the third quarter of 2011 the margin was razor thin, and was mostly the result of rising fares and canceled service. Adjusted for growth of the economy, airline capacity is now at its lowest level since 1979, according to the trade group Airlines for America, and the industry has announced plans to cut another 1.5 percent of available seat miles in the first half of this year.

High fuel prices, to be sure, are a factor in this tale of woe. In 1999, fuel comprised 10 percent of an airline’s budget; now it ranges from 30 to 40 percent. But while high fuel costs make the price of providing short-haul service to sparsely populated areas higher than it has been in the past, they are not sufficient to explain the continuing deterioration of the airline industry. Nor can we blame the problem on the effects of the Great Recession. After decades in which the price of energy has risen and fallen and the economy has boomed and busted, the long-term trend is clear. The industry has been in turmoil and decline for more than thirty years, barely able to earn its cost of capital in the best of times and only then by cutting service and quality. It’s now evident that the industry’s problems are structural and deepening, as is the crisis faced by cities and industries that depend now more than ever on frequent, affordable air service to remain competitive in the global economy.

No doubt a few Wall Street tycoons and consulting firms have made billions merging and stripping down the airline industry over the last generation. But the fundamental problem is that the business model that airlines are left with doesn’t work for common shareholders, airline employees, or the American business community, much less the public.

One reason this business model doesn’t work is that it’s at odds with the basic physics of flying. It requires a tremendous amount of energy just to get a plane in the air. If the plane lands just a short time later, it’s hard to earn the fares necessary to cover the cost. This means the per-mile cost to the airlines of short-haul service is always going to be much higher than that of long-haul service, regardless of how the industry is organized. Yet the value of airline service to the public and the economy depends on providing connectivity to as many places as possible. Thus, without some form of cross-subsidization between short hauls and long hauls, the economic benefits of the network will be compromised. Fewer people will be flying to fewer places, which by itself hinders economic activity, while the high fixed cost of the remaining service has to be spread among a diminished number of passengers.

This highlights another problem that inevitably leads to declining service. It costs virtually the same to maintain an air traffic control tower, a runway, and ticketing and baggage-handling facilities whether an airport serves five or fifty flights a day, or whether each plane carries five or fifty passengers. So the per-passenger cost on low-volume routes is necessarily more than on high-volume routes, which again requires some form of cross-subsidization if robust connectivity is to be maintained.

Dealing with high fixed costs is a challenge common to virtually all networked industries, and in one way or another, America has grappled with the problem throughout the country’s history. The Founders understood that private enterprise could not by itself provide broadly distributed postal service because of the high cost of delivering mail to smaller towns and far-flung cities, and so they wrote into the Constitution that a government monopoly would take on the challenge, providing the necessary cross-subsidization.

Throughout most of the nineteenth century and much of the twentieth, generations of Americans similarly struggled with how to maintain an equitable and efficient railroad network, and for much the same reason. During various railroad bubbles, exuberant investors would build lines to the farthest corners of continent, much like start-up airlines in the 1980s. But over time, the high fixed cost of railroading and the basic economics of any networked industry left all but the core of the emerging system unprofitable before it received the benefits of government regulation. In the 1870s, railroads accounting for more than 30 percent of domestic mileage failed or fell into court-ordered receivership.

This was true even though most railroads maintained a near or total monopoly in most of the intermediate towns through which they ran. As Charles Francis Adams wrote in his 1878 book, Railroads: Their Origin and Problems:

    Every local settlement and every secluded farmer saw other settlements and other farmers more fortunately placed, whose consequent prosperity seemed to make their own ruin a question of time. Place to place, or man to man, they might compete; but where the weight of the railroad was flung into one scale, it was strange indeed if the other did not kick the beam.

This was bad enough, but matters soon got worse. High fixed costs combined with ruinous competition in the early railroad industry created an overwhelming business incentive to consolidate and downsize, again much like what’s happening in the airline industry today. And consolidation in turn led to even more monopoly power—not just over small and midsize communities but over large cities as well. By the 1880s, the fortunes of such major cities as Philadelphia, Baltimore, St. Louis, and Cincinnati rose and fell according to how various railroad financiers or “robber barons” combined and conspired to fix rates. Just as Americans scream today about the high cost of flying to a city like Cincinnati, where service is dominated by a single carrier, Americans of yesteryear faced impossible price discrimination when traveling or shipping to places dominated by a single railroad “trust” or “pool.”

This, more than any other factor, is what led previous generations of Americans to let go of the idea that government should have no role in regulating railroads and other emerging networked industries that were essential to the working of the economy as whole. “While the result of other ordinary competition was to reduce and equalize prices,” Adams noted, “that of railroad competition was to produce local inequalities and to arbitrarily raise and depress prices. The teachings of political economy were at fault.”

And indeed they were. The response was the creation of the Interstate Commerce Commission in 1887—a move that most Americans viewed as essential to preserving free enterprise and their way of life. The ICC took on the task of moderating the price discrimination that railroads practiced, evening out the burden among different regions and classes of passengers and shippers in a way that allowed railroads to earn enough money to cover their fixed costs, improve their infrastructure, and give their investors a fair reward. In effect, the profits railroads earned on some highly trafficked long-haul routes came to be rechanneled by government policy to cover the cost of providing balanced and affordable service throughout the country. Railroads were regulated much as telephones and power companies came to be—as natural monopolies that would be allowed to remain in private hands and earn a profit, but not at the cost of skewing the overall efficiency, balance, and fairness of American economy.

The process was messy and far from flawless. Striking the right balance required that Americans hash out what would today be called an “industrial policy,” and to do so in sometimes minute detail, such as setting the relative prices of shipping hogs verses hams from Dubuque to Chicago. But overall, government regulation of railroad pricing and routes worked better than letting a few financiers rule the system for their own private benefit. The country, after all, emerged as an industrial powerhouse during this period. Managing the structure and pricing of railroads was particularly essential to maintaining the competitiveness of small-scale entrepreneurs and of midsize manufacturing cities like Cincinnati or St. Louis. It wasn’t that the government picked winners or losers; rather, it prevented the machinations of railroad financiers from doing so.

Starting in 1938, the U.S. adopted much the same approach to the newly forming airline industry. Through the creation of the Civil Aeronautics Board, the government allowed the industry to become highly concentrated. Underpinning the legislation was a belief in a “public right of transit,” the idea that citizens were entitled to a reliable aviation system designed to meet their business and safety needs—and the knowledge that unregulated competition would be unable to provide it.

As intended, the CAB nurtured the healthy maturation of a fledgling industry, forestalling ruinous competition and protecting airlines against bankruptcy. At the same time, airline fares fell dramatically, thanks largely to high levels of technological innovation, such as the introduction of the DC-8 and other mass-market jets. By the 1970s, the long-distance passenger train was dead, and jet travel had already helped to create a mass market for tourist destinations such as Disney World and the Caribbean. By 1977, 63 percent of Americans over eighteen had taken a trip on an airplane, up from 33 percent in 1962.

So why did Ted Kennedy and the Carter administration decide, over the strong objections of the airline unions and incumbent management at the time, that it was time to blow up government’s regulation of airlines? One reason was that the old regulatory regime had become highly litigious and rule bound. Kahn used to complain that his desk at the CAB was piled with papers demanding answers to trivial questions, such as “How many travel agents may a tour operator give free passage to inspect an all-inclusive tour? And must those agents then visit and inspect every one of the accommodations in the package?”

At the same time, many pointed to the example of Southwest Airlines, which got its start in 1971 by flying only within Texas, thereby escaping regulation by the CAB. Southwest’s success with discount fares particularly resonated with liberals at a time when inflation was liberalism’s greatest liability, and when the ascendant consumer movement made low prices a liberal imperative.

There were also ideological currents at work on the left that are little remembered today. Ralph Nader, for example, was popularizing the 1960s’ “New Left” notion that the New Deal regulatory state had been captured by incumbent industries, leading to what he called “corporate socialism.” Under the CAB, no new major airlines had emerged since the 1930s. Protected from competition, both airline management and unions had become overpaid and sclerotic at the expense of “the consumer,” Nader argued—and never mind if workers in those industries and their unions were stalwart members of the Democratic coalition.

The Carter administration accepted this analysis and used it to justify deregulating not just airlines, but soon the railroad, trucking, and natural gas industries, while also taking the first steps toward rolling back banking regulation as well. That most managements in these industries resisted deregulation at the time only confirmed many liberals in their belief that deregulation was needed, and they told themselves that any trend toward monopoly would be checked by rigorous antitrust enforcement.

At first, the program—which was, naturally, embraced by many free market economists and the incoming Reagan administration—seemed to pay off. To be sure, many communities instantly lost air service, and the industry rapidly restructured into the hub-and-spoke system that still exists today, leading to the elimination of many direct flights. But the early years of the new regime also saw a burst of competition and price cutting in the airline industry.

What both policymakers and the public generally missed, however, was that any positive effects that occurred would be temporary, and that many of them would have occurred without deregulation. The price of energy, for example, cratered in the mid-1980s, making it possible to cut fares and even expand service on many short hauls. But that wasn’t an effect of deregulation; it was the result of a temporary world oil glut. Indeed, after adjusting for changes in energy prices, a 1990 study by the Economic Policy Institute concluded that airline fares fell more rapidly in the ten years before 1978 than they did during the subsequent decade.

A study published in the Journal of the Transportation Research Forum in 2007 confirms that the pattern continued. Except for a period after 9/11, when airlines deeply discounted fares to attract panicked customers, real air prices have fallen more slowly since the elimination of the CAB than before. This contrast becomes even starker if one considers the continuous decline in service quality, with more overbooked planes flying to fewer places, long waits in hub airports, the lost ability to make last-minute changes in itineraries without paying exorbitant fares, and the slow strangulation of heartland cities that don’t happen to be hubs. Moreover, most if not all of the post-deregulation price declines have been due to factors that cannot be repeated, such as the busting of airline unions, the termination of pension plans, the delayed replacement of aging aircraft, the elimination of complimentary meals and checked baggage, and, finally, the diminution of seat sizes and legroom to a point approaching the limits of human endurance. (Eliminating seats altogether, however, remains an option.)

Going forward, all industry forecasts call for further consolidation and continually rising fares and fees, accompanied by declining service on all but the most heavily trafficked routes. From time to time, short-term fare wars may break out on particular routes, particularly if foolish investors bring a start-up airline to town. Periodic dips in energy prices may bring a temporary reprieve. But over time, experience has shown that nearly all start-ups are eventually crushed by incumbent carriers, which in turn, despite their increasing consolidation, heavy public subsidies, and reductions in vital service to major cities, remain unable to earn even their cost of capital over time. Nobody wins except a few fast-trading financiers flying in private jets.

This result would hardly surprise Charles Francis Adams, Louis Brandeis, and many other great Americans who struggled in the late nineteenth and early twentieth centuries with how to harness the emergence of railroads, telephones, electrical power, and other networked industries to public purposes. They’d recognize the familiar boom-and-bust cycle of new entrants that occurred in the early period of airline deregulation and the subsequent trend toward consolidation, deteriorating service, and increasing price discrimination. What else would anyone who knows economic history expect of a natural monopoly that lacks the benefits of government regulation?

To be sure, any regulatory regime can degenerate and wind up stifling competition, and the CAB of the late 1970s did become too procedure bound, ruled, as it came to be, by contending private lawyers rather than technocrats. It would have helped, too, if the country had not largely abandoned antitrust action after the Reagan administration. But even strong antitrust enforcement wouldn’t have helped that much, because airlines— just like railroads, waterworks, electrical utilities, and most other networked systems—require concentration both to achieve economies of scale and to enable the cross-subsidization between low- and high-cost service necessary to preserve their value as networks. And when it comes to such natural monopolies that are essential to the public, there is no equitable or efficient alternative to having the government regulate or coordinate entry, prices, and service levels—no matter how messy the process may be.

This is easy to see in extreme examples. It would be outrageously inefficient if each city had scores of waterworks and sewers, and also needlessly unfair; millions of Americans would still be waiting for indoor plumbing, just as millions had to wait decades for telephone and electrical service, until the government stepped in to enforce interventions like the New Deal’s rural electrification program.

Transportation in all its forms is not much different, as most people can see easily when it comes to highways. If we had a “deregulated” private interstate system, we’d have lots of high-quality toll roads running straight and fast between the largest population centers—indeed, probably far more than we need. And from time to time, exuberant entrepreneurs might try to make a profit by constructing a new artery road here or there as well. But the high fixed cost of building roads would mean that most smaller cities either would remain off the network or would have to pay such high tolls that they would never stand a chance of growing. Either way, owners of major highways, seeking to avoid competition, would gradually buy up owners of lesser highways, and then each other, until everyone was paying outrageous tolls and the whole economy suffered.

That was the lesson previous generations learned from railroads; the current generation has to learn it all over again, from our experience with deregulated airlines. Why have we become so passive and reluctant to face up to the hard task of governing ourselves and our markets? We don’t need to recite “The Serenity Prayer.” We need to get out from under the thrall of the false prophets of deregulation, conservative and liberal alike, and make the benefits of true capitalism work for us once again.