What Prompted Airline Deregulation 20 Years Ago? What Were the Objectives of That Deregulation and How Were They Achieved?
Presentation to the Aeronautical Law Committee of the Business Law Section of the International Bar Association at its Annual Meeting in Vancouver, B.C. on 15 September 1998
In 1998 we celebrate 20 years of airline deregulation in the United States. Coincidentally we can also commemorate 60 years of airline regulation and 40 years of airline reregulation.
In 1938, when the Civil Aeronautics Act was passed, there were 16 trunk airlines in the United States. "Trunk" was the generic name for the common carriers that provided scheduled national and international air service. Government assistance through protection, subsidy, promotion and regulation was thought to be necessary to permit the new industry to develop. For example, at that time the railroads were still the dominant form of both passenger and freight transportation, so railroads were specifically forbidden to have a financial interest in an airline. The fear was that the then very rich and powerful railroads would smother the competition from the fledgling airline industry, just as decades before in the Panama Canal Act the railroads were forbidden to have in interest in competing water carriers, for fear that the railroads would start cut throat competition on the high seas for traffic between the East and West Coasts of the United States, thereby dooming the viability of the Panama Canal. The Congress created a new government agency, the Civil Aeronautics Authority, to regulate air carriers the same way that the Interstate Commerce Commission had regulated surface carriers since 1890, that is, as if they were public utilities. The CAA was authorized to issue certificates to provide air service between specific points and to approve all fares and schedules.
Twenty years later, in 1958, Congress brought air carrier regulation into the post-war worldÂ—a world where aviation was already a giant industry in the United States. Coincidentally, 1958 was also the beginning of the jet era, which was soon to change the game materially. But in the Federal Aviation Act of 1958 the Congress essentially repainted the plastic flowers of the existing public utility-type regulatory regime, changed the name of the CAA to the Civil Aeronautics Board or CAB, and hoped that the carriers would flourish in their gridlockedÂ—and padlockedÂ—garden.
Twenty years later, by 1978, six of the original 16 trunklines were history and no new trunkline had been allowed to come into existence. The ten that had survived accounted for 90% of the air carrier market. In 1978, the supersonic commercial jet era was two years old (Concorde flights between Europe and the United States had begun in 1976), but the CAB machinery of airline regulation had slowed to the pace of a horse-and-buggy bureaucracy. Meanwhile, the energy crisis of 1973-1974 had also changed the economics of air transportation and in 1974 had doused the U.S. airlines in a bath of red ink ($100 million Â—a big number 20 years ago).
I had been at the U.S. Department of Transportation since 1971, with no more prior qualifications to shepherd the transportation industry than being a 40-year old Republican lawyer, which was the White House's profile for a new General Counsel at DOT. But by the end of 1974 my immediate boss Under Secretary Bud Krogh had been swept away by Watergate, I had moved up to his job, and Secretary Brinegar and I had begun cannibalizing six bankrupt railroads in the Northeast in order to create one survivor, Conrail. And in the process I had become convinced that one of the main reasons that the Penn Central and the Erie and the others had gone bankrupt was because there had been too much railroad too little utilized, and that there had been too much railroad because there had been too much public-utility-type economic regulation of the railroads.
I mention this phenomenon of the railroads not only because it was the source of my personal epiphany for airline deregulation, but also because it became an increasingly common subject for congressional comment and in itself a significant basis for the subsequent decisions to strip away airline regulation before it strangled the airlines. The major trunk airlines were flying coast-to-coast with 40 percent load factors and Pan Am was hoping the Shah of Iran would bail it out. The Congress was preparing to put up billions of dollars to send the Penn Central and its five stable mates to the fat farm for their reincarnation as Conrail. The key transportation figures in the Congress wanted to avoid a Penn Central with wings.
I do not mean to suggest that we brought airline deregulation down on tablets from the mountain of bankrupt railroads. There were many advocates ahead of us and even more behind us to finish the job in 1978. By that time I was taking a sabbatical at the American Enterprise Institute in Washington. In the final push to deregulation in 1977 and 1978, my role was limited to that of a private citizen in a think tank invited to testify before congressional committees.
But by way of authenticating these observations about the origins of airline deregulation, I can say that, in February 1975, as the Acting Secretary of Transportation, I had the opportunity to be the first Executive Branch witness to testify in Congress in favor of airline deregulation. There are two amusing footnotes to that congressional appearance. The Ford Administration was already working on an airline deregulation proposal. The invitation from Senator Ted Kennedy to testify on the subject before his Judiciary Committee Subcommittee on Administrative Practice and Procedure was a welcome opportunity to float the Administration's deregulation views in a friendly forum, in preference to the Aviation Subcommittee of the Senate Commerce Committee, which was the more appropriate forum to consider such issues. Moreover Senator Howard Cannon had already introduced a bill that would liberalize some of the rules about charter flights and he had scheduled hearings on that bill for later in the month. While we all knew that Senator Cannon was very suspicious of airline deregulation, and we also knew he would be upset with having Ted Kennedy setting up wickets to play on his pitch. To be allowed to use that favorable forum, Senator Kennedy's Subcommittee, therefore required considerable debate at the White House. President Ford himself had to give me the green light, because he was concerned about offending his old friend Senator Cannon, who had long been "Mr. Aviation"in the Congress. The White House debate showed that former Minority Leader Gerry Ford was truly a creature of the Congress.
The other amusing footnote is that, at the hearing itself, when Senator Kennedy started to quibble with some of my answers to the questions that his counsel had prepared for him to ask, his counsel poked Senator Kennedy in the ribs and said in audible whispers:
"That's the right answer, Senator. Ask the next question."
His counsel for those hearings is now Mr. Justice Stephen Bryer. At the time he was on leave from the Harvard Law School . Senator Kennedy did not know that Steve Bryer and I had cooked up both the chairman's questions and my answers the night before. Congressional history and "congressional intent" have always been a thriving, self-serving cottage industry in Washington.
So what more specifically brought the concept of airline deregulation to a boil in the mid 1970s and to fruition in 1978? I have arbitrarily grouped the contributing factors into seven categories, although obviously the categories interact. And I will not attempt to describe these categories in order of importanceÂ—some factors were more important to some constituencies than to others.
First I would put airline pricing. The sharply rising cost of airline tickets was of increasing concern to the public, and the lack of fare flexibility was a growing concern both to the non-scheduled and charter carriers and to the U.S. Department of Transportation. Ironically, the inability to raise prices easily was also a matter of growing concern to the trunk airlines, which had begun losing money. TWA and Pan Am were hemorrhaging and had even been talking merger.
In those days, as I have already mentioned, the airlines were regulated as if, and on the theory that, they were public utilities. Every fare had to be approved by the CAB, and the CAB regulated fares on the basis that an airline was entitled to a 12% return on investment. Not bad, eh? Unless you have to pay such a cost-plus fare. But how would the CAB determine what fare would return 12% of the airline's investment? After squabbling over how to measure carrier investment, the CAB would assume that the airline would fill 55% of its seats at the full fareÂ—and it would also assume that the aircraft still had the same number of seats that it came with. I don't remember that there was any standard for annual or average daily hours of flight operation, and indeed those numbers were all over the map because of the peculiarities and inefficiencies of route structures long locked in concrete. Of course in those days airlines were experimenting with taking out seats in order to accommodate a piano bar, for example, because in-flight services and amenities were the only way that airlines could compete. But the CAB nevertheless assumed the original seats were still there for purposes of calculating ROI.
In the 1960s some airlines had succeeded in obtaining approval for a variety of discount fares, strictly limited to be sure. Do you remember Youth Fares? But by 1970 discount fares were also history.
When United, AA and TWA next proposed discount fares, the CAB in early January 1975 promptly suspended all the discount fares because United had proposed them in all its markets. So Senator Cannon was already indignant with the CAB when he announced the hearings on this bill in his Aviation Subcommittee, shortly before Senator Kennedy actually started his hearings in February. (Senator Kennedy had announced the previous November that he was interested in studying airline regulation, which is what led to our working with his Subcommittee staff long before I actually testified.)
In fact, there was by then widespread unhappiness with the routine inability to persuade the CAB to liberalize fare regulation, or to experiment more boldly with Travel Group Charters (TGC's) and with Affinity Group charters. Indeed, the CAB proposed to eliminate Affinity charters at a time when they were accounting for 40% of domestic traffic, 54% of U.S. international traffic and 80% of the supplemental airlines' traffic. Instead the CAB proposed to substitute more constricted Advance Booking Charters (ABC's). The CAB also refused to liberalize Inclusive Tour Charters (ITC's), which the CAB had first approved in 1966 (you had to make three stops, stay two weeks and pay a minimum of 110% of the published airfare for the entire route!). (I should note that at that time much more liberal ITC's were the bread and butter -- and jamÂ—of the U.K. and European charter industry.) And there had also been the bruhaha over OTC'sÂ—One-stop Inclusive Tour Charters.
Only reluctantly did the CAB give up the concept that, in any of these charter fares, each charter passenger had to pay an equal share of the full cost of the charter, instead of a fixed price for his ticket. Thus, if someone canceled at the last minuted and the carrier had not already received that passenger's money or couldn't find a replacement, the fare for everybody else on the charter went up! That is a good example of how excessive regulation had been crippling the air carriers in the marketplace.
The second and third factors prompting deregulation are two different types of "Entry".
First there was the difficultyÂ—read inabilityÂ—to get into the trunk airline business at all. I have already mentioned that the CAB did not admit any new trunk carrier after 1938. To be sure, by 1975, there were eight regional service carriers, some quite large (e.g., Frontier), and there were ten supplementals, a few intrastate carriers in Texas and California, and air taxis. But when, for example, World Airways, a charter airline, applied in 1967 to fly a scheduled service between New York and Los Angeles at low prices, the CAB "studied" the matter for six and a half years and then dismissed the application because the record was "stale".
Secondly, even if you were a member of the club there was the difficultyÂ—read forget itÂ—to obtain CAB approval for a new route. At the same time, under CAB regulation an air carrier that wanted to deploy its assets more efficiently would have difficulty obtaining CAB authority to abandon a route. It was the same problem that the railroads had with the ICC. As an example of the difficulty of securing approval of a new route, Continental had to wait eight years to add San Diego/Denver to its system, and finally succeeded only because a U.S. Court of Appeals told the CAB to grant the authority.
In another case Federal Express sought CAB authority to use an existing exemption to fly a larger cargo plane on its busiest routes. Fed Ex had been able to enter the air cargo business by using the CAB exemption for small planes. When Fred Smith's business took off, he found he had to fly two small jets wing to wing between Memphis and his busiest markets in order to carry his increasing loads. He sought authority under the same exemption to fly one larger jet instead of two small ones. The CAB said no. Fred Smith then went directly to Congress with a landmark postcard write-in campaign and I found myself testifying before a House subcommittee on Government Operations. I had to hedge the Administration's position on cargo deregulation because, at the Madison Hotel in Washington the night before, I had not been able to persuade Joe Healey and Wayne Hoffman of Flying Tigers, then the largest all cargo air carrier, that air cargo deregulation was in their interest. Because of the very short notice of the hearings, I had been authorized to promote all cargo deregulation at the hearing only if I could get politically powerful Flying Tigers on board.
Ironically, when air cargo deregulation went into effect as of January 1, 1979, a year ahead of passenger deregulation, Fed Ex and Flying Tigers were both grandfathered into the new system, where a year later the only test for new entry would be "fit, willing and able". And both made a killing in the deregulated air cargo environment. And then of course Tigers swallowed Seaboard World Airlines and then Fed Ex swallowed the Tiger. Meanwhile Airborne and Emory and DHL and finally UPS all jumped into the air, and so on. The fruits of cargo deregulation.
There was indeed an informal moratorium on route entry after 1969. The legal problem with entry into the airline business or onto a particular route was very simple, and an incumbent trunk airline lawyer's dream of a slam dunk. The applicant for authority to add a route to its system had the burden of proving not only that the carrier was "fit, willing and able", but also that the applicant's service on the city-pair was "required by" the public convenience and necessity (or "PC&N"). But if the addition of the applicant to the city-pair would hurt a carrier already serving the routeÂ—and how could it not?Â—the new entry was clearly not "required by" PC&N. Indeed, in the CAB's view, it was contrary to PC&N. To an old antitrust lawyer, that criterion was an "injury to a competitor" test, not an injury to competition test. That frustration with the system is also why I had put industry and route entryÂ—and the threat of entry, which is "potential competition"Â—at the top of my personal priorities. I was satisfied that price flexibility would follow.
But more flexible pricing rules and relaxed entry and exit standards would have been hollow rights if the CAB could continue its practice of sitting on applications interminably. The CAB was beginning to rival the ICC. I have already mentioned the cases of World Airways and Continental. So in 1974 and 1975, I believe that the fourth factor prompting at least reregulation, if not complete deregulation, was the very significant delays at the CAB.
At this point I should mention that, during the public debate on airline deregulation, the opponents of a revised law said that the CAB, led by John Robson in the later Ford years and then by Fred Kahn in the Carter years, could accelerate decision making and could relax pricing and entry standards. Robson and Kahn were both effective proponents of deregulation, but their power to effect real change was limited by the statute and by the court precedentsÂ—and by the bureaucracy. Fortunately that disingenuous, diversionary tacticÂ—"let the CAB do it"Â—did not seduce any of the congressional decision makers once the case for substantial deregulation had been made.
The fifth factor prompting deregulation was the general displeasure with the CAB's love affair with capacity limitation agreements. The CAB would approve an agreement between the two or three trunks on a particular route to limit the number of seats they would offer, and thereby immunize from antitrust attack what otherwise would have been an illegal market allocation agreement. The ploy was first adopted for the big guys in 1970 when they were already flying coast-to-coast half empty and had failed to trim their sails in anticipation of the economic downturn. Capacity limitation agreements were perpetuated in the name of energy conservation in 1973-1974. The result was that by 1975, 29% of the RPM's (revenue passenger miles) of the three largest carriers were protected by capacity limitation agreementsÂ—and I invite you to hazard a guess whether or not the fares on those routes were abnormally excessive.
A related concern was the CAB's proclivity to approve airline mergers without testing their effect on competition, as the antitrust laws would have required. The CAB's ability to bless anticompetitive arrangements and agreements was very popular in the industry.
The sixth separate factor prompting deregulation that I would identify was the simple fact that, as I have already mentioned, the planes were flying only half full. In FY 1974 and 1975 the load factors on the trunks were 55.4% and 53%, respectively. The load factors on transcontinental routes were in the 40s. If load factors rose on those routes, the carriers would add more flights in the hope of obtaining a larger market share by virtue of their greater frequencies. Most airline executives protested that in order to provide satisfactory service, 50 plus percent was all the seats they should fill. To the airlines with their cost-plus mentality, satisfactory service meant permitting anyone who wanted to get on any flight to be able to do so. Penalties for no-shows had proven a failure. The late Charlie Tillinghast, then chairman of TWA and an articulate opponent of deregulation, was honest enough to admit to me at one White House meeting with the industry that he could provide an acceptable level of service with a 65% load factor. He was almost alone in the industry. But the economistsÂ—and the publicÂ—knew that people shouldn't be paying fancy, fixed prices for one seat in order to have the next seat Â—or statistically more accurately 9/10ths of the next seat, vacant all the time. Although we may appreciate having an empty seat next to us to put our papers, or not to have to scrunch into an economy seat next to a Sumo wrestler, most travelers would prefer to fly on fuller planes in order to pay less.
In any event, the politicians and the public alike had already seen that satisfactory service with fuller capacity could be achieved through charter and non-scheduled air carrier services and by the intrastate carriers, PSA and Southwest. The CAB didn't seem to care. Fares were predicated on the CAB's assumed, artificial 55% load factor.
This is not to say that the airlines today have an entirely satisfactory system for filling up their seats, or for solving their overbooking problems. I only argue that the low load factors in the 1970s and the industry's reluctance or inability to do anything about it while prices were rising was a stimulant to airline deregulation.
And finally, my seventh provocation for congressional action was the well publicized success of a few intrastate carriers like PSA and Southwest that were not regulated by the CAB and that were selling seats for much less than their CAB-regulated competition. Lamar Muse of Southwest proved you could provide satisfactory service and make moneyÂ—at least in certain marketsÂ—with fares that were half the competition (until the competition had to lower its fares). Lamar used to say "You spell competition P R I C E ."
Perhaps I should add an eighth factor that led to congressional action on deregulation. The industry had cried "wolf" and Congress had seen, for example, that the chaos predicted by the Air Transport Association (the association of trunk carriers) if charter rules were relaxed did not arrive. In 1974 ATA President Paul Ignatius testified that the 1974 bill authorizing OTC's would be "the beginning of the end of the Nation's air transportation system as we know it today". And indeed it was: the bill was not passed, but the CAB nevertheless authorized the charter flexibility that the bill would have directed. The subsequent two years of One-stop Inclusive Tour Charters demonstrated a bonanza for both the public and the airlinesÂ—and that the ATA had cried "wolf" without reason. In 1976 when Chairman Cannon again opened hearings on airline reregulation, he noted ironically that the largest single beneficiary of OTC's was United!
In 1975, a year after ATA's prophecy of "the beginning of the end", the ATA told Senator Kennedy that the result of the legislation he was proposing would be elimination of 272 non-stop trunk routes plus 826 subsidized routes of regional carriers, that the 1,267 non-subsidized routes of regionals were at risk, and that federal subsidy costs would rise from $70 million per year to more than $1 billion. The wolf was at the door again. There would indeed be an ongoing problem with service to smaller communities, but it never assumed the proportions that the ATA threatened. Instead a whole new family of air carriersÂ—the commutersÂ—came into existence.
In retrospect it looks obvious; something had to be done before fares went through the roof, and before carriers sank to the point where they could not earn the money to finance the new planes they needed, or to retrofit the ones they already had in order to meet new noise requirements. That could indeed be added as a factor prompting deregulation: the need to be able to finance the reduction of aircraft noise at airports, which could only be achieved by more efficient use of air carrier assets. Neither the Ford nor the Carter Administrations nor the Congress were willing to have the public pay the bill for retrofitting the air carrier fleet, so this was an added reason for shaking up economic regulation of the airlines to keep them healthy.
Notwithstanding this litany of the horrors of the regulatory maze, the list of people advocating substantial deregulationÂ—not just tinkering with the system like changing the burden of proof on entry, or changing the entry test from "required by" PC&N to "consistent with" PC&N, or giving the CAB ten months to act on an applicationÂ—was relatively small. The academics and economists I have mentionedÂ—Jim Miller, first at DOT and then at CEA (and later OMB director); several other people in the Ford Administration (Bill Coleman, John Snow, Bob Binder, George Douglas, Rod Hills, Paul McAvoy); then a large number of people in the subsequent Carter Administration, after our watch. Consumer groups and eventually shippers who had teethed on railroad and motor carrier deregulation in the Ford years added their voices and their political clout. Many liberal Democrats who thought first of the consumer and only secondly about organized airline labor (which was largely opposed to deregulation) saw a populist issue. Conservative Republicans and Democrats who wanted to put the decisions in the industry in the hands of management embraced the opportunity to attack government regulation per se. And graduallyÂ—over a four year periodÂ—the Congress took up the battle.
And then even more gradually, some of the airlines: Bob Six of Continental was an early convert: he objected to United's Hawaii routes being protected when AMEÂ—automatic market entryÂ—was on the table (one route a year for two years, then two for three years, but little guys could protect certain routesÂ—it was like the baseball draft). Bill Sewall of Pan Am became a convert because he saw the possibility of obtaining domestic routes, failure to develop which subsequently contributed to Pan Am's demise when, in the deregulated arena, all the other majors could start jumping the puddles; Don Nyrop at super-cost-conscious Northwest could succeed either wayÂ—Northwest's break-even load factor in those days was 16% below United's, 43% against 59%.
But almost all of the airlines were violently opposed to deregulation: Al Casey and later Bob Crandall at American and Ed Colodny at then Allegheny were among the most articulate and vociferous (and yet they were the biggest winners when dereg came to pass!), Eastern's Frank Borman, who went down with his ship, the TWA and Delta economists. Dick Ferris of United was eventually less adamant. Most airlines were largely comfortable with the status quo -- cost-plus fare structures, so if you have to pay the pilots more, you can raise prices. They argued they would not be able to finance new aircraft because their route certificates would lose their economic (read monopoly) value if anyone could start up service on their routes. Similarly, many airports were afraid they would no longer be able to sell revenue bonds to the soon-to-be destitute airlines if the airlines lost their security blankets. Smaller cities feared loss of trunk airline service. The financial community was nervous, both in its role as financiers to carriers and as investors. And the unions feared both pressure on their pay scales, if fares were no longer cost-plus, and even worse, the prospect of non-union airlines.
And everybody opposed to deregulation said that airline safety would suffer. That was a hard argument to handle, and obviously a very important consideration. How could you know or prove that airlines that were going to have to be more cost conscious would not skimp on maintenance as competition increased and there was downward pressure on fares? Was the FAA up to the job? I acknowledge that safety was and is and always will be a tough issue.
But I had and have my own answer, whether or not the FAA could keep the industry flying "straight and level", as pilots say. My experience with the aviation community has been that the aviation community puts the good of aviation first and the economic well-being of their employers second. And the good of aviation requires a zero tolerance for accidents, however optimistic or unrealistic that goal may be. So I am still comfortable that aviation safety is not being jeopardized by deregulation.
And so, to jump ahead, what happened in 1978 was that the public-utility type of passenger airline economic regulation was eliminated almost entirely, albeit phased out over time. The freedom to raise and lower fares and to enter and leave markets met the first three objectives that I have describedÂ—pricing flexibility and ease of industry and market entry. The transfer of the few remaining CAB regulatory authorities to DOT met objectives four and fiveÂ—regulatory delays and authority to immunize anticompetitive agreements (though I confess I think the DOT then went too far too fast in blessing airline mergers). With all the foregoing it was inevitable that planes would be fuller and that the interstate carriers would be on an equal footing with PSA and Southwest, my factors six and seven. And Congress was right and the ATA was wrong: the industry has not only survived but thrived in many of the 20 years since deregulation. And an even less debatable result, more of the public is flying for less, much less, than before 1978.
Thank you for your attention and for indulging me in my war stories. I have attached to the copies of this paper a one-page "commentary" from the October 25, 1976 issue of Business Week. It fairly summarized the political factors at play at the end of 1976, a few months before I left the Government. That was the score at half time in the Airline Deregulation game. But the score that counts is not the score at half time, of course, or even the score when the game was over and deregulation was a fact. I am looking forward to hearing how Dick Fahy looks at that period and where we are today.
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