How To Reform and Stabilize Airline Industry

Few industries in the United States match their markets as poorly as do airlines. Why? Until 1978, Federal regulation of fares allowed greedy unions and cowardly managements to set costs and fares far above actual market value. These entrenched interests thwarted the free market discipline promised by deregulation. The airlines thus lose tens of billions of dollars during bad economic times. And Washington repeatedly bails these big campaign donors out.

But the crushing blows of 9/11 and the 2001-2002 economy finally broke the backs of unions and management at the big pre-deregulation “network” carriers. A shakeout thus looms that will shrink these six carriers–American, United, Delta, Northwest, Continental, and US Airways–to three or four. Washington must resist the temptation to keep propping up losers. They must also reject predictable “Cinderella” merger pleas from these airlines, which could short-circuit the free market. In short, failed airlines must be allowed to simply shut down.

The real problem is an imbalance of capacity between what are actually two complementary, side-by-side airline industries. The network carriers connect US cities of all sizes to each other and the world. Their hub airports allow you to fly from Binghamton to London, or Appleton to Tokyo. Newer low-cost-structure carriers, including Southwest and JetBlue, maintain economies of scale by flying denser routes and simple fleets. They offer low fares that stimulate traffic, create jobs, and produce strong profits.

As the low-fare carriers expand–from 15 percent of the USA market in 1995 to 25 percent today–fewer and fewer city-pairs will tolerate the high fares needed to support the network carriers’ high cost structures. Which is as it should be: a free market will find the most efficient way to provide a good or service. When the dust settles, probably well before 2010, low-fare airlines will probably carry 50-55 percent of fliers, and network carriers 45-50 percent.

The network carriers delayed this cost-reduction and capacity-shift process for two decades after deregulation by means of predatory practices. This strategy is now crumbling. Corporations, facing competition in China and India, can no longer afford their road warriors’ demands for costlier network-carrier tickets that offer frequent-flier miles good worldwide. Vacationers find it worthwhile to drive two or three hours to increasingly-available low-fare airlines to get truly low fares.

The network carriers still don’t get it. During 2002 they restored about half of the 15 percent of seat capacity they shed after 9/11, thinking the old market conditions still applied. But passengers refused to pay the high cost of these seats. The network carriers wound up losing $10 billion, and their debt reached $100 billion. The wage and productivity concessions these carriers extracted from unions after 9/11 were insufficient.

Some rationalization has happened without political interference. On November 3, 2003, American Airlines closed the unprofitable St. Louis hub it acquired from TWA in 2001 St. Louis will directly lose 2,200 jobs. University of Illinois economist Jan Bruckner argues that St. Louis may become slightly less attractive to businesses due to the loss of so many nonstop flights. But new low-fare airline jobs will arise, if not all in St. Louis.

How should the coming network-airline shakeout happen? Former Delta CEO Leo Mullin has promoted consolidation through mergers. Mergers, by most accounts, would result in three megacarriers. They could restore enough market power to the network carriers to threaten or delay the free market and low-fare carriers. On the flip side, costly mergers could sink their partners. United and US Airways’ ill-fated 2000-2001 merger attempt cost over $200 million.

Merger agreements can also inflate share prices and rip off shareholders. United agreed to buy US Airways for $65 per share, but the market valued US’s shares at $30 and less. Plus, inheriting labor agreements and cultures is costly and disruptive. Mergers are not the path to cost rationalization.

Instead, the Federal government should allow shutdowns. United Airlines is weakest, operating in Chapter 11 bankruptcy. The airline failed to achieve sufficient cost savings after its December 2002 bankruptcy. Now the airline wants three additional months on its bankruptcy, plus a second crack at a (previously rejected) Federal loan guarantee. Both requests should be rejected.

US Airways achieved about 20 percent cost savings during its 2002-2003 bankruptcy. But CEO David Siegel says the airline will only survive if $200-300 million more is cut. US Airways also wants big taxpayer subsidies: $800 million from Pennsylvanians to preserve a Pittsburgh hub likely to close anyway. The airline wants $300 million to keep its Philadelphia hub, which doesn’t need subsidy because of its big population and traffic base. Elected officials must have the courage to reject such outrageous demands.

More network carrier hubs must close in order to rationalize capacity and demand. Suriving carriers would probably pick up valuable hubs, like US Airways’ Philadelphia hub and United’s successful Denver hub would. Continental, which closed its competing Denver hub in 1995, wants to return.

But United’s Chicago, San Francisco, and Washington, D.C., hubs would likely shut down and other carriers would absorb their local traffic. Among other airlines, Northwest’s Memphis hub and Continental’s Cleveland hub have difficulty maintaining critical traffic mass to offer strong connecting opportunities.

Many scenarios exist for the rationalization of airline industry capacity and finances. Governments and financial markets must stop enabling inefficiency. If the free market is allowed to do its painful work, network carriers can become as prosperous as their low-fare peers. A stable right-sized industry, with four leaner network carriers and increased low-fare carrier capacity, can produce shareholder returns, good customer service, and stable employers for their communities.


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