Should The US Adopt A Full Open Skies Agreement With The EU? Open skies would be a disaster for the U.S. carriers Interview with Bob Crandall, CEO American Airlines (1985-1998), Apr 2 nd 2006 America clearly stands to gain (from open skies) as its free market efficiency would be extended to a new sector of global activity Speech by Martin Broughton, Chairman British Airways, at HBS Jan 19 th 2006 The U.S. and E.U. have been in discussions to open up their aviation markets for over a decade. The latest attempt to open up the markets is currently on hold and looks likely to be rejected by the U.S. administration over concerns on foreign ownership. The proposed "open skies" agreement would bring together the world's two largest aviation markets, allowing E.U. and U.S. airlines to fly to wherever they want and charge whatever they want on trans-atlantic flights. Under the present bilateral pacts, European airlines can fly to any U.S. airport only from airports located in their home country. Because of this nationality clause, European airlines risk losing U.S. landing rights if they merge - which has led to fragmentation in the European industry. The E.U. also wants the U.S. to lift foreign ownership restrictions to allow cross-border mergers and investment to take place. This paper will analyse the pros and cons for the U.S. in the open skies proposal and make a recommendation as to whether it should go ahead. The most important underlying debate is how much to use competition verses regulation to produce the most efficient outcome for the U.S. aviation market. There are also the secondary issues of national security, national pride and trade policy consistency which will be discussed later. The U.S. de-regulation of 1978 was a dramatic shift to using competition to regulate the market and the question is now should that process be extended to the next level. Governments have traditionally opted for increased regulation in industries where there is large monopoly power. For example, in utilities where there is only one provider of a service, the government has stepped in to prevent the sole provider from gauging consumers. The airline industry, with huge fixed costs and large barriers to entry, has sometimes exhibited oligopolistic tendencies. For example, in many markets today there are only 1 or 2 airlines, offering similar fares. On the other hand, competition from new entrants has caused fares to drop considerably showing the power of the market to benefit consumers. The famous Southwest affect showing that fares will drop by at least 35% if 1
Southwest enters a market is a good example of this power. And because airlines must share their financial data, this perfect information flow means that an airline can easily enter an oligopolistic market where there are supernormal profits. It would be useful to look back at U.S. deregulation to see whether the shift to using competition rather than regulation actually benefited the industry. Was there a greater tendency to exploit consumers using their oligopolistic power or did competition increase efficiency? Airline deregulation has worked. It would be ironic if, by misdiagnosing our present discontents, we were to return to policies of protectionism and centralized planning at the very time when countries like China and the Soviet Union are all discovering the superiority of the free market. Alfred Kahn, The Concise Encyclopaedia of Economics Alfred Kahn, who was chairman of the Civil Aeronautics Board during de-regulation, analysed the impact of deregulation on the U.S. market. He showed that it had brought in lower prices and increased productivity. Between 1976 and 1990 average yields per passenger mile declined 30 percent in real, inflation-adjusted terms. He acknowledges that the wave of mergers and airline failures has made the industry more concentrated at the national level than it was before deregulation. However, he argues concentration at the national level is not as important as concentration on individual routes. In fact, deregulation produced an estimated 25 percent increase in the average number of airlines per route, despite the mergers. He concludes that, the airline industry is far more competitive than it was; the benefits of that competition have been widely distributed; and industry profits have been lower, on average, since deregulation. In addition, he believes by allowing foreign airlines to compete for domestic traffic, either directly or by investing in American carriers, that this competitive force will produce further efficiencies. However, Kahn s view may be too optimistic. In fact today half of all passengers are travelling on bankrupt airlines. And the airline industry has lost more money in the few years of the 21 st century than in the whole of the 20 th century. Has this competitive force got out of control? Or have government subsidies and bankruptcy protection laws prevented the market from operating efficiently, by removing inefficient players? If we look at the current state of the U.S. airline industry we can see that there is an oversupply of capacity, shown by the fact that fares are being depressed so low that airlines cannot make money. In a normal competitive environment the market would drive out the highest cost suppliers. 2
However because of the bankruptcy laws this does not happen, because inefficient airlines are able to survive the market cannot operate inefficiently. The Darwinian survival of the fittest is not allowed to take place. Therefore we can argue that it is not competition that has caused the U.S. airline industry to be unprofitable, but the fact that competition cannot operate freely and drive out underperforming companies. Thus, full competition is to be encouraged rather than limited. If you believe this argument, the question one must then answer is will open skies bring more competition or less? I spoke to Bob Crandall, who was at American airlines for 20 years following the de-regulation. He believes that Open skies will be a disaster for the U.S. carriers. The only reason an international carrier would buy a US carrier is to eliminate competition. If United and Lufthansa merge there is only one airline to Germany. However, Crandall s argument is surprisingly simplistic. In his German example, there will be other airlines serving Germany with 1 stop connections. If the market generates large profits then other airlines will now be able and in fact compelled to enter. We would expect open skies to lead to consolidation at the global level, as with the 1970s deregulation but this should not be confused with less competition. The additional freedom to enter any market should lead to increase competition at the market/route level, the same as occurred after de-regulation. This is consistent with the beliefs of Martin Broughton, Chairman of British Airways. He thinks there will be increased competition from open skies. In a speech at Harvard Business School, he said It doesn't take an Einstein to see that the model that has worked for so many other consumer products and services may be worth considering. That is the 'Open Market' model. He believes that companies should be allowed to operate on a global scale so that the most efficient operations are successful. Airlines should be allowed to operate new routes or acquire competitors to enter those routes. It would be a world where the strong get stronger and the weak go out of business either through acquisitions or bankruptcy, he said. Therefore looking at the underlying argument of competition verses regulation, one can show that open skies and consolidation would be beneficial to the airline industry. One can draw some interesting parallels with the move to introduce competition into the U.K. railway industry. This move has been widely seen as a failure and thus argued that competition will not prove to be successful in transport where there are natural monopolies. However, unlike in the railway industry, an airline is free to operate wherever and whenever 3
it likes. It is not constrained by infrastructure as in the railway industry. Therefore as soon as a market appears profitable, it is easy for a competitor to enter. If the airline industry is truly free it will not exhibit the tendencies of a natural monopoly, but it will be perfectly competitive like any other industry. Therefore regulation, apart from ensuring minimum safety standards, is not needed to produce efficiency in the airline industry. Let us now turn to the secondary issues around the debate, national security, national pride and trade policy consistency. On the issue of security, Frank LoBiondo, a New Jersey Republican, sums up the protectionist argument: "Allowing the daily operations of our airlines to be controlled by competing and potentially unfriendly foreign interests could significantly undermine our homeland security" (The Guardian, Apr 4 2006). However, Alfred Kahn refutes this argument well: The claim that it will harm national security is belied by a simple fact: the US Department of Defence has blessed it. The only reason to restrict foreign ownership and control is to ensure the defence department's ability to mobilise commercial aircraft in a military emergency. But that can be done without limiting foreign investment: for maritime shipping, the department relies on commercial companies that are incorporated in the US and fly the US flag despite being foreign owned (Financial Times, Feb 15, 2006). Martin Broughton also states that the trump card of national security can be easily overcome. The right to commandeer civilian planes for national defence could be placed on any airline operating within the US domestic market, as an operating licence condition not an ownership condition. Therefore there are conditions which can be put in place to overcome any national security concerns. If we look closer at Crandall s rejection of open skies, one can see that his reasoning is more nationalistic than economic. We already showed above that his economic reasoning was too simplistic and that competition should increase rather than decrease through open skies. In the interview he went on to say that The U.S. accounts for more than 50% of world traffic, and there is no point in allowing foreign carriers to participate in that traffic. It is particularly stupid to allow foreign carriers to buy interests in U.S. airlines, since there is no shortage of capital in the U.S. This shows that he wants U.S. airlines to remain American. This argument is fair the U.S. has the right to keep American assets and choose to lose economic efficiency in the process. The large amount of government subsidies to the industry following September 11 th are a testimony to the protectionist view of airlines. However, from a rational and impartial perspective, is the U.S. consumer better off with more U.S. owned airlines or less? Are they willing to continue to subsidize poor 4
performing airlines or would they rather benefit from global best practice? I believe that the U.S. consumer will be better off by having fewer and more efficient global airlines serving them. The U.S. airlines can also expand and acquire other airlines around the world and airlines like American Airlines could become as successful as McDonalds and Coke across the world. One should also mention that the U.S. is applying double-standards advocating protectionism in the airline industry when it is calling for free trade and open markets across the world. Alan Johnson, the British trade and industry secretary, launched a passionate attack on Washington this month. "There can't be one set of rules when your team plays away and a different set of rules when they play at home," he said. "Such hypocrisy makes global progress impossible." (The Guardian, Apr 4 2006). Thus the U.S. should be consistent and open up the U.S. airline market to worldwide competition. In conclusion, the author believes that the U.S. should support the open skies proposal and open up the U.S. aviation market. It should continue upon the path of competition over regulation. It has been shown since deregulation that consolidation did not limit competition, with significantly declining fares since the 1970s and more airlines operating on individual routes. Open markets and competition has been successful in producing efficiencies in other industries and this process should be continued, since the airline industry is not a natural monopoly if it is truly free. Underperforming airlines should be acquired or allowed to go bankrupt so that the market can operate most efficiently. Airlines should be free to enter any market they choose, so that competition will increase on markets with high profitability. And the final sticking point of national security can be easily overcome by having provisions to commandeer aircraft in the event of an emergency. 5
Bibliography Speech by Martin Broughton, Chairman British Airways, at HBS Jan 19 2006 Interview with Bob Crandall, CEO American Airlines, Apr 2 2006 Washington Digs In Against The Invaders, David Teather, The Guardian, Apr 4 2006 The Sky Must Be No Limit To Global Competition, Alfred Kahn And Dorothy Robyn, Financial Times, Feb 15 2006 Alfred Kahn, The Concise Encyclopaedia of Economics [www.econlib.org/library/enc/airlinederegulation.html] 6