Trillion Dollar Economists_How Economists and Their Ideas have Transformed Business

by Robert Litan

  It is difficult to understate how remarkable these economic studies were. Airlines were regulated, so it was thought, in order to reduce airline prices, ostensibly on the theory that air flight exhibited economies of scale and would enable airlines to exercise market power, or charge prices well above marginal cost. In fact, regulation shielded the major airlines from competition, and by encouraging them to compete on the basis of flight frequency rather than cost, the airlines responded by flying their planes roughly half-full. This had the effect of keeping average costs high, and likewise for passenger fares, which were regulated to ensure the airlines could recover their average costs with a profit on top.

  The Kennedy Hearings

  This crazy situation probably would have persisted for a long time—the airlines were happy with it, after all, and passengers didn’t know what the world would look like with lower fares—but for a totally unexpected turn of political events.8

  The origins lie in the decision by Senator Edward Kennedy, who upon learning in 1974 that he would be assuming the chairmanship of the ostensibly minor Subcommittee on Administrative Practice and Procedure of the Senate Judiciary Committee, cold-called one of the leading administrative law professors in the country at the time, Professor Stephen Breyer of the Harvard Law School (20 years later, Breyer would be sitting on the Supreme Court). Kennedy asked Breyer for a list of hearing topics leading to possible legislative reforms, and to come to Washington to direct the subcommittee’s staff. Among the list of administrative law topics he provided, Breyer included the suggestion that Kennedy’s subcommittee hold hearings to examine the impact of CAB’s regulation of the airline industry. Breyer was steeped in the economics of the subject, which he taught his law students, but told Kennedy he could not take the staff director position fulltime given his tenured position at Harvard. Breyer suggested instead that he work on the subcommittee’s staff during the 1974–1975 academic year, which coincided with his sabbatical. Kennedy accepted the deal.

  Once on the job, Breyer quickly went to work organizing hearings that were held in 1975 that showcased the economists and their research, especially the contrast in fares between intrastate and interstate routes. The hearings stretched out over seven days, and brought in consumer advocates, officials from the CAB, and airline executives. It turned out that the only witnesses who favored the status quo were those who benefited from it, the industry and its regulatory agency. That coincidence, coupled with consensus among the economists that regulation was misguided, convinced Senator Kennedy that something needed to be changed.

  Initially, the aim of the hearings was quite modest: simply to have the Antitrust Division of the Justice Department, as the arm within the Executive branch charged with protecting consumers from excessive prices, weigh in on regulatory matters before the CAB. As the hearings went on and as Kennedy became more engaged, he realized that the entire system of airline regulation eventually had to be dismantled. This was evident from the massive evidence compiled by the Senate committee report of the perverse effect of CAB regulation on airline entry and fares.9

  Kennedy and Breyer both were politically savvy and aware that any move toward deregulation could bring the risk of higher fares on routes to smaller communities, an especially sensitive issue with rural state senators. The legislation that eventually deregulated airline traffic met this concern by authorizing subsidies for these routes.

  Air Cargo Deregulation

  The Kennedy hearings clearly got the airline deregulation ball rolling, and helped provide political cover for the Ford Administration to begin taking administrative steps to undo airline regulation, acting through the chairmanship of the CAB by John Robson. Robson took his first crack at the lowest hanging fruit, the aspect of regulation that none of the certificated carriers liked, air cargo regulation. Dating from the 1940s through the mid-1970s, only four carriers had certificates to fly cargo independently of passenger airlines (cargo could be flown in the belly of passenger planes but this was an exception), and had rejected other applicants seeking to carry both domestic and international air cargo.10

  In the 1970s, the CAB relented and allowed a new company, Federal Express, to enter air cargo transportation, but at first only by flying small aircraft. Moreover, under the rules of the Interstate Commerce Commission (ICC) at the time, airlines could not transport air cargo by truck beyond 20 miles of an airport. Federal Express was severely constrained by this rule, which of course, appears totally anachronistic today. Both Federal Express and UPS now operate full fleets of planes and trucks that deliver all kinds of packages and cargo throughout the United States and all over the world. But in the highly regulated world before the 1980s, none of this was yet possible.

  In 1976, Robson proposed an air cargo deregulation bill to Congress, but Kennedy was not able to convene hearings on both air cargo and passenger deregulation combined until 1977, by which time a new president, Jimmy Carter, had assumed office. The timing could not have been better. Carter and his domestic policy advisers had a strong commitment to transportation deregulation that went far beyond airlines. Given the strong backing of the air cargo airlines themselves, including the then upstart new entrant, Federal Express, Congress was able to pass an all-cargo deregulation bill by the fall of 1977, which President Carter signed into law in November.

  Air Passenger Deregulation

  Deregulating air passenger regulation was a heavier lift, because all of the established trunk carriers, with the exception of United, didn’t want more rate freedom if it also was coupled with more entry. If deregulation of passenger traffic was going to be accomplished, it was going to take a combination of both administrative and legislative action.

  President Carter saw this from the beginning, realizing he needed not just a CAB chairman who was committed to airline passenger deregulation, where it could be accomplished administratively, but other commissioners and staff who had the same objective. The administration’s domestic policy advisers on these issues, Mary Schuman (then a young former staffer for Senator Magnuson), and Simon Lazarus (former staffer at the Federal Communications Commission, and someone with whom I later practiced law and who has been a longtime friend), found that leader in Alfred Kahn. At the time, Kahn was the leading academic expert on regulation in the country (he is profiled in the following box). He was paired with another notable academic, Elizabeth “Betsy” Bailey (also profiled shortly), together with some high-powered economic staffers, Michael Levine and Darius Gaskins. Both Levine and Gaskins went on to have remarkable post-CAB careers (discussed in later profiles).

  Alfred Kahn

  There probably is no more venerated expert on regulation in the history of the economics profession than Alfred Kahn.11 This is because Kahn was not only the author of numerous scholarly articles and several editions of the definitive textbook on the subject until the 1980s, but also because of his practical knowledge of the subject, and his engaging personality.

  Kahn served in the 1970s as the chairman of the New York State Public Utility Commission, testified as an expert on regulatory matters in numerous legal proceedings, and was integral to the success of National Economic Research Associates (NERA, now NERA Economic Consulting), one of the leading economic consulting firms (discussed also in Chapter 5).

  Kahn’s rise to fame was not surprising given his early brilliance. Born to Jewish immigrants and raised in New Jersey, he graduated from high school at the age of 15 and from New York University at the age of 18. He earned his doctorate in economics from Yale during World War II. He thereafter served in the Army, and spent time at the Brookings Institution and the Antitrust Division at the Department of Justice. He began his teaching career after the war at Ripon College, where he quickly became chairman of the economics department. He moved to Cornell in 1947 where he remained (except for his detours in public service) through the rest of his distinguished academic career. As just one example of his versatility, Kahn was a noted singer on the Cornell campus, performing in nume
rous Gilbert and Sullivan productions.

  Interestingly, Kahn’s first choice of an agency to chair when contacted by the Carter transition team was the Federal Communications Commission. However, given Kahn’s prior consulting work with Bell Labs, the Carter team thought Kahn would have an easier confirmation (and face fewer recusals) if he were nominated for the CAB. It was clearly the right choice. In two short years he became a father of airline deregulation.

  From the CAB, Kahn moved on to become President Carter’s anti-inflation czar in 1979, overseeing the newly formed Council on Wage and Price Stability (which was dismantled by President Reagan, and essentially made unnecessary by the anti-inflationary monetary policy of the Federal Reserve under the chairmanship of Paul Volcker). Kahn quickly became a popular figure in that position, despite the difficulty of his job—all he could really do was jawbone, because neither he nor anyone else had the statutory power to control prices and wages.

  One mark of a person is whom they mentor and launch toward future success. Kahn taught many thousands of students during his career and I cannot pretend to know his impact from the classroom. But from personal experience, here are just a few examples of successful individuals who worked for him at the CAB and later when he was the inflation czar: Darius Gaskins and Michael Levine, both profiled elsewhere in this chapter, and Joshua Gotbaum, who worked for Gaskins at the Department of Energy before coming to work with Kahn. Gotbaum went on to have a highly successful career on Wall Street, administering the 9/11 recovery fund after that tragedy, running an airline, serving in a number of prominent posts in the Clinton Administration, and then as director of the Pension Benefit Guaranty Corporation during the Obama Administration.

  On a personal note, I first met Kahn when I was a staffer at the Council of Economic Advisers (CEA) during the Carter Administration. Thereafter I had several opportunities to meet and talk with him on various professional matters, all memorable occasions. He was a remarkable individual and it was a privilege for me to know him.

  Whether deliberately or not, Kahn and Senator Kennedy proceeded to act like a tag team whose actions reinforced the case for air passenger deregulation, leading to ultimate success. Kahn and his fellow CAB commissioners would take administrative deregulatory steps, setting the stage for Senator Kennedy, Senator Cannon (who had initially opposed deregulation but later joined forces with Kennedy), and eventually the full Congress, to see the virtues of going all the way.

  For example, because neither Kahn nor Kennedy would have wanted airlines to increase their fares on certain routes out of the box, the CAB moved quickly in 1977 to grant permission to the airlines to lower their fares without filing new rates (which otherwise could have been contested and thus delayed for months, if not years). Although the airlines might have objected to lower fares, certainly consumers would not, so this was a clever political strategy that also validated the earlier-cited academic studies documenting lower rates on intrastate routes than interstate routes of comparable distance. The Kahn-led CAB also liberalized entry for carriers serving certain underserved airports such as Newark, Baltimore, or Chicago’s Midway (all thriving airports today).

  The CAB’s air passenger initiatives, coupled with the success of air cargo deregulation, and the activism of Senator Kennedy, combined to push the landmark airline passenger deregulation bill into law by the end of October 1978. The law phased in deregulation over a five-year period and eliminated the CAB as of January 1985. Airline safety regulation remained at the Federal Aviation Administration, while authority for international airline negotiations and antitrust oversight was shared between the Department of Transportation (a mistake in my view) and the Justice Department.

  Airline deregulation had some predictable, beneficial consequences—lower fares in particular—but also led to an unexpected restructuring of routes in the United States. The effects of airline deregulation on business, in particular, are explored in greater detail later in this chapter.

  Elizabeth “Betsy” Bailey: Pioneer

  When I was studying economics as an undergraduate there were very few women in the profession. Perhaps the best known was Joan Robinson, the acerbic and brilliant colleague of Keynes and other stars at Cambridge in the 1930s and later.

  By the time I made it to Brookings as a research assistant, my first full-time job out of college, I became acquainted with Alice Rivlin, then a senior fellow at Brookings, who has become an icon in the profession; you will meet her in Chapter 14.

  But no female economist I know has overcome the kind of discrimination against women in our society and in the economics profession more than Elizabeth “Betsy” Bailey.12 After graduating with a degree in economics from Radcliffe, she took her first job in 1960 at Bell Labs as a technical assistant, a lower job ranking because she was a woman than her equivalently credentialed male counterparts. Bell Labs then had an incredible stockpile of economic and other scientific talent. The economists were devoted, as one might expect, largely to studying regulatory issues in the telecommunications industry. At Bell, Bailey toiled as a researcher for other more senior scholars for four years until the Civil Rights Act of 1964 changed her life.

  That Act prohibited discrimination on the basis of race and sex in the workplace and other public places. Shortly after its passage, AT&T and other large companies began to change their employment practices. For Bailey, the changes meant that she was then able to obtain a master’s degree in economics at nearby Stevens Institute of Technology, at company expense, like her male colleagues. She also was promoted and given wider recognition within Bell Labs. After gaining her master’s, Bailey was accepted for PhD work at Princeton. She already was working on her dissertation before enrolling there, and also had an article published in the prestigious Bell Journal of Economics, which quickly became the top journal for regulatory economics in the country.

  As she was working on her PhD degree and after she completed it, Bailey continued working at Bell Labs, as one of the senior scholars herself. Shortly after President Carter assumed office, Bailey was called by the White House Domestic Policy Staff asking if she would be interested in filling one of the two Republican slots at the Civil Aeronautics Board. She was told that Fred Kahn, the dean of regulatory economists in America and an adviser to Bell Labs, was to become the chairman, but first she was asked if indeed she was a Republican. Not active in political life, Bailey thought a moment and then reported she had voted for some Republican candidates for office because they, more than Democrats in New Jersey, were more vocal in their advocacy for issues relating to child disabilities, an issue of great personal interest to Bailey. That answer was sufficient for the administration (an answer that seems quaint in light of the vastly increased partisanship in elected politics today), and in 1977 Bailey was sworn in as a CAB member, joining the board that launched the program of industry deregulation that no one thought was possible until then.

  After the CAB, Bailey spent over two decades as a professor of economics at the Wharton School of Finance at the University of Pennsylvania where she continued her scholarly work in regulatory economics and industrial organization.

  Trucking Deregulation

  Once the deregulation ball began rolling with airlines in the late 1970s, it turned out to be hard to stop. Thank goodness, because that ball led to one of the most important, but largely unrecognized, policy reforms of that era: the deregulation of prices and entry into interstate trucking, and to a lesser extent, of railroads.

  If price and entry regulation were not suitable for airlines, they clearly couldn’t be for trucking, which had both major national firms and thousands of independents all competing against each other, but under the thumb of a command-and-control regulator, the ICC. Yet neither the trucking firms nor their unionized workers from the Teamsters wanted this system to change. Forget delivering services to shippers in the way they wanted. To those doing the driving, it was good to have the government approving routes, and thus effectively limiting competition,
and allowing the truckers themselves to use effectively legalized cartels or rating bureaus to set shipping rates that the ICC routinely approved. The regulated system ensured that the firms would have profits from which they could meet union demands for high wages. Public choice theory cannot explain how this cozy system ever would have been eliminated.

  But public choice does help explain how it all got started. It didn’t take long after the automobile was invented and successfully commercialized for some companies to realize that these vehicles could do a lot more than carry people. With some modification, autos could be (and were) turned into trucks that would carry freight and directly compete with railroads but in a far more flexible fashion. Railroads were limited to carrying their loads down tracks, and once having arrived at their destinations, had to have their goods unloaded and put into the distribution chain—to manufacturing plants (if raw materials, like coal or metals), or to warehouses (if finished goods). The horse and buggy did much of this work, until the truck came along. And when that happened, the railroads faced a new kind of competition they hadn’t seen, for trucks were not only useful for ferrying goods to and from railroad platforms, but they could also carry goods long haul instead of railroads themselves!