The Great Reversal

by Thomas Philippon

  It took several decades for Europe to create broad, independent, and powerful regulators. The Treaty of Rome laid the foundations of European competition policies in 1957 but did not specifically mention merger control. The need for merger control at the EU level was only recognized in the 1970s,g and the European Commission did not obtain merger control authority until 1989, as part of the Single Market.h

  The EU framework is similar to that of the US, with some important differences. The EU is more decentralized than the US, and member states have national competition authorities (NCAs) to deal with cases that have a mostly national impact. Which mergers are examined by the European Commission? If the annual turnover of the combined businesses exceeds specified thresholds in terms of global and European sales, the European Commission must be notified of the proposed merger. Below these thresholds, the national competition authorities in the EU member states may review the merger. These rules apply to all mergers, no matter where in the world the merging companies have their registered offices, headquarters, activities, or production facilities. The European Commissioner for Competition and the Directorate-General for Competition (DG Comp) enforce European competition law in cooperation with the NCAs. DG Comp prepares decisions in three broad areas: antitrust, mergers, and state aid. One significant difference between the two legal frameworks is that antitrust cases in the US are tried in courts. In the EU the DG Comp makes decisions first, which can then be appealed in courts. This effectively gives more power to DG Comp.

  The similarities between the US and EU frameworks did not arise by chance: US ideas about regulation and antitrust played an important role in the construction of the EU’s free-market doctrine.i By the late 1990s, the antitrust doctrines of the US and EU had largely converged. In 2004, amendments to the European Commission Merger Regulation (ECMR) made DG Comp more transparent and more accountable to the public (Foncel, Rabassa, and Ivaldi, 2007). It clarified the notion of unilateral effects in a way that resembles the US approach. At the same time, economic analysis became more prevalent, in particular with the creation of the position of Chief Competition Economist in 2003.

  The differences between the EU and the US come from the unique nature of the European Union. The EU is not one country in the way the US is. The EU is decentralized, and EU countries have broader powers relative to their federal institutions than US states have relative to US federal institutions.

  Reciprocally, however, the few areas where decisions are truly made at the EU level become all the more important: trade policy, competition policy, and—for euro area countries—monetary policy. The president of the European Central Bank plays a key role in the EU. Similarly, the position of EU Commissioner for Competition is prestigious, attracts high-caliber politicians, and benefits from strong public recognition. Everyone remembers the tenure of Mario Monti (1999–2004), and within the EU, Margrethe Vestager has become a household name.

  The Peculiar Case of State Aid Rules

  Antitrust doctrines are largely comparable in the EU and the US, although there are important and growing differences in implementation, as we will discuss shortly. State aid, on the other hand, is a uniquely European concept.

  After World War II, and following Monnet’s idea, France and Germany agreed to set their production of coal and steel under a single international authority. This did not happen by chance. Monnet focused on the one area where economic nationalism was most prevalent and most dangerous: coal and steel. European nations, Germany and France in particular, had always intervened aggressively in these markets. From the very start, the EU project was therefore focused on limiting state interventions in important markets for goods and services.

  State aid rules have no equivalent in American regulations, or anywhere outside Europe for that matter. As I have explained above, limiting arbitrary state aid was part of the DNA injected into the European project by Jean Monnet. These rules are at the core of the recent high-profile case forcing Apple to pay taxes to the Irish government that had originally been waived as part of a package of tax breaks. As a matter of principle, such rules require that illegal aid be repaid to remove the distortion of competition created by the aid. Commissioner Vestager, in charge of competition policy, argued that “Ireland has to recover up to 13 billion euros in illegal state aid from Apple.”

  Many of my American colleagues were perplexed by the whole story. It did not make much sense to them. Most of my European colleagues, however, found it rather straightforward. I am not taking a stand on the merits of this particular case, although the scale of tax evasion by large multinational corporations has become a severe problem, and internet companies are often among the worst offenders.j My broader point is that cases like this one should be expected given the foundational importance of state aid rules. Without such rules, corporations have incentive to shop around for subsidies, pitting one state against another and leading to inefficient outcomes. Amazon, for instance, selected New York City as one of two new campuses in November 2018 after securing almost $3 billion in tax breaks, which could have created an unfair advantage for Amazon over its competitors. The deal collapsed in early 2019, and the eventual result was a waste of time, effort, and legal fees. In Europe, wealthy regions cannot provide subsidies to lure large companies, with exceptions for smaller firms and poorer regions.

  What is even more interesting in the example of Apple is the extension of state aid rules to fiscal issues as opposed to other forms of direct aid that the original state aid regulations were meant to cover. “Natura abhorret vacuum,” wrote François Rabelais. Like nature, politics abhors a vacuum. State aid rules were not designed to address fiscal issues, but once we agree that illegal aid is a problem, it is only logical to prosecute illegal tax subsidies as well.

  Deregulation

  In the late 1970s developed countries began to lift regulations in various markets. As in the case of antitrust enforcement, the US had a head start over Europe. The US government deregulated the air (1978), road (1980), and rail (1981) transportation industries, electric power (1978+), natural gas (1978), banking (1980), and telecommunications (1996). The deregulation effort was deemed a success. In 1999, the OECD noted that the “United States has been a world leader in regulatory reform.”

  In the US, the process was mostly led by the federal government and by federal agencies. Congress is the only body that can write federal laws, but more than sixty executive agencies can issue subordinate regulations. Indeed, these agencies issue thousands of new regulations each year, compiled in the Code of Federal Regulations.

  Regulatory reform efforts in the EU are more recent. Some countries, such as the UK, pursued economic deregulation independently as early as 1979. But concerted, EU-wide reform efforts started in a limited way in 1985 with the Single Market Plan and accelerated in the 2000s with the Lisbon Strategy, which aimed at “removing obstacles to competition in Member States and creating a business environment more conducive to market entry and exit” (Zeitz, 2009).

  EU institutions have only partial oversight over member states’ regulatory environments.k So how does the EU influence reform efforts? Name and shame and peer pressure.

  Take the implementation of the Lisbon Strategy, for example. The overall objectives were set jointly by the EU and member states. From then on, member states were in charge of implementation but were also required to submit progress reports to the European Commission.l Public EU reports and peer pressure were deliberately used to encourage reform. For countries in the process of accession (that is, countries applying for EU membership), stringent reform requirements were negotiated in advance, and new EU member states in Central and Eastern Europe made remarkable progress (Hölscher and Stephan, 2004). Finally, even for existing members, the commission can curtail the allocation of the EU Cohesion Funds to members that fail to implement reforms.

  Although the Lisbon Strategy failed in some dimensions, substantial product market reforms were implemented. European economies have some of
the lowest barriers to trade and foreign investment in the world.

  Let us look at a few examples before we give a full account.

  Airlines

  The US began liberalizing air travel in 1978 when Congress passed the Airline Deregulation Act. By the 1990s, US skies were competitive. Figure 8.3 shows the evolution of concentration and profits in air transportation over the past two decades in the US and in Europe. Concentration was stable in the US during the 1990s and until 2008. Profits were highly cyclical and volatile. They were hit by the 2000 recession and even more by the 9 / 11 attack, but they returned to their 1990s level by 2007. But from 2008 onward both concentration and profits increased sharply. Concentration and profits per passenger are now much higher than they used to be. The rise in US concentration and profits closely aligns with a controversial merger wave that included Delta–Northwest (2008, noted by the vertical line), United–Continental (2010), Southwest–AirTran (2011), and American–US Airways (2014).

  Europe began deregulating its airline industry a decade after the US. For most of the postwar period, European airlines were controlled, regulated, and protected by their states of origin. In fact, many were owned by the state. Competition was severely restricted. Less than 15 percent of the routes that existed in the European Community in the 1980s had more than two carriers. Air France and British Airways enjoyed a duopoly on the highly profitable London–Paris route and charged the highest fares on record at the time. This started to change in 1987 through the initiative of the EU Commission, and by 1997 European skies were formally deregulated. In theory, any European carrier could fly any intra-European route. I write “in theory” because in 1997, two-thirds of European routes still had only one carrier.

  FIGURE 8.3  Air transportation concentration (a) and profits (b), European Union versus United States. Chart compares concentration (HHI) and the evolution of net profit rates in the transportation–air industry (ISIC code 51) for the US and Europe. Data sources: Concentration based on Compustat, adjusted for database coverage using OECD STAN. Sales shares are defined as the ratio of firm sales to gross output from OECD STAN. Firms included only if data for the corresponding country are available in STAN. Profit rates are from OECD STAN.

  As a result of the efforts of the commission, new airlines entered the market. Although the US pioneered the business model of low-cost airlines in the 1980s, they have mostly disappeared today. Even Southwest’s cost structure resembles that of other major airlines. Europe pushed in the opposite direction. Europe has had two powerful low-cost airlines for more than twenty years: RyanAir and EasyJet. RyanAir has priced aggressively at the low end of the market, forcing other airlines to adjust.

  You can see the impact of competition on profit margins of European airlines in Figure 8.3. Since 2000, concentration has remained stable in Europe. Meanwhile, concentration in the US airline industry has increased: today the top four firms control 80 percent of the market. In Europe, the top four control only about 40 percent of the market.

  France provides a fascinating case study of the role of barriers to entry in the airline industry. For a long time, Air France had a near monopoly on domestic flights. Air France was also partly owned by the state. It had (and still has) a powerful pilots’ union and high operating costs. By the mid-2000s, many government officials had given up hope that Air France would reform itself internally. In 2007, younger and reform-minded cabinet officials decided to bring in outside competition.m EasyJet was allowed to enter the French market in 2008, and its market share grew quickly. Low-cost airlines such as Transavia, Hop, and Vueling now provide more than a third of all domestic flights within France and about half of flights to other EU countries.

  This is not to say that competition in French skies is completely free and fair today. Take-off and landing slots are heavily regulated. Paris has two airports. Charles de Gaulle is the larger one, with the most international connections. Orly is smaller and more conveniently located, especially for domestic flights. The rules for allocating slots are still severely biased toward incumbents. As a result, Air France continues to control half of the slots at Orly, which limits the expansion of EasyJet.

  The situation is much worse in the US, however. The allocation of landing slots at major airports near New York, Washington, DC, and Chicago leads to an almost complete entrenchment of incumbent airlines. Moreover, the US forbids foreign airlines from flying domestic routes. In the late 1990s commentators lamented that the deregulation of European skies had not (yet) produced the same benefits for consumers as the ones achieved by the US.n Twenty years later, these commentators would be pleased by the state of European skies and flabbergasted by what happened in the US.

  The Entry of Free

  The telecommunications industry provides another example of successful competition policy in Europe. National public monopolies had traditionally dominated the EU telecom markets, but starting in 1988, several legislative packages opened up competition.o

  The combination of ex-ante market access regulation and ex-post enforcement has made EU telecom markets more competitive, providing consumers and businesses with increased choices, affordable prices, high quality, and innovative services. Figure 8.4 shows the price of communication in France relative to the US.

  Once again, France provides a striking example. In the late 1990s, Free was an internet service provider and part of Iliad S.A., a telecom company founded by French entrepreneur Xavier Niel. Free offered internet access without a subscription or a surcharged phone number. A critical issue in the 2000s was unbundling, which forced the incumbent carrier France Telecom to lease the local loop (the pair of copper wires between the edge of the telecom network and the house or office of the subscriber, sometimes called the “last mile”). The unbundling process was supposed to start in 2000, but it was delayed until the end of 2002 by a long legal fight between France Telecom and the French regulation authority. Unbundling was a critical step for the expansion of fast internet access in France.

  Today, Free Mobile is the wireless service provider of the Iliad group. When it obtained its 4G license in 2011, it became a significant competitor for the incumbents, making an immediate impact. Until 2011, French consumers paid between €45 and €65 per month for their smartphone plans, with limited data and a few hours of talk time. Free offered unlimited talk, unlimited SMS and MMS messages, and unlimited data with a speed reduction after 3 GB for €20. The number of Free Mobile clients grew quickly, from about 2.6 million in 2012 Q1 to 8.6 million in 2014 Q1. Its current market share is around 20 percent, and it aims for 25 percent.

  FIGURE 8.4  Telecom prices in France relative to the US. French prices are converted into dollars using the FOREX rate. The vertical line shows the entry of Free Mobile in the 4G market. Data source: ICP

  The benefits to consumers spread far and wide: incumbents Orange, SFR, and Bouygues launched their own discount brands, offering €20 contracts as well. In three years, France went from 15 percent more expensive than the US to 25 percent cheaper.

  A Theory of Europe’s Free Markets

  Let us now return to our main puzzle: what happened in Europe, and why? Germán Gutiérrez and I have tried to understand how Europe became the land of free markets, and we have proposed an explanation in two parts.

  We first argue that, although EU institutions look like American ones, there is a subtle but important difference: they are more independent. As we have explained, EU institutions resemble American ones in terms of goals, scope, and doctrine. They are, however, granted more political independence than their American counterparts. This is true of the two leading supranational institutions: the European Central Bank is not subject to the same level of parliamentary oversight as the Federal Reserve Board, and DG Comp is more independent than the DoJ or the FTC.

  This is surprising because it appears to contradict the conventional wisdom about European and American preferences. Did Europeans make the European Central Bank fiercely independent because t
hey studied Milton Friedman’s writings more than Americans? Did they make DG Comp more independent because they trusted in free markets?

  That does not seem plausible. Instead, we argue that bargaining among sovereign nations leads to supranational institutions that are more politically independent than what the average politician would choose. We build a formal economic model to show that this is exactly what game theory predicts. Imagine a world where politicians and civil servants design a regulator and can make it more or less independent from business and political influence. Our key result is that this degree of independence is strictly higher when two countries set up a common regulator than when each country has its own regulator.

  The key insight is that politicians are more worried about the regulator being captured by the other country than they are attracted by the opportunity to capture the regulator themselves. French and German politicians might not like a strong and independent antitrust regulator at home, but they like even less the idea of the other nation exerting political influence over the institution. As a result, if they are to agree on any supranational institution, it will have a bias toward more independence. This is exactly how Monnet convinced Adenauer in 1950 to accept the Schuman Plan.p

  Our theory makes three testable predictions:

  EU countries agree to set up a regulator that is tougher and more independent than their old national regulators.

  Countries with weaker ex-ante institutions benefit more from supranational regulation.

  Returns to lobbying decrease in Europe, or at least increase less than in the US.