by Robert Litan
To be sure, financial deregulation has been somewhat an exception, essentially a mixed bag. As I argue in Chapter 12, certain ideas urged by economists were taken too far by the unscrupulous and the reckless that later contributed to disastrous results, including the misuse of stock options (discussed earlier in Chapter 8) and the failure to police the development of certain mortgage securities. But the origins of the 2007 to 2008 financial crisis, which among other things helped give the economics profession the bad reputation that I discussed at the outset of this book, are complicated and many. There were many policy mistakes along the way that economists did not support or of which they were largely unaware. At the same time, a number of financial deregulatory measures had desirable social impacts and led to the creation of businesses that have helped investors. They deserve to be highlighted and credited for their contributions.
Finally, if so much deregulation outside of finance was such an unqualified success, what took policy makers so long to make the necessary changes? This, too, is a complicated story that is outside the scope of this book, although it deserves a brief discussion before I get into the details of each deregulatory measure.
Briefly, there are two broad schools of thought about regulation and deregulation. One posits that regulation or deregulation is adopted to advance the public interest. It is as if legislators and regulators read and follow the basic economic textbooks and only regulate to correct market failures in the most cost-effective manner possible.
For example, the public interest view is broadly consistent with the introduction and elaboration over time of various forms of social regulation, which are aimed at protecting the safety of our air, water, food, and, in a financial sense, our financial institutions. In addition, the initial economic regulation of a number of industries that were characterized by natural monopolies—railroads, electric utilities, and telecommunications—also seems consistent with the public interest. But the extension and maintenance of economic regulation in these and other industries as technology weakened or eliminated natural monopolies does not sit well with the public interest view. Instead, the public interest was rescued only when policy makers finally listened to those economists who had pointed this out and began, in the late 1970s, to deregulate prices and entry in many sectors where it was no longer economically justified.
The alternative view of regulation is called public choice theory and is premised on the notion that, as a general rule, the industries subject to regulation, both social and economic, generally want it, even if some industry members protest that regulation is unnecessary or has gone too far. The reasons why firms would want regulation vary, but at bottom they boil down to making it too costly or impossible for competitors to enter their industry (economic regulation), or to give them some advantages over competitors that might not have the resources to comply with certain regulatory requirements (social regulation).
For decades, developers and supporters of the public choice model were in the distinct minority of economists, but the view gained respectability when one of its founders, James Buchanan, won the Nobel Prize for his work in the field. Other prominent economists who have developed this theory or aspects related to it include Buchanan’s sometime collaborator, Gordon Tullock, Chicago’s Sam Peltzman and George Stigler, and my colleague at Brookings for many years, Anthony Downs (whose book Economic Theory of Democracy, written as his PhD thesis under the supervision of another Nobel winner, Kenneth Arrow, helped lay the foundations for public choice economics).
Like its counterpart—public interest theory—public choice has its limits, too. Industry generally did not back the major legislation that authorized most social regulation—such as the Food and Drug Act, the National Highway Traffic Safety Act, the Clean Air Act, the Clean Water Act, and the Occupational Safety and Health Act—which were pushed by consumer and environmental groups and labor unions. Nor was industry universally behind much economic deregulation, though in some cases they were, as various chapters in this part will show.
In sum, there is no grand universal theory of regulation and deregulation that can explain each and every regulatory statute or major regulation. Rather, elements of both major theories, public interest and public choice, have played important but different roles at different times.
What I want to emphasize in this part of the book, however, is the important roles that economists played in the economic deregulation of many key industries in the U.S. economy, which in turn has had profound impacts on many firms. Many economists over the years have joined in this effort and deserve credit for building the intellectual case for deregulation where it has proved especially beneficial. I have profiled a number of these individuals in this part.
I want to conclude this introduction to Part II, however, by singling out two particular economists who have had a major impact on the field and on my own thinking about regulation and the role of government during my own career, and yet who do not fall neatly within any one of the topic-specific chapters that follow. Readers who are interested can easily find their substantial body of work through any standard Internet search engine.
Roger Noll, now a professor emeritus at Stanford University where he taught economics for over two decades (and at this writing is still teaching a seminar for advanced undergraduate economics majors), is one of those rare polymaths, who is always fun to talk with, and who constantly comes up with stimulating ideas that make the listener want to explore further (no wonder he is such a great teacher). Blessed with a loud and infectious laugh, Noll has written on a wide variety of microeconomic subjects, including the regulation or deregulation of just about everything that matters, as well as topics relating to antitrust law and economics. Noll also taught at the California Institute of Technology and for a time was a senior fellow at the Brookings Institution. You might not see Roger’s name attached to any specific sentence in the chapters in this part, or in earlier chapters, but he’s there between many lines. I owe special thanks for his useful suggestions for topics in Chapter 11, in particular.
Lawrence “Larry” White, another longtime friend, has been a professor of economics at the Stern School of Business at New York University for most of his career. White is one of the leading specialists on what economists call industrial organization, the economics of antitrust law, and on the economics and regulation of the financial industry. White has held a number of government positions that have informed his views: as a senior staff economist for President Carter’s Council of Economic Advisers (where I first met him), as chief economist for the Antitrust Division at the Department of Justice, and as a member of the Federal Home Loan Bank Board (which used to oversee the savings and loan industry). White’s chapter on the influence of economists in antitrust enforcement in John Siegfried’s edited volume Better Living through Economics, cited in Chapter 9, is not only must reading for specialists in this field, but also makes clear how economists have taken over the thinking about how the nation’s antitrust laws should be enforced. This has had and will continue to have important effects on how businesses with significant presence in particular markets are allowed to behave, and when it is most likely that mergers between firms will be challenged.
Noll and White are just two of the many economists who have influenced my own thinking through the years, and from whom I have learned, in conversation and through their written works. I also thank them for their friendship.
Chapter 9
Planes, Trains, and . . . Trucks
This chapter may not be as entertaining as the movie with a similar title (with automobiles at the end instead of trucks), but I will promise you this: It will demonstrate how extraordinary things can happen when regulators and legislators pay attention to some very simple economic insights that had long been promoted by many economists before policy makers actually acted on them.
The insights center on the role that competition, rather than regulation of prices and entry, can and should play in markets that do not display ch
aracteristics of natural monopoly. The extraordinary consequences are the new businesses and business models in the world of transportation, as well as substantially lower prices than would be the case if prices and entry into the transportation business were still regulated. Indeed, I will bet that many consumers of these businesses, and even many of their founders, may not appreciate the extent to which they owe their good fortune to the power of some simple economic ideas that led to transportation deregulation in the late 1970s and early 1980s.
How did all this happen? The answer differs by industry. The public choice theory of regulation only explains the deregulation of air cargo transportation and rail traffic (where affected industries wanted it), but it doesn’t explain passenger airline and trucking deregulation (industries in which firms liked the regulated life). In all these cases, however, economists from across the political spectrum were well ahead of the politicians and regulators in advocating deregulation.
Economists did not predict every outcome of deregulation, however. That is not surprising since markets have a way of developing and revealing behavior that few can anticipate.
The fact that each of the transportation industries reviewed in this chapter was deregulated, especially during a Democratic administration, was something of a miracle. I have already previewed the reasons why in the introduction to this section, but the circumstances that led to deregulation of each of the transportation modes are sufficiently different, as are the natures of the platforms that each created for business, that each deserves its own short discussion. Along the way, I highlight the role of economists in prodding the processes along. In the last part of the chapter I document the huge impact that transportation deregulation has had on the economy, and more relevant for readers of this book, on many businesses that would not exist in their present form, if at all, without deregulation.
Origins of Transportation Regulation
Since the invention of railroads, and later the car and the airplane, America has been a nation on the move. By one estimate, in 2007, total spending on transportation services amounted to $2.4 trillion, or about 17 percent of GDP,1 roughly on a par with health-care spending as a percentage of the economy.
It’s easy to take transportation for granted, except when something bad happens, like airplane crashes (which are much less frequent and generally less deadly than in earlier eras) or train derailments. But the fact is that our lives, as consumers, workers, and entrepreneurs, and as businesses, depend on fast and reliable transportation.2 People use their cars to travel to and from work, to go on vacations, to visit friends, and to shop. We use mass transit—railroads, planes, buses, and subways—for business and pleasure. Businesses require transportation services to deliver their supplies and final goods to wholesalers and, increasingly (in the case of Internet sales), directly to consumers.
This is all true now, but it took roughly two centuries to reach this point, beginning with the invention of railroads in the early 1900s. Railroads began as steam engines, the technology that defined the Industrial Revolution, put on top of wheels on tracks. The tracks cost a lot of money and time to build. The process of laying them, beginning in the populated east coast, and later extending throughout the country, culminating with the cross-continental railroad track project after the Civil War, was an immense undertaking. It was made possible with the combination of foreign financing and lots of cheap unskilled labor. Those who want to know more about this amazing story can read any one of several classic books on the subject.3
Unlike the other modes of transportation to follow—airlines, and even more so, cars, trucks, and buses—railroads require substantial fixed investments to operate, which means there are significant economies of scale in operating them, and economies of scale limit the number of firms that can operate at a profit.
In other words, it makes little economic sense to build multiple tracks between the same locations. Unless the tracks can be shared, then only one railroad can operate on them, much like telephone, electricity, or cable lines in landline telecommunications. Each of these industries is liberated from the economies of scale problem when there are multiple methods or modes of transporting people, goods, or electrons from place to place. That is eventually what happened to railroads, which always had competition from barge traffic in rivers and lakes in some places (but not all), yet clearly found more competitors once airplanes and trucks were invented. As is discussed in Chapter 11, the same thing happened in communications once information was digitized and capable of being sent through the air as well as over wires.
But I am getting ahead of the story, if only to let you see where it eventually ends. At the beginning, when railroads made their debut, they quickly became the principal mode by which goods, the supplies that made them possible (like coal), and people were transported over long distances. After the Civil War, complaints arose from shippers who objected to the alleged monopoly prices that railroads were able to charge. More complaints followed after the discovery and later refinement of oil in the latter part of the nineteenth century, as large refiners (notably Standard Oil) were able to extract volume discounts at the expense of smaller shippers that had to payer higher rates.
In response, a number of states attempted to control railroad rates, but the Supreme Court overruled their efforts in 1886 as an unlawful encroachment on the Commerce Clause of the Constitution. Congress responded the following year by subjecting rail rates to price regulation overseen by one of the nation’s earliest regulatory agencies, the Interstate Commerce Commission (the Comptroller of the Currency preceded it in the early 1860s, as the overseer of national banks authorized by Congress).
Although academics have disputed the need for the ICC in the twentieth century, one thing is clear: The agency and its mission were not demanded by the rail industry to which it was subject. Instead, the ICC and the rail rate and entry regulation it administered were definitely seen to be in the public interest.
The ICC’s mandate was extended in the twentieth century with the invention of the car and truck—motorized competition for rail. This extension of regulation better fits the public choice model, but only halfway: While railroads later wanted trucks under a regulatory tent to contain competition with them, the same was not true of trucking firms until they and later their unionized workers, too, became accustomed to the comforts of regulation. As for rail, the ICC not only limited the prices trucks could charge, but also required approval of new routes. The agency subsequently added other rules, especially on what trucks could or could not carry on their return, to further limit competition between trucking firms and rail transport.
The airplane was the next major transport invention, proving its value initially in a military context during World War I. When the war ended, the postal service used airplanes to deliver mail, which prompted private operators to use them for carrying cargo. Rather than give the ICC regulatory control over the airlines, however, Congress in 1938 created an entirely new agency, the Civil Aeronautics Board (CAB), to oversee prices and entry into both the cargo and passenger airline traffic business. Since planes flew routes that took them over rail tracks, and yet could only operate with large fixed investments in airports, they looked to policy makers to bring them under regulatory protection, too. After all, were not airplanes simply railroads or trucks with wings (to paraphrase the economist Alfred Kahn’s quip that planes were “marginal costs with wings”)? Since flying over specific routes exhibited economies of scale in much the same way railroads did, wasn’t there also a good public interest rationale to regulate prices and entry into the air traffic business as well?
Whatever theory best explains the creation of the CAB and the regulatory system it was supposed to implement, the CAB quickly moved after its creation to authorize a limited number of airlines fit to fly major point-to-point routes. No others were later allowed to fly these routes, at least as long as the CAB was in business.4
Airline Deregulation
Once establish
ed, the regulation of prices and entry into the major modes of mass transportation became something like the woodwork or plumbing in a house: just taken for granted. Incumbents that had their routes were happy with them, even though price controls limited their profits. In return, the authorized carriers were protected from competition with new firms in all of the different transportation modes.
There was one major loophole in this cozy system: Under the Constitution, which authorizes Congress to regulate interstate commerce, the CAB could only oversee travel between states. What the states did within their own borders was their own business.
For most states, this didn’t really matter, because they were either too small or too sparsely populated to support multiple carriers within any transportation segment. This was not true in airline or truck traffic, however, especially in the two largest states (by land area): California and Texas. Both served their roles as laboratories well, especially regarding airlines.
Michael Levine, one of the pioneers of what would eventually turn into full-scale airline deregulation, and later William Jordan, published studies of intrastate air traffic in California in 1965 and 1970, respectively, and compared its cost to interstate travel over comparable distances. Their startling conclusion: Intrastate fares were roughly half the comparable interstate fares.5 This finding reinforced the conclusion reached in an earlier, more academic study by one of America’s then-leading industrial organization and trade economists, Richard Caves, of Harvard University, that the airline industry displayed no evidence of economies of scale and therefore was not suited for price and entry regulation.6 A subsequent study in the 1970s by economists George Douglas and James Miller (who later went on to head the Federal Trade Commission and the Office of Management and Budget) found that regulation led airlines to schedule too many flights, explaining their low load factors, while denying consumers the ability to choose cheaper, unregulated flights.7
