SPECIAL REPORT

PLAYING BY THE NEW RULES

DEREGULATION HAS CREATED TURMOIL

JOHN DALY August 10 1992
SPECIAL REPORT

PLAYING BY THE NEW RULES

DEREGULATION HAS CREATED TURMOIL

JOHN DALY August 10 1992

PLAYING BY THE NEW RULES

DEREGULATION HAS CREATED TURMOIL

Victor Pappalardo calls himself a “baby of deregulation.” He is also one of its casualties. In September, 1984, he took advantage of airline industry reforms that the federal government had implemented earlier that year and launched a new carrier, City Express. With just one turbo-propelled 50-seat plane, the fledgling airline offered one-way economy flights between Toronto's small island airport and Ottawa for $69. Pappalardo soon added service to Montreal and Newark, NJ. But in the fall of 1990, Air Ontario, a subsidiary of Air Canada, began competing head-to-head with City Express from the island airport. It flooded Pappalardo’s routes and drove him out of business in February, 1991. Now, Air Ontario charges $186 for a one-way ticket to Ottawa. Last week, after beleaguered Canadian Airlines International Ltd. announced that it plans to hold merger talks with Air Canada, Pappalardo said: “It is ironic. Canadian Airlines got the squeeze play from Air Canada just like we did.”

To many economists and regulatory lawyers, the experiences of both City Express and Canadian Airlines illustrate the potential benefits and dangers of deregulation.

When Prime Minister Brian Mulroney took office in September, 1984, he said that he was determined to replace regulation by bureaucrats with the discipline of competitive markets. His government moved ahead with airline reforms initiated by the Liberals and developed a plan to deregulate the entire transportation sector. The Tories also began deregulating oil and gas, financial services and other industries.

Initially, at least, those reforms increased competitive pressures on companies to cut prices and costs. They also provided consumers with more choice and opened doors for upstarts like Pappalardo. But at the same time, the reforms have given such dominant firms as Air Canada

more freedom to put pressure on their smaller rivals. And the result in the airline industry is that there are now fewer competitors, not more.

Mulroney and his ministers had plenty of precedents demonstrating both the rewards and the risks of deregulation before they implemented their reforms. Presidents Jimmy Carter and Ronald Reagan had provided them with a road map. Carter deregulated airlines in 1978, allowing them almost total freedom to set their domestic routes and fares. Reagan accelerated the program when he assumed office in 1981. In 1982, he deregulated the savings-and-loan industry, predicting that it would make the institutions “a stronger, more effective force.” And in 1984, the giant American Telephone & Telegraph Co. agreed to relinquish its monopoly on long-distance telephone service to settle an antitrust suit.

In all of those sectors, the reforms sparked a competitive free-for-all that yielded substantial benefits for consumers. U.S. airlines slashed

fares, introduced frequentflyer programs and expanded their route networks. As well, such newcomers as People Express and America West Airlines made huge inroads against established carriers. In total, the Washington-based Brookings Institution, a private economic think-tank, estimates that U.S. passengers have saved an average of $9 billion a year under deregulation. Meanwhile, in the savings-and-loan industry, the deregulated institutions increased interest payments to depositors. In the long-distance telephone market, after adjusting for inflation, rates are now almost half the level they were before deregulation.

Painful: But deregulation also forced painful restructuring in those industries.

Since 1978, more than a dozen major U.S. airlines have merged or declared bankruptcy, including newcomers and such long-established carriers as Trans World Airways and Eastern Airlines.

As well, more than 50,000 U.S. airline employees have lost their jobs. Moreover, consumer advocates say that they now fear that the reduced number of surviving carriers will soon lead to increased fares. And in the savings-andloan industry, more than 600 institutions have collapsed since deregulation in 1982, largely because they plunged into high-risk real estate investments and junk bond deals in an attempt to improve their earnings. Congress estimates that bailing out the industry will likely cost taxpayers more than $600 billion during the next three decades, the largest financial collapse in history.

Despite that dislocation, many experts argue that U.S. deregulation has been a success. Alfred Kahn, an economist who supervised the deregulation of airlines as chairman of the Civil Aeronautics Board under Carter, said that although there are now fewer carriers, “there is no question that there are more airlines competing route-by-route than there were before.” He added that if Washington is worried about a handful of domestic “mega-carriers” dominating the industry, it should deregulate it even further and eliminate restrictions preventing foreign-owned airlines from flying on American domestic routes or from buying or merging with U.S. airlines.

Outside the airline industry, Kahn claims that deregulation would have been more successful if it had been even more extensive. He added: “In the case of the savings and loans, we retained government deposit insurance, which, in effect, said to them, ‘You cannot fail.'” In Canada, deregulation has also caused

dramatic restructuring. After Ottawa and the provinces cleared the way for banks to enter the stock brokerage business in 1987, four of Canada’s five largest banks, the Bank of Montreal, the Bank of Nova Scotia, the Royal Bank of Canada and the Canadian Imperial Bank of Commerce, bought investment dealerships. The Toronto-Dominion Bank, in turn, set up its own brokerage house. Now, the five bankowned firms dominate the brokerage business.

In the airline industry, the National Transportation Act, the brainchild of then-transport minister Donald Mazankowski, came into effect on Jan. 1, 1988. It removed the last remaining restrictions on domestic routes and fares. As in the United States, that sparked a competitive free-for-all. But Air Canada and Canadian Airlines soon bought up Canada’s 11 regional airlines. And in January, 1990, Canadian Airlines took over third-ranked Wardair. Now, Air Canada appears poised to regain a domestic airline monopoly, and industry analysts predict its proposed merger with Canadian Airlines will result in higher fares and the loss of 10,000 jobs.

Mistake: Critics say that the fact that deregulation in those two sectors resulted in fewer competitors demonstrates that it has failed. Andrew Roman, a regulatory lawyer with the Toronto-based law firm Miller Thomson, says that Ottawa made a mistake by deregulating airline fares and routes but not eliminating other restrictions that protected Air Canada from competition. Among them: laws preventing foreign airlines from flying between Cana-

dian cities and the 25-per-cent limit on foreign ownership of a Canadian carrier. Roman says that the ownership limit prevented Canadian Airlines and other carriers from tapping U.S. investors for capital. Said Roman: “What is important is the most efficient way of transporting people around, not whose name is spray-painted on the back of the plane.” Barriers: As for financial deregulation, Roman argues that it is “irrational” for Ottawa to have allowed banks to enter the brokerage business but still maintain barriers preventing banks and insurance companies from competing head-to-head. Declared Roman: “This isn’t deregulation. It’s partial deregulation of some barriers.” But other experts argue that partial deregulation has given Canadian consumers most of the benefits of increased competition, low prices and greater choice, even though it has not increased the number of competitors. In the brokerage industry, Steven Kressler, a financial services analyst with the Torontobased brokerage firm Midland Walwyn Inc., says that the bank-owned investment dealers compete just as aggressively with one another as they did before. He added that if Ottawa breaks down the barriers between banks and insurance companies, “it is entirely possible there will be more competition with fewer players.”

Indeed, in the airline industry, Air Canada and Canadian Airlines have continued to wage fare wars that generated huge losses for both airlines even after their other competitors disappeared. According to Ottawa's National

Transportation ocy, inflation-adjusted fa* jn 25 Ca-

nadian domestic routes are at about the same level as they were in 1988. Supporters of deregulation also say that it has made the airlines more efficient by forcing them to cut costs, trim payrolls and match schedules with demand. Said George Lermer, dean of the faculty of management at the University of Lethbridge in Alberta: “When bureaucrats were setting fares and schedules, we had planes running back and forth that were two-thirds or three-quarters empty.” Monopoly: Even if Air Canada gains a domestic monopoly, Lermer contends that Ottawa should be wary of reregulating its fares and routes. He says that upstarts would still be free to jump into the market at any time if Air Canada raised its fares too high. As well, Lermer says that flying on U.S. airlines between cities near the Canadian border is also an option for. 90 per cent of Canadians.

In contrast to the airline and the brokerage businesses, Ottawa’s deregulation of the natural-gas industry in 1985 actually created a free market with hundreds of healthy competitors—small and large. But even before deregulation, the industry, with over 700 producers, resembled the free market economist’s ideal of competition much more closely than financial services or airlines. While companies like Shell Canada Ltd. and Dome Petroleum Co. were large, they were not as dominant in their industry as Air Canada or the Big Five banks. And although gas producers suffered through dislocation after the government lifted price and export controls, that turmoil was not the result of unbridled competition. The cause was a five-year decline in international prices that began in 1986. Both large and small producers suffered, cutting back operations and reducing payrolls. But this year, they have all benefited from a rise in gas prices. Said James Gray, president of Calgarybased gas producer Canadian Hunter Exploration Ltd.: “In our industry, deregulation had the desired effect.”

Certainly, the aim of deregulation for the policymakers who spearheaded it in Canada and the United States was to put all companies in an industry at the mercy of the market, regardless of their size. But large firms in some of those industries clearly had different goals. And as Victor Pappalardo and other small companies discovered the hard way, the industry giants’ goals have often prevailed.

JOHN DALY