June 27, 2002
Facts And Fictions About Deregulation
What Consumer Reports Didn't Know (or Didn't Want You to Know)
by Peter VanDoren and Thomas Firey
Peter VanDoren is editor of Regulation, the Cato Review of Business and Government, published by the Cato Institute. Thomas A. Firey is managing editor of Regulation, the Cato Review of Business and Government.
In its July issue, Consumer Reports offers a harsh review of government deregulation in the airline, telephone, banking, cable TV, and electricity industries. CR associate editor Jeff Blyskal claims, "Our research concluded that while consumers have made some gains under deregulation, on balance they've lost ground." Jim Guest, president of CR's parent organization the Consumers Union, calls for "strong and effective government oversight [of those industries]." And the magazine's website claims "consumers suffer most in a free market."
As a magazine about product testing and comparison, CR does fine work; indeed, we both are subscribers. But as an analyst of deregulation's history, economics, and effects on consumers, the magazine is not up to the same standard. Let's look at what it claims about the various industries it analyzes:
Airlines – CR concedes that inflation-adjusted airfares fell 37 percent in the 22 years since the industry's 1978 deregulation. But, the magazine states, prices fell "just as much and just as fast" in the 22 years before 1978. CR thus leads the reader to conclude that deregulation has had little, if any, effect on fares; prices would have kept falling even if deregulation had not occurred.
It is true that fares dropped significantly in the middle of last century as old-technology propeller planes gave way to jets. But those technology gains ended by 1970, and prices became steady. Only after the 1978 deregulation and the rapid expansion of competition did fares move downward again, falling 40 percent from 1977 to 1996. The result has been dramatic growth in air travel as an increasing number of Americans fly, and fly frequently.
Though CR acknowledges the lower fares, it criticizes airline deregulation for allegedly giving consumers few choices among major airlines. In fact, choice has expanded since 1978; that year, just four major carriers (United, American, Delta, and Trans World) dominated the skies, according to data from the old Civil Aeronautics Board. Today, seven airlines (Delta, United, American, Southwest, US Air, Northwest, and Continental) have market shares of 6.5 percent or more, according to the Federal Aviation Administration. That choice would expand even further if lawmakers would withdraw current regulations that prohibit foreign carriers from offering domestic service, and limit how much foreigners can invest in U.S. airlines.
Finally, CR claims that fliers experience more delays, crowded planes and airports, and smaller seats in the wake of deregulation. That is true; with tickets no longer luxury items, aircraft are more full and airports more crowded. CR considers that a disservice to the consumer, but the truth is the opposite: Consumers, in shying away from more expensive "first-class" carriers, indicate that they are willing to accept some inconvenience so that airlines can implement cost-cutting measures that result in cheap fares. That being said, congestion at airports and on runways would be alleviated significantly if the federal government loosened regulations on who can use the Airport and Airway Trust Fund money accrued from taxes on aviation fuel and passengers, and if government distortions didn't undermine private investment in air infrastructure.
Telephones – CR does acknowledge the considerable improvement in telecommunications following the AT&T breakup in 1984. The magazine notes that inflation-adjusted calling costs have dropped almost 37 percent between 1984 and 1999, while Americans' phone usage has increased almost 68 percent. (CR's graph of long-distance rates fails to capture the extent of that savings because it focuses on only one company's rate during peak calling time.)
CR tries to dismiss deregulation's role in producing the lower prices, claiming that phone rates fell "in large part because of regulated cuts." In saying that, the magazine refers to the federally mandated reduction in taxes ("access charges") on long-distance calls that were (and, to some extent, still are) used to subsidize local service. To be sure, some of the reduction in long-distance rates has occurred because of the reduction in access charges. But Brookings Institute economist Robert Crandall has shown that, setting aside the access-charge drop, the average inflation-adjusted revenue per minute in long-distance calls has decreased a remarkable 60 percent from 1984 to 1999. In other words, long-distance rates have dropped dramatically because firms have been forced to cut their per-minute profits to remain competitive.
There have been other benefits to deregulation besides the lower long-distance rates. CR notes that customer satisfaction is higher now than in 1984. Consumers can choose from a wide variety of phone equipment for the household, with basic units selling for almost nothing. And cellular technology, which the Federal Communications Commission once blocked, has emerged following Congress's decision to auction off the spectrum and restrict states' ability to control rates.
There is room for criticism of telecom deregulation - namely, that it did not go far enough. Monopolies or giant incumbents still dominate local calling; long-distance firms are still taxed to subsidize local service and thus can't price calls in a manner that truly reflects their cost. Further deregulation of both long-distance and local calling would produce more investment, innovation, competition, and benefit to consumers (although a minority would see their prices increase as cross-subsidies disappear).
Banking – CR attempts to blame the 1980s savings and loan collapse and $160 billion taxpayer bailout on deregulation. In fact, the S&L debacle was instigated by the poor U.S. economy in the 1970s, even though the collapse didn't come until after early banking law reforms.
In the late 1970s, interest rates skyrocketed, severely squeezing S&Ls between the billions of dollars in low fixed-rate mortgages that they had issued and the higher interest now earned by depositors. By the end of the decade, the majority of S&Ls were insolvent and Congress faced the prospect of having to shut them down and repay depositors with federal deposit insurance funds. To make matters worse, federal deposit insurance did not have enough money to cover the outstanding liability.
Congress, in desperation, decided to deregulate interest rates paid to depositors as well as the rules limiting investments to residential mortgages, enabling the S&Ls to invest in high-risk, high-return commercial real estate. The move, in essence, was a gamble to avoid the looming financial disaster. And, initially, the gamble paid off as high oil prices fueled a commercial real estate boom in Texas and Oklahoma. But when world oil prices dropped in 1985, the "bet-the-bank" strategy failed and the S&Ls finally succumbed to the insolvency that had chased them for half a decade.
CR gives readers the false impression that banking regulation historically has been pro-consumer. In fact, banking regulation from the nation's earliest days was intended to benefit government, chiefly by providing revenue. From those early years onward, states held tight control of banks, awarding them market power over small geographic areas in exchange for extracting heavy taxes and fees. To protect the revenue stream, states prohibited nationwide banking and severely limited statewide banking, even though such branching would have been a great convenience to consumers, a boon to business, and would have protected banks from regional recessions like the ones that preceded the Great Depression.
With the lifting of banking restrictions in the 1980s and 1990s, bank efficiency greatly improved and customers benefited. Economists Jith Jayaratne and Philip E. Strahan found that, following deregulation, loan losses and operating costs fell sharply, which translated into lower interest rates for borrowers. Better performing banks quickly branched out, providing customers with more convenience and stability. It now appears that the old state branching restrictions acted as a ceiling on the size of well-managed banks and S&Ls, preventing their expansion and protecting less efficient, more risky competitors.
Cable TV – CR understandably criticizes the doubling of monthly cable rates between the first attempt at deregulation in 1984 and 1998 (an increase that continued during the reregulation of 1992-1996). The magazine further notes that 95 percent of households have only one cable provider to choose from, just as they did during the tight-regulation era. (The magazine does not note that local and state laws protect most of those monopolies.)
But CR gives almost no attention to the area in which deregulation has produced astounding quality and choice: channel selection. In 1985, less than 10 percent of cable subscribers had access to 54 or more channels; by 2000, that percentage eclipsed 60 percent. Instead of just one news channel, sports channel, music channel, and a smattering of other offerings that usually was the extent of cable in the early 1980s, today's subscriber can choose from many different news, sports, education, business, entertainment, movie, music, and other channels, along with options like high-speed Internet and more than a dozen premium channels. Economists Robert Crandall and Harold Furchtgott-Roth, in their 1996 Brookings Institution book Cable TV: Regulation or Competition? estimated that the added channels increased the value of cable by $65 per household each year. That more than offsets the price increase. Consumers seem to agree; the number of households with cable more than doubled between 1983 and 2001.
Still, the cable industry is plagued with complaints of poor service and little ability for customers to select what channels they want (and want to pay for). Ending local governments' awarding of monopoly rights to various cable operators would help to create the competition that would produce better service and selection.
Electricity – CR correctly acknowledges that "it's too soon to meaningfully assess electricity deregulation because it has not honestly happened yet." As demonstrated by the California fiasco of the 2000-2001 winter, half-hearted schemes that mix strong regulation in some places with market forces in others result in a "worst of both worlds" scenario that produces bankrupt companies, debt-burdened taxpayers, and unhappy customers.
There is a clear need to end traditional electricity regulation. The old regimes, forged by politicians and power companies, awarded utilities monopoly control and protected them from competitors, consumer choices, and market forces. Those regimes were based on an agreement that government would ensure long-term profits for power companies, regardless of poor business decisions - an agreement that made possible the nuclear power boondoggle.
The regulatory nightmare grew worse following the 1978 passage of the Public Utilities Regulatory Policy Act (PURPA), which endeavored to boost power production to avoid a supposedly impending energy shortage. PURPA required utilities to purchase all generated power from independent producers at very high rates established by state regulators. The cost, which was passed on to consumers, ended up being far above what market forces dictated. With electricity rates increasing because of failed regulation and government policy, consumers began demanding a move to deregulated power.
Unfortunately, what consumers often received was not deregulation, but restructured regulation that produced retail customer prices determined by state law rather than market forces. Nationwide, there is little pricing of electricity according to cost; prices are too low during the day and too high at night.
In fairness to the regulators, it is very difficult to establish a true energy market because of technological limits. There is no simple, inexpensive way for multiple companies to share the power grid that connect all houses, nor can "smart meters" that bill according to usage times be installed easily. But the terrible effects on consumers that occurred under the old regulatory regime demand that communities continue to explore ways to bring competition and market forces to the electricity industry.
Why so wrong? – As we have shown, Consumer Reports significantly misunderstands the history and economics of deregulation. What is more, it fails to discuss other industries with deregulation success stories, like freight transportation. That leads us to ask, how did CR get things so wrong?
The article reflects a worldview that academics call the "public interest" theory of regulation. In that view, markets often do not serve consumer interest because of "market failures." Only omniscient, benevolent government can step in and ensure the markets serve and protect consumers.
Since the 1950s, scholars in economics, political science, and law have found considerable evidence that the public interest theory is false; markets do a pretty good job of meeting consumer desires while government typically enacts regulation that offers political gains, not public ones. The "public interest" theory of regulation has been replaced by the "redistributive" theory, which holds that regulation is enacted to serve special interests by taxing certain firms and consumers. Regulation, like politics in general, creates concentrated benefits for favored interests and consumers, paid for by diffuse losses to other firms and consumers.
Given the redistributive view, it becomes easy to understand how CR can identify consumers who "lost" under deregulation, such as the South Dakota family that no longer receives subsidized airline tickets. But consumers, in general, benefit when competition increases and the distribution of government favors declines.
Consumer Reports has done its readers a great disservice by publishing an article that paints an intellectually incomplete picture about markets and regulation. It reflects a "public-interest" view of regulation that is 50 years out of date. The magazine is correct that competitive markets best serve consumers, but it falsely asserts that most markets are not competitive through natural forces and that government regulation makes them more competitive. To be sure, not all markets are competitive, but the reason usually is the existence of government intervention rather than its absence.