A famous saying, especially prescient in times like this, is “those who do not learn from history are doomed to repeat it."
Last month, Congress mortgaged the nation’s future in a matter of days by rushing through a historic $2 trillion stimulus bill in response to the coronavirus. The problems with the bill seem as numerous as the dollars handed out as a result of it.
One such problem involves massive bailouts for major industries. In particular, the CARES Act promises $58 billion to airline carriers for, among other things, direct payment for wages to keep some workers on payrolls, loans with very beneficial terms, and other funds to cushion the blow and prevent looming bankruptcy brought on by the sudden and immediate drop in consumer demand in response to the coronavirus.
The gifts, however, are not without strings. In exchange for the financial assistance, the airlines will not be allowed to lay off or furlough workers, they cannot buy back shares of their own stock, issue dividends to shareholders, and executive pay is capped at 2019 levels. However, the most harmful string of all is the equity stake that government will have in the companies who take money under certain loan provisions of the bill.
When government has as much say—or more, depending on the size of the equity stake—as private shareholders in the operations of a business, things can get out of hand fast. Or, as Erik Gordon, professor at the Ross School of Business at the University of Michigan, put it: “This is going to be hard to unravel,” [i]ndustries that are propped up stay propped up for a long time.”
No doubt, a great many articles and books will be written in the coming weeks, months, and years dissecting every good intention chasing the inevitable bad outcomes that will flow from this bill. But, for now I want to focus on just the bailouts in exchange for government control of important business decisions, because we have been here and done this before.
A similar story played out 150 years ago in the then-dominant travel industry of the day, railroads. Burton W. Folsom, Jr. outlined this story in his book, The Myth of the Robber Barons, identifying two models of entrepreneurship; the “political entrepreneurism” of lines like the Union Pacific and Central Pacific versus the “market entrepreneurism” of James J. Hill and his Great Northern Railway.
As Folsom details, the former chased government largesse, ultimately in exchange for loss of control of their business, while the latter chased profits through prudent business decisions. Hill’s success juxtaposed with UP’s and CP’s failure is due in no small part to his steadfast refusal to accept any federal subsidies. In short, UP’s and CP’s government subsidized incentives were vastly different from Hill’s profit driven incentives, which lead to vastly different outcomes.
Federal subsidies incentivized speed, not efficiency. The subsidies were paid in the form of both land grants and direct payments. For each mile of track laid, the UP and CP would receive 20 acres of land and either $16,000 (for track on flat land), $32,000 (for track on hilly terrain), or $48,000 (on mountainous terrain). This incentive for speed resulted in winding, inefficient, routes built with inferior materials, ultimately culminating in a federal price tag of 44,000,000 acres and $61,000,000 (astronomical sums in the 1860s-70s). Despite all this federal assistance, shortly after the golden spike was driven on May 10, 1869 at Promontory Summit, Utah, the UP and CP were nearly bankrupt and required further assistance to stay afloat.
The lines which were born and brought up on federal aid needed federal aid to continue. This led to the passage of the Thurman Law in 1874 which forced UP to pay 25% of its earnings a year to pay its federal debt.
UP’s profitability decisions were also subject to government approval. Branch lines—smaller lines off the main line into rural communities—which could have helped UP’s bottom line, were often not approved by federal bureaucrats. Additionally, the federal Bureau of Railroad Accounts required constant checking of UP’s books. All these measures stifled the ingenuity that UP so desperately needed to make its line profitable. UP quickly found out that the power to subsidize was the power to destroy.
Hill’s line on the other hand was methodically surveyed and built, on the shortest routes possible, with the least gradient possible, and using the best steel and other materials on the market at the time. Rather than political largess, Hill made his decisions based on profit and loss. But, for all the efficiency that Hill built into his line—he was able to transport across the country faster, cheaper, and with less maintenance costs than could the UP and CP—arguably the most important aspect for the viability of his business was the freedom to conduct business untethered by the strings that accompanied government subsidies.
While Hill was free to build when and where he wanted so long as he reached voluntary agreements with landowners, consumers, and employees, UP was tied up in red tape. As Hill’s line grew evermore profitable and reliable for customers, the UP and CP struggled along on federal aid, until they ultimately went bankrupt in 1893.
For his part, Hill’s line was the only transcontinental railroad to never go bankrupt.
Hill’s lesson is a warning to every stakeholder in today’s proposed bailouts. It is a warning to the industry itself that the rope intended to pull you out of this hole is the same that might later hang you. It is a warning to customers who might see their traveling options and experiences limited as airline carriers on the dole become increasingly deeper sinking funds. And, it is a warning to every taxpayer who is being sold on the premise that we must save these companies or global travel will be brought to its knees, and that this is only a temporary measure for which we can soon recover.
As Milton Friedman said, “nothing is so permanent as a temporary government program.”
Rather than bailouts for capital managers that have demonstrated their inefficient use of scarce resources—i.e. engaging in share buybacks during the good times without saving for a “rainy day” if/when the bad times came—these carriers should be allowed to go bankrupt. Their assets will be redeployed by better managers, as demonstrated by their prudent management which put them in the position to purchase and redeploy the failed managers’ assets in the first place, at no cost to American taxpayers.
In other words, let bankruptcy work. Let it clear the market and make way for better companies to rise to the top on their own merits rather than allowing government to pick winners and losers in the marketplace. Because the ultimate lesson of Hill and his Great Northern is that the “winners” government picks today are the “losers” of tomorrow.