Thursday, February 20, 2014

Mexico to its rail franchisees: “Yanqui go home”

Written by  Frank N. Wilner, Contributing Editor
At the turn of the 20th century, seven-term Mexican President Porfirio Diaz is cited as having complained, “Poor Mexico, so far from God and so close to the United States.”

Obviously, such geographic closeness did not facilitate an understanding of free-market economics practiced north of the border, as today’s Mexican leaders, when it comes to railroads, appear more comfortable with the instructions of Cuba’s Fidel Castro and Venezuela’s late Hugo Chavez and Nicolas Maduro than political philosophers Adam Smith or Ayn Rand, whose teachings on rational self-interest are a keystone of American railroad efficiency and productivity. Or even, for that matter, Thomas Jefferson, who counseled, “The merchants will manage commerce the better, the more they are left free to manage for themselves.”

Alas, nearing passage in Mexico’s congress is a law that would seize private property by cancelling 30-year franchises—barely half-through their lives—of Mexico’s two dominant railroads, Kansas City Southern de México and Ferromex. The former is a subsidiary of U.S.-based Kansas City Southern; the latter is also privately owned, with U.S.-based Union Pacific a minority owner and Grupo México the majority holder. Mexican railroads were privatized during the mid- to late-1990s under the leadership of former Mexican President Ernesto Zedillo.

The proposed legislation would require those railroads to permit others to operate on their tracks, with a wished-for objective of increased investment and lower freight rates. History records, however, that such schemes cause investors to flee and ruinous competition to set in, whereby each operator reduces rates well below fully allocated costs in an effort to ruin the other, regain the business, and restore compensatory rates. Left in the lurch are shippers, who suffer ever more poor service.

Substantial investment is required to build track, acquire rolling stock and locomotives, build stations, and construct loading and off-loading facilities. Indeed, Kansas City Southern and Union Pacific have invested some US$8 billion in Mexican railroads since obtaining their franchises, and that investment would be at substantial risk were a scheme implemented to force freight rates lower.

Such a scenario played out in the United States in the late 1880s, and again in the 1960s and 1970s, when railroad freight rates barely covered operating expenses and left little or nothing to cover fixed charges such as repayment of loans, dividends on stock, taxes, and administrative costs. In both those periods, railroad bankruptcies soared, investors fled, deferred maintenance mounted, and service quality tumbled.

In its famous Munn vs. Illinois decision in 1887, the U.S. Supreme Court, while recognizing that the public has an interest in private property used for public purposes, said railroads had “invested capital relying upon the good faith of the people and the wisdom and impartiality of legislators for protection against wrong.”

Early in its existence, the Interstate Commerce Commission (ICC, now the Surface Transportation Board, or STB), reasoned that “the question of the reasonableness of rates involves so many considerations and is affected by so many circumstances and conditions, which may at first blush seem foreign, that it is quite impossible to deal with it on purely mathematical principles or on any principles whatever, without a consciousness that no conclusion which may be reached can by demonstration be shown to be absolutely correct.” It was a confirmation of Adam Smith’s invisible hand efficiency.

Indeed, the ICC—as does the STB today—allowed railroads the determination of reasonable rates, stepping in only where there is conclusive evidence of discrimination as to places, freight, or passengers.

In 1898, the Supreme Court spoke again, saying that “the basis of all calculations as to the reasonableness of rates ... must be the fair value of the property being used by it for the convenience of the public. And in order to ascertain that value, the original cost of construction, the amount expended in permanent improvements, the amount and market value of its bonds and stocks, the present value as compared with the original cost of construction, the probable earning capacity of the property under particular rates prescribed by statute, and the sum required to meet operating expenses, are all matters for consideration, and are to be given such weight as may be just and right in each case ... [W]hat the company is entitled to ask is a fair return on the value of that which it employs for the public convenience.”

By contrast, the proposed Mexican legislation is intended as a sledge hammer to rates, without consideration to the rights of investors—and when those rights are trampled, investors bid “adios,” which leads to rapid service degradation that the lower freight rates, which can only be evaluated in relation to service quality, become a millstone on commerce.

While backers of the proposed legislation bemoan insufficient investment—notwithstanding that KCS, UP, and Grupo México have pumped almost US$8 billion into their railroads over the past 15 years, and well above the under US$2 billion contemplated when the franchise agreements were reached—there are no credible examples of investment increasing when prices and rates of return are pounded down by government fiat. Moreover, the claim by the legislation’s supporters of unreasonably high railroad rates ignores underlying costs of operation, such as a 369% increase in fuel costs in recent years.

America’s first business weekly, the Commercial & Financial Chronicle, observed in 1906 that the then assault on railroad freight rates “is predicated on the idea that [railroads] are extremely prosperous and that some of their profits might well be taken from them and appropriated for the benefit of shippers and the general public.” Such thoughts would sit well with the Cuban and Venezuelan governments, although the state of those economies is the greater evidence of the consequence of takings of private property.

Congress and rail shippers—even the National Industrial Transportation League, which recently turned tail in search of quite questionable short-term gains for its shipper members—agreed in the late 1970s that the preservation of a privately owned rail network and shipper-acceptable rail service quality depended most assuredly on railroad revenue adequacy.

During the 1970s, poor earnings, poorer prospects, high-debt ratios, and the reality of bankruptcies squeezed nearly every American railroad out of the equity markets and deterred investment, capital renewal, and normalized maintenance. Only by removing the heavy hand of government from the railroad throttle, through passage of the Staggers Rail Act in 1980, did American railroads avoid nationalization and restore for shippers the rail service quality they demanded.

Current Mexican President Enrique Peña Nieto, elected on a platform of promises to revitalize Mexico’s troubled economy, may well be of the mind that renationalization of Mexico’s railroads will help to deliver that intent—the lessons of Cuba and Venezuela notwithstanding.

Not to be ignored is Peña Nieto’s fit of pique that he is actually second in power in Mexico—in the shadow of telecommunications baron Carlos Slim Helu, who owns 90% of Mexico’s land-line telephone network, sits on a fortune of $73 billion, and is second only to Bill Gates as the world’s richest human. An attack on Carlos Slim Helu’s telecommunications network may well require, as a stalking horse, the attack on Yanqui financial control of Mexican railroads—but for what economic purpose?

In a nation where 44% of the population lives in poverty, according to the U.S. Embassy there, not to be ignored is an unintended consequence of the proposed legislation Peña Nieto supports: When freight rates are forced below full costs, downward pressure is exerted on worker compensation and headcounts. In an already fragile Mexican economy, such a result would lead to troubling labor unrest and popular demonstrations.

Peña Nieto might also take counsel from predecessor Carlos Salinas de Gortari, whose attempts at sweeping economic reform, imposed by government fiat, led to devastating national economic collapse in 1988. The efficiency of free markets does not survive the virus of heavy-handed government intrusion.

The United States may be closer to Mexico than God, but Mexico’s president and legislature are tempting a devilish result by ignoring the lessons of economics and history that have been learned, too often painfully, north of the border.

Attacks on private property have yet to serve the interests of long term, or even medium term, economic growth and health. Mexico can take that to the bank, where it is worth its weight in gold, and far more than even Carlos Slim Helu’s pesos.