Southwest Airlines, and When Finance Wrecks the Real Economy

Capitalism and markets are supposed to be about spreading prosperity and making America stronger, not weaker. Why allow finance-led arbitrage and corporate games to undermine the real economy?

Southwest Airlines recently announced it would end its policy of allowing two checked bags for free. Southwest’s bag policy was one of the airline’s distinguishing features. It was the reason a lot of people flew Southwest. Why make such an obviously self-destructive decision? Because an activist hedge fund moved a large sum of money into Southwest’s stock, and it wants to juice it for a quick profit.

I understand why the hedge fund wants this. I don’t understand why we allow it. Why allow finance-led arbitrage and corporate games to undermine the real American economy?

I’m quite far from anti-capitalist. I like markets and don’t believe central authorities are wise enough to micromanage vast sectors of the economy. However, markets run on rules. Market economies are attractive because they’re great at producing things, spurring innovation, and creating prosperous, abundant lives. If they’re actually producing the opposite—socially-useless arbitrage sabotaging the real-world economy—what exactly is the point?

Understanding why this is a problem may be the elusive silver bullet for a stronger, more prosperous, and more vibrant version of America.

HOW SOUTHWEST AIRLINES WAS DIFFERENT

Here’s the crux of this story: a hedge fund guy plowed a bunch of money into Southwest’s stock, which allowed him to remove two-thirds of Southwest’s board. Now that he controls the board, he’s trying to boost the stock short-term to turn around a quick profit. He really doesn’t care whether Southwest Airlines is in a better long-term position, whether American aviation is harmed, or whether millions of Americans who fly are miserable. By the time any of those costs arrive, he’ll long ago have shifted his money elsewhere.

Essentially, Southwest is a pot of value he can seize. The real-world impact is irrelevant.

Not long ago, Southwest had a reputation as the best-run airline in America. Until 2019, it was still under the spiritual leadership of its co-founder and longtime CEO Herb Kelleher. Kelleher helped build the airline as a scrappy start-up company back in the 1960s, became its CEO in 1981, and presided over the company until his retirement in the early 2000s. Then he remained on its board as a leader until his death in 2019. Like most entrepreneur-founders, Kelleher loved his business. His role as founder gave him power to make decisions against the grain of his industry—think Apple’s Steve Jobs ignoring MBA business practices, or Costco’s Jim Sinegal keeping cheap hot dogs on the menu. As a scrappy low-cost airline, Southwest maintained a fun and irreverent atmosphere, and it adopted unique policies like its no-assigned-seat boarding process. When other airlines started nickel and diming customers with bag fees—fees that now average $35-40 per bag—Southwest bravely stood against the tide. It became a powerful reason many people chose Southwest.

Checked-bag fees, of course, are among the worst innovations in commercial aviation. It’s obvious why airlines do it—the industry earned $33 billion from bag fees last year. Customers hate bag fees, but tend to book tickets solely based on sticker price without considering extras. Extortionate bag fees allow airlines to charge more for tickets while still looking competitive. However, the fees intentionally degrade the flying experience. Everyone now tries to cram over-packed bulky baggage into limited overhead bins, and we all have to fly with coats and laptop bags crushed against our feet. Boarding and disembarking is a circus, as tense passengers sometimes get into testy spats over bins. Bag fees are an anti-excellence policy. They make the world worse, for no real-world benefit.

Over the last few years, Southwest struggled a bit, making it a potential target. The hedge fund Elliott Investment Management used some of the $7 billion it manages to buy up 11% of Southwest’s stock, which allowed it to launch a legal fight to control the board. Once in control, the hedge fund began forcing changes like ending Southwest’s unique boarding process and, now, instituting bag fees. In theory, investors like Elliott claim they’re seeking to turn struggling firms around. In reality, they force through short-term changes that boost the stock and then sell, while the brand gets permanently damaged. Once-nice things are broken, American industry is degraded, millions of American suffer, and America gets weaker.

A lot of the economy works like this these days. It’s like the way private equity firms create shells that borrow money to buy companies, secured by the company’s own assets. This allows investors to buy a company with its own money, and then siphon the profits while the company gets burdened with their debt. Investors force through changes that move money out of the firm into their pockets, understanding that the worst case is the debt-burdened company fails and they lose little because nothing of theirs was truly at risk. Firms that make things in the real economy—parts, boats, or consumer products—get destroyed, and the families they supported left behind. The real world of America is worse off.

I don’t fault investors. If you’re smart enough and can spot the right schemes, you can siphon a lot of value from the economy this way. Back in law school, I myself liked to daydream clever methods to create corporate entities and merge them into each other in unlikely ways, or use obscure corporate law to seize entire firms without investing a dime. It’s fun. The problem is, it’s also socially useless, wielding abstractions and arbitrage to break real things. At worst, it destroys the real world we live in.

This isn’t the capitalism I learned about in school. Capitalism is meant to be a way to unleash innovation, recognize talent, reward risk, and build prosperity. It’s a system to build, make, and create things. It discovers ignored opportunities without having to ask permission from lumbering authorities without imagination or sense. That’s what they taught me, at least—capitalist systems are better than faceless officials vainly trying to administer the world because market systems create abundance and wonders, instead of grim Soviet housing blocks.

Rampant financial manipulation and arbitrage does the opposite. Instead of creating value, it destroys. Instead of unleashing innovation, it turns everything dull and mediocre so some small group can short-term boost the appearance of growth. Instead of unlocking excellence, it sees excellence as a pot of value it can loot. It’s the fable of the paperclip maximizing machine brought to life.

THE FABLE OF THE PAPERCLIP-MAXIMIZING MACHINE

You might have heard of philosopher Nick Bostrom’s thought experiment of the paperclip-maximizing machine.

Imagine a powerful AI in charge of making paperclips. There’s nothing wrong with making paperclips. However, with time the superintelligent AI starts seeing opportunities to make even more paperclips. It converts people’s homes and possessions into paperclips. It starts to convert all the food. Eventually, it even starts breaking down human beings into their fundamental elements to make more paperclips. Before long, the entire earth is a massive pile of paperclips and the human race extinct. What makes the paperclip maximizer terrifying is it isn’t evil. It’s focused on a reasonable goal, just to the exclusion of anything else. Maximizing one single goal will kill everything that makes human life worthwhile.

What if we’ve turned our economy into a paperclip-maximizing machine?

Everyone today takes for granted an idea that only emerged in the 1970s—the Cult of Shareholder Value. Economist Milton Friedman popularized the idea that the sole purpose of a public company was to increase the return to its owners by increasing the price of shares. At the time, the American economy was cooling after the post-World War II boom and American companies had become inefficient. Executives at great corporations were obsessed with pointless empire building, using company funds to buy more and more unrelated businesses to make executives more powerful and important. This is how you got General Electric invested in businesses spanning appliances, lighting, television stations, aerospace, and finance. The Cult of Shareholder Values claimed that was wrong. The only job of management was to make the stock go up.

The idea of shareholder value is reasonable. Shareholders ultimately own corporations and it should be presumed they want the value of their investments to rise. The spread of this idea in fact helped make American businesses more efficient. It helped unwind the inefficient conglomerates, end the stagnation of the 1970s, and create the boom of the 1980s and 1990s. The problem is it also was an over-simplification. Why does every firm always have to grow?

Great entrepreneur-led companies, who don’t have to deal with constant demands for growth and shareholder value, vastly outperform public companies run by finance guys and business-school drones obsessed with making green numbers rise. People like Steve Jobs could focus on creating great products that people loved, and in turn improve the real world we live in. At some point, there’s no more room to grow—no more places to build another Starbucks, and no new coffee products people want. The only remaining place to find growth is to cheapen the experience—stealing future value in a game of arbitrage between what people assume they’re getting, and what they’re going to get. Why isn’t it okay to serve great coffee in a nice environment at a fair price to everyone in America who wants it, while making an enormous profit? Why must everything always grow?

At some point, the Cult of Shareholder Value becomes a paperclip-maximizing machine. When growth and stock prices become your only goal, you start destroying everything else that matters. You make the real-world experience of everyone in America worse. Instead of delivering prosperity, efficiency, innovation, growth, and joy, you create a dystopia of mediocrity and frustration.

CAPITALISM DOESN’T NEED TO ALLOW THIS

There’s nothing in capitalism that says we have to do this.

Setting up rules and incentives is an important part of making capitalist systems work. Creating ground rules for competition is an entirely separate issue from putting bureaucrats in charge of running everything as in a Soviet factory. For example, it might be cheaper to dump pollution into the drinking water, but you’re not allowed to do that. Firms must compete without dumping toxic chemicals in the lake. If it was legal to lie about the quality of your materials, nobody could trust the labeling of products and everything would become cheap trash. If you could steal people’s trademarks, brand value would drop to zero. If you could publish fraudulent financial statements, financial markets wouldn’t work.

Why, then, allow finance and arbitrage games to wreck the real economy?

Everyone is always looking for a magic bullet to unleash growth, prosperity, and innovation. Instead of tinkering with interest rates or subsidizing industries, why not just prohibit financial games that destroy real things? The point of capitalism isn’t to make money but to build a better, stronger, America that creates the things we need. Our best minds should be dreaming up ways to make the real world around us better, not worse. That sort of thing has nothing to do with capitalism. This is simply common sense.

Prohibit these sorts of games, and you instantly unlock value across the economy. The rules we establish for the game of capitalism determines what we reward, and what we don’t. We shouldn’t reward behavior that’s socially useless, much less destructive. We don’t need to allow clever people to seize control of businesses they didn’t found or build and wreck them. We can just change our corporate laws and tell them no—invest your money in building and improving things if you want to make a profit. Do something socially useful—fund new businesses and innovation, instead of looting the real economy.

I’m disheartened by what’s happening at Southwest. It happens to a lot of once-great American companies. The reign of financial engineering and arbitrage games at the expense of excellence makes America weaker and worse than it needs to be. It’s also a choice. We need not simply shake our heads in resignation. We can easily fix it, encouraging building rather than extraction, and rebuilding the strength of America.

What do you think about the role of financial arbitrage? Join the conversation in the comments.