The Temptation of the Two-Tier System
B-Scales, Housing, Envy, Resentment and Justice
Welcome to everyone who came here from The Diff last week!
In past issues we looked at economic clusters and the dangers of groupthink, companies that create wealth by moving to adjacent spaces, the advantages of investing in productive assets, and explanations for the growth in administrative employment.
This week we will talk about housing again, but we will start with a quick story from the airline industry in the 1980s, as described in Thomas Petzinger Jr.’s Hard Landing.
In the wake of deregulation in 1978, American Airlines emerged as one of the most innovative legacy carriers. Under the leadership of CEO Bob Crandall, they invented the modern frequent flier program, they pioneered yield management (selling seats at different prices), and they built Sabre, the computer reservation system which today is still the leading airline software provider in North America.
Back in the early 1980s, American was worried about competition from upstart low-cost carriers like Southwest, which were growing rapidly. Among other advantages, these carriers had much younger, lower cost staffs, and better labor relations.
American felt they had to find a way to grow but also felt they could not do so within their legacy wage structure. Naturally, their unions did not want to give up their high wages, a holdover from contracts negotiated during the era of regulation.
The airlines and their pilots unions have a unique and delicate relationship. The unions can put the airline out of business quite easily by going on strike - airlines have no way to stockpile inventory, nor do they have any easy way to bring in replacement workers to keep the airline running. On the other hand, the pilots want their airline to remain healthy - pilot pay is strictly seniority based, on a steep curve, and if they have to move to a new airline, they have to start all over again at the very bottom.
Crandall and his team proposed a typically creative solution to the dilemma between the airline’s desire for growth and the union’s desire for high wages for current employees. They proposed that all existing employees would retain their pay packages, but all future employees would permanently be paid half of what the existing employees got paid.
The future employees would still get raises as they gained seniority, but no matter what, they would get paid far less than existing employees at the same seniority level. The contract would create a permanent divide between employees hired before and after the early 1980s. This permanent second-tier wage structure for new employees was eventually dubbed the “b-scale” by the unions.
Better yet for current employees, the resulting growth of the airline would allow the existing pilots to get promoted to captain faster, giving them an additional pay bump.
If everything played out according to plan, the new b-scale employees would eventually replace all of the existing a-scale employees, giving American a b-scale cost structure without requiring any sacrifice from existing employees. Win-win!
The plan was not without risk. Observed Petzinger:
In the year 217 A.D. the expansion-minded Roman Emperor Caracalla introduced history’s first known two-tier system, with lower rates of pay for some soldiers. Although it was not the only morale problem that the emperor faced, it most certainly fueled the plot by which eventually he was assassinated by his own troops.
In any case, although they had misgivings, the unions approved the plan, and in 1983, the b-scale was established at American.
A few years into the expansion, Crandall recorded a message for his new employees:
You will become aware of the fact that people hired some years ago, during the years of regulation, are paid at what we call the “existing employee” pay scales, while you and most of your coworkers are paid at “market rate” scales. Some people have suggested that our new employees may feel some resentment towards those with more seniority. That’s very unrealistic, and I hope you won’t let it happen to you. Keep in mind that the more senior employees worked for the company during the years of regulation. They helped build American into the great company it is. In effect, they built the legacy that promises a good future for all of us.
No doubt the new b-scale employees noticed that no other airline had such a severe disparity between new and existing employees, or that their Dallas neighbor, Southwest, was doing just fine, if not better, without the benefit of senior employees who had inflated wages from the days of regulation. Despite Crandall’s pleas, the new employees indeed felt resentment.
As American rapidly expanded, the proportion of b-scale employees grew. As the proportion of b-scale employees grew, discord grew within the organization, not only between labor and management, but within the union itself.
Fortune reported on the situation in 1997, three years into a bitter contract negotiation:
The pilots hired at what came to be known as the "b-scales" developed a sort of inferiority complex. "All of a sudden, there was a whole group of people working there who were extremely resentful of the fact that the person sitting next to them was making a lot more money for exactly the same job," says Larry Crawford, president of Avitas, an aviation consulting firm in Reston, Virginia. "They began to wonder what kind of scheme was coming at them next." It might seem strange, given that many of their jobs might not have even been created without the b-scales, but they still resented their status as second-class citizens.
This was not the only problem with the b-scale plan. From the same article:
Thanks to growth made possible by all the cut-rate hiring, American expanded so quickly that the b-scale pilots eventually made up the majority of the union that Crandall is haggling with today. The b-scalers, whom some at the airline now refer to as the Killer B's, are largely responsible for a grassroots movement called Pilots Defending the Profession that has sprung up on the Internet during the latest round of negotiations. Though the union leadership had approved a tentative settlement offer from American last year, the leaders of the splinter movement persuaded the pilots to turn it down (by almost 2 to 1) when the full membership voted on ratification in January.
In hindsight, the b-scale scheme was doomed from the beginning. Management was naive to think that new employees would passively accept permanent second-class status. What’s more, the growth of the airline ensured that it would not be long before b-scale employees attained a majority of the union, and overturned the whole system, which they did shortly after the publication of that 1997 article. After fourteen years, the b-scale experiment was over.
Managing any organization is a constant balancing act. On one hand, a certain amount of inequality is desirable, if it can be used to attract and incentivize highly productive contributors. On the other hand, humans are perhaps more than anything driven by envy and resentment, as anyone who has been on Wall Street during bonus season can attest. The b-scale creates envy and resentment where none existed before.
Charlie Munger has a fantastic talk on psychological tendencies, in which among others he discusses the Kantian Fairness Tendency, which holds that humans are wired to get very angry when they perceive that someone else is behaving unfairly. We saw that here as well - the new American pilots were not necessarily getting paid less than they would have any other airline, but they were upset at having to be forced to work alongside others who negotiated a contract to get double the pay at their expense.
Peek under the hood of any firm, and you will see that a lot of thought (or at least trial and error) has been put into managing these psychological tendencies. Firms outsource a lot of their highest cost work (banking, consulting, law) even when they could do it more cheaply internally, and they outsource a lot of low cost work even when they might benefit from having more control. This creates a more equal distribution of income within the remaining organization.
Firms actually have a lot of compensation policies designed to make employees less angry and resentful. Matt Levine likes to say that investment banks are managed as socialist collectives in many ways, which is true - compensation is often redistributed throughout the firm, away from the people who generated most of it. Startups frequently pursue a cash compensation policy that pays everyone fairly equally (although equity is another story). Teachers and professors are compensated fairly equally regardless of the subject they teach, even though their private sector peers are compensated quite differently.
These policies do not always work, but there seems to be some correlation between shareholder return to a firm’s ability to manage internal employee discord and strife. Costco seems to have figured out how to manage inequality better than any other retailer, offering relatively high pay to its lowest paid associates and relatively low pay to its top executives, and the company has performed tremendously.
The legacy airlines of this era had to contend with another powerful force, something Munger dubbed Deprival-Superreaction Tendency, which is a fancy way to say that humans really hate having anything taken away from them. His example was his family dog, which would only bite you if you gave it a bone and then tried to take it away.
The legacy airlines were in a difficult position, where their pre-deregulation workforce was compensated based on a pay scale that new airlines did not have to match. They were caught between a rock and a hard place, where the only way to compete with the new airlines was to reduce their cost structure, but any attempt to do so would be met by bitter resistance from the existing workforce. The b-scale was a creative way to try to establish a compromise.
Economists have a term to describe the tendency of employers to avoid wage cuts at all costs - “sticky wages”. In most cases, they prefer layoffs to wage cuts, even if it is theoretically less economically efficient. Part of the reason we have an inflationary monetary policy that devalues the currency by 2% every year is because it allows employers to avoid explicit wage cuts.
It is worth noting that American was the only major airline that ever imposed a true b-scale, because other unions understood these forces and anticipated the danger. Two years after American sealed their b-scale, its main rival at the time, United Airlines, responded by offering the exact same deal to their pilots, to stay competitive.
Anticipating the internal division and strife that would follow if they sold out the next generation, the United pilots rejected the deal and went on strike for a month, even though the benefits to the contract they demanded would mostly accrue to future pilots. United management mostly backed down, and the b-scale was averted.
This brings us back to housing, which we looked at two weeks ago. In summary, if the airline industry worked like the housing business, the airlines would get together to enforce a shortage of planes and a ban on new airlines and start raising airfares precipitously as a result. And then instead of intervening, the government would decide instead to exempt the airlines from income tax, and then on top of that would send the biggest and wealthiest airlines billions of dollars of subsidies each year based on their interest payments to creditors.
The mysterious thing about the current high cost of housing in some regions is that interest rates are so low. For a fixed asset that lasts decades, long-term real interest rates are a key determinant of cost, and at a sufficiently low interest rate, housing is practically free. At the current 3% rate, a $320,000 house (the median in the US) would cost only $1,350 a month if you borrowed the entire amount on a traditional 30-year fixed mortgage.1 (By comparison, this is less than the average monthly health insurance premium for a family of four in the US.)
A generation ago, in 1990, the median house would have cost $246,000 in 2021 dollars, but at the 10% rate prevailing at the time, that would have been $2,150 per month in 2021 dollars. There are some considerations here around the high value of mortgage interest tax deduction back then, and the option value of refinancing later on, but generally housing should be much cheaper today than it was back then, and the quality of the median house should be higher.
There is no evidence that we lack the technology to produce very nice $320,000 homes in quantity. The major publicly traded homebuilders routinely build and sell tens of thousands of luxurious 2,000 square foot homes in the suburbs of major cities across the Sunbelt each year in that price range or lower, and manage to pocket a nice profit.
Even away from the Sunbelt suburbs, developers routinely produce luxury apartments near major high-income cities in that cost range. AvalonBay Communities, a major publicly traded real estate company, now reports having 5,128 apartments near completion in high-cost metro areas for a projected total cost of $1.95 billion, about $380,000 per apartment. That total cost includes everything from land to permits to interest, and these are true luxury communities with all of the amenities.
As wealthy as the US is, housing should not be an issue. In the US, economic output per household in 2019 was $171,000 ($65,240 GDP per capita x 2.62 people per household)! Recall that we can produce brand new high quality apartments and houses that only require a monthly mortgage payment of $1,350 per month, or $16,200 per year - a monthly mortgage payment that gets cheaper in real terms every year and goes to zero after thirty years.
On top of that, we have 140 million existing housing units always looking for occupants. One would think that we could develop a taxation and housing regime to ensure that even the poorest households would have access to good housing.
And yet. In California, our largest state, and one of our richest, 29% of renters spend more than half of their household income on housing. Of course, in California, you are lucky to even have a home - the well-publicized homelessness crisis grows every year. The housing shortage is obvious to all, but the beneficiaries of the housing shortage are well organized and politically powerful. They fight against new construction, believing that allowing the construction of new housing would threaten their wealth.
Wealth can be a misleading concept. It is conventional wisdom that housing is the best way to build wealth in America, and in the traditional accounting sense, this is true. You stop building houses, and like magic you end up with an asset on your personal balance sheet that goes up and up in value.
However, in this case, the spiraling value of houses is a sign that the country is getting poorer, not richer. What this accounting doesn’t capture is that part of this “wealth” is really just the present value of future excess transfers from renters to owners, as a result of the artificial shortage of housing - the medallions we discussed in the previous essay. This is a giant liability for society, but it doesn’t get recorded on any balance sheet.
Returning to our airline analogy, if the airlines were allowed to raise prices and block competition, no doubt their profit margins would explode, and their stock prices would soar as a result, making their shareholders millionaires. But real GDP would be reduced, as we would be paying far more for the same airline tickets, and the public would be forced to consume fewer flights. It is for this reason we have antitrust laws.
It was obvious to Adam Smith back in the 18th century that our standard of living is determined by our level of productivity, and certainly the notion that we could be wealthier if only we had less housing in this country is laughable.
The problem is not so much that we lack the economic ability to produce adequate housing, but that we have managed to build a b-scale into the provision of a basic necessity. For a house to be a magical asset that spins “wealth”, rather than an ordinary investment asset like an airplane, we had to manipulate the market with zoning restrictions and tax breaks, and we taught people that they have to defend those rights to the death, or their economic futures would be threatened. The b-scale is a side effect of those manipulations - for the assets of the a-scalers to be so valuable, we had to create artificial scarcity, leaving the younger and poorer b-scalers on the outside looking in.
It is tempting to build a b-scale into an organization. You can do something politically popular now, and completely defer the cost to the next generation. You can even bend and twist and find rationalizations as for why the next generation actually deserves to be treated as second-class citizens.
Once you create a b-scale, it necessarily means that you have an a-scale, and the people on the a-scale will be like Munger’s dog with a bone - they will snarl and bite if you so much as suggest you want to take it away. You quickly regret ever giving them the bone in the first place. If the bone is large enough, you will be forced to take it away eventually, which will be a very unpleasant experience.
That is not the only drawback. One thing that keeps coming up when reading about the American Airlines situation is trust. Once you are complicit in something as underhanded as a b-scale, you lose all trust in the future. This makes doing business difficult going forward.
Finally, it is clear that a b-scale is almost always unsustainable. Eventually, there will be a day of reckoning, once the b-scalers sufficiently grow in number and flex their muscle. It happened very quickly at American because it was growing so fast, but it is inevitable in any organization that isn’t stagnant or shrinking.
Increasingly, it feels like we are living in a b-scale society.2 It’s easy to pick on the California housing market - not only do they drive up rents for the young by preventing most new construction, but because of Prop 13, property taxes are imposed most heavily on younger homeowners. This is abetted by federal policy that makes this not only legal, but subsidized for the wealthy.
Education is another major example. Primary education is funded locally and tied to housing, and suffers from the same issue. Access to higher education, particularly elite higher education, is inequitable, and even within higher education, there is the divide between the older tenure-track professors and the growing number of low-paid, non-tenure track faculty.
All of this contributes to the general feeling that the game is rigged. On the evidence displayed here, it is in many ways. In America, we are at a point economically where we can provide basic needs for everyone. The problem is that to do so, we have to generate the political will to bite the bullet and take away certain entitlements that people have gotten used to, and now believe that they actually deserve. It feels absurd that we have to fight a political battle to legalize building shelter, but that is where we are right now.
History teaches us that the best way to deal with b-scales is to stop them before they get started. Don’t start handing out bones that you will have to take back. You inevitably end up in a worse position than when you started; the system will eventually fall apart anyway, and in the end everyone will be angry and trust will be broken.
B-scales are far from inevitable; we saw the example of the United pilots that took the longer view in the 1980s, and more recently, Portland, Minneapolis, Seattle and Berkeley have moved to prevent the exclusionary zoning that has vexed so many cities in California. There is hope.
We are traditionally focused on solving our economic problems by developing new technology, allowing us to create more output with less input, growing the economic pie. That we have $171,000 of annual GDP per household is a testament to the success of this country in producing real wealth.
But even technology has its limits. The housing crisis in California is a good reminder that even the wealthiest of societies are prone to economic ailments that are political in origin. No matter how big the pie gets, there is no pie so big that poor governance cannot spoil it.
You can’t borrow the entire amount unless you have a VA loan or something similar, but this an easier way of doing the math. You can get an FHA loan with a very low down payment by paying a small additional monthly fee for insurance.
This essay focuses on America, but of course there are even more examples outside the US, where older workers have contracts and protections not afforded to younger workers.