Airline executives will close the books on 2001 with a sigh of relief. Even before the terrorist attacks devastated air travel, major carriers were already struggling from a rapid downturn in traffic as businesses pared back travel budgets.

Months later, continuing weak demand compounds the troubles of airlines that have distressed balance sheets. A few weeks ago, Moody's rating service slashed debt ratings on United parent company

UAL

(UAL) - Get Report

and

Continental

(CAL) - Get Report

, both of which were already rated as junk. The action followed earlier downgrades on American Airlines parent

AMR

(AMR)

and

Delta

(DAL) - Get Report

, which also had already carried junk-level ratings.

As dire as the situation may be, it's worth remembering that the airline industry has always been a highly cyclical business, says Kenneth Button, an air transport expert and public policy professor at George Mason University. He thinks air travel is likely to pick up when the economy regains strength. But that doesn't make airlines a great investment, given that their returns have historically lagged those of other sectors, he adds.

Read on to get Button's take on the prospects for a recovery in air travel in 2002.

TSC: What's the early verdict on holiday travel? Did air traffic over Christmas meet expectations?

Button:

It depends on the expectations. Basically, the number of people flying during the Christmas period this year was down 18 percent compared to last year, though comparisons are a bit difficult. It depends on which day Christmas falls on from year to year.

And we still have a legacy of pre-Sept. 11. One thing people have forgotten about the current situation is that a lot of people book flights for the Christmas period some months in advance. It will take a while for that picture to clarify.

TSC: You mean demand over the holiday period could appear greater than it really was, because people booked those flights before the attacks?

Button:

It could well have been held up a little by people having booked well in advance.

TSC: What about airfares? The airline trade industry group reported domestic airfares were down 16 percent in November from a year ago. That's a pretty sharp decline.

Button:

What you find is that business fares haven't gone down very much, but there are pretty good deals with restricted fares. If a person doesn't have a rigid timetable, there are extremely good deals there, including international fares.

But even before Sept. 11, the average amount people were paying for seats had declined a fair bit.

TSC: What about labor disagreements? It seems like that's always a problem for airlines, and morale must be really low now after all the layoffs in the industry. President Bush just barred workers at United from going on strike. Do you expect there to be lots more situations like that?

Button:

The difficulty is that pay negotiations don't all take place at once. In United's case, certain groups like the pilots had very large pay raises, and other groups are now coming in for their raises, just when United doesn't have any money.

Labor problems are just exacerbated because of the events of Sept. 11. It's a major problem that I'm not sure how they're going to resolve. Some airlines are negotiating for various forms of pay reductions.

TSC: How much will the federal bailout package help airlines that are in trouble?

Button:

It makes quite a big difference. There's $5 billion in compensation for when the air traffic control system was closed down by the government. That money provided instantaneous liquidity when it came through. As an airline, you may be able to cut costs but you still have to pay your workers.

The second part

of the package was $10 billion in loan guarantees: The government will give a 100% guarantee to the private sector

for lending money to airlines. I don't think it will be allocated till the first quarter of next year. But airlines have to produce a quite detailed business plan for how it will be used. You have to demonstrate your commercial viability in the long term.

TSC: Will that be a hard case for some companies to make? How weak are airlines' balance sheets?

Button:

Of course, Midway went bust the day after

the attacks. They were going under and decided to quit that day.

US Airways

(U) - Get Report

has clearly got problems. Its CEO resigned, and it has high labor costs. It may not go bankrupt, but it could be taken over by a bigger carrier. Alternatively, you could have carriers buying up certain parts of it.

It's said United is spending $15 million a day, though that will decrease

over time because of cost-cutting measures in place. And

America West

(AWA)

has asked for some money now from the

government-backed loan.

TSC: Another potential issue for airlines is insurance liability. A couple of weeks ago the first Sept. 11-related lawsuit was filed against United by a widow whose husband died on one of the hijacked planes. Do you think lawsuits will become a big problem for the airlines?

Button:

It's hard to say. I don't think many people blame airlines for the attacks. They blame the security system rather than the airlines. And the government's given a certain amount of protection to the airlines, probably correctly so. The people who took weapons on board actually broke no law until they hijacked a plane. Their

knives conformed to regulations; the blades were less than four inches long.

TSC: Will airlines have to spend a lot of money themselves to improve security? Are they doing it already?

Button:

I think there's a lot more money being spent; I'm not sure there's additional security. The evidence is that the electronic high-tech approach is not stopping people. But to adopt the Israeli approach, which involves very detailed scrutiny of passengers, is very, very expensive.

There's going to be a cost to the traveling public and ultimately, I suspect, to the taxpayer.

The costs associated with improved security include having to redesign aircraft, flying air marshals, which takes up space on a plane, rescheduling flights and redesigning

airport gates -- a lot of little things that add up.

TSC: What about the risk of another attack -- how does that play into the prospects for recovery in air traffic?

Button:

People will accept a certain level of risk in all activities, but it takes a while to reach that equilibrium. Far more people have died on the roads in the U.S. since Sept. 11 than died in New York City, but people still drive. If you're perceived to be doing your best

as an airline, people accept a certain risk. It just takes a while for that adjustment to take place.

I think the industry is very depressed and will take a while to recover, but I personally believe it will pick up again as the economy starts growing. One of the difficulties of Sept. 11 was that it hit not just the airline industry, but it hit the U.S. economy as it was going into recession. It's what's known as derived demand -- people fly because they have to for business purposes, or they have leisure destinations. But with less business activity and income, people will simply fly less. So you've got that effect, entirely separate from the simply psychological effect from Sept. 11.

The airline business is pretty volatile, anyway. The rate of return for airlines is way below the average in the U.S. economy. I think the rate of returns for airlines is about 8 percent and for the U.S.

economy is about 13 percent, though it depends on the year you look at it.

The airline industry has never been particularly prosperous, in that sense. It always goes up and down. The first part of the 1990s was disastrous for airlines with record losses all around. The second part, they had record profits. But the average is below the

overall average.