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They Just Want to Be Free

Telecom can end its crisis if only the FCC will let firms truly compete

by Randolph J. May
Legal Times, November 11, 2002

In July, in the wake of WorldCom's bankruptcy, Michael Powell, chairman of the Federal Communications Commission, admitted in a Wall Street Journal interview that the nation's telecommunications industry is in a state of "utter crisis." Since then, the situation has only worsened.

There are different yardsticks by which the extent of the telecom industry meltdown can be measured. But no one really disputes that in the past two years approximately 500,000 industry jobs have been lost, telecom capital expenditures have plummeted by half to $50 billion, and more than 65 telecom companies have declared bankruptcy.

Just in the past few weeks, headlines have blared the continuing pain. From The Wall Street Journal: "SBC to Lay Off 11,000 More Workers." From a Washington Post article about the high-tech Dulles Corridor: "A Telecom Boomtown Looks Like Ghost Town." And the world's leading telecom equipment makers, such as Lucent Technologies and Nortel, are hovering on bankruptcy's doorstep. You get the picture. But what happened and why? There are several causes. No doubt the sector suffered from the "irrational exuberance" that plagued the general economy, and from association in investors' minds with the high-flying dot-com sector. As Yochi Dreazen pointed out [also in The Wall Street Journal], the oft-repeated, but erroneous, assumption that Internet traffic was doubling every three months contributed to the problem. Such optimistic predictions-this one largely spun by WorldCom-gave credence to those seeking funds from Wall Street to start new carriers.

And no doubt the erosion of investor confidence attributable to disclosures of accounting irregularities, such as those that hastened WorldCom's downfall, played a role in the sector's downturn. So did other disclosures of potential wrongdoing. For example, Salomon Smith Barney, one of the chief underwriters for new telecom startups, earned $24 million in banking fees from new entrant Winstar, while its star telecom analyst, Jack Grubman, continued to tout Winstar as a good investment until shortly before the company's bankruptcy.

But regulatory policy played a contributory role as well, and regulatory policy has a role to play in accelerating a telecom recovery. What happened, in essence, is that the Telecommunications Act of 1996 was implemented in an overly regulatory way that encouraged a boom/bust cycle.

The FCC's implementing rules encouraged many new entrants and their investors to believe that the government would support even uneconomic entry in the marketplace, especially the local service segment, merely for the sake of toting up new "competitors" on a scorecard. When investors came to realize that too many new competitors had been created to serve too few customers with too little revenue to spend-and that even more favorable government support policies were unlikely to ensure the survival of many of the new entrants-the telecom bubble deflated.

As an aid to opening up the local telephone marketplace to competition, Congress directed the FCC to promulgate rules requiring the incumbent telephone companies, like Verizon and SBC, to share their local networks with new entrants like Winstar, as well as with established firms like AT & T and WorldCom. Because the 1996 act, as Justice Antonin Scalia put it in AT & T Corp. v. Iowa Utilities Board [1999], "is not a model of clarity," the agency was left with fairly wide discretion to fashion the sharing rules.

Even so, in that case, the Supreme Court remanded the initial rules for, contrary to the statute's intent, giving the new entrants "blanket access" to the incumbents' entire local network. "Rules that force firms to share every resource or element of a business would create not competition, but pervasive regulation," wrote Justice Stephen Breyer in a concurrence.

This past May, after the FCC spent two years tinkering with the rules in minor ways, the D.C. Circuit held unlawful the revised regulations for still requiring unlimited facilities-sharing. In United States Telecom Association v. FCC, a unanimous court explained that, in the highly capital intensive telecom industry, "[i]f some parties who have not shared the risks are able to come in as equal partners on the successes, and avoid payment for the losers, the incentive to invest plainly declines." And it rejected the notion that Congress intended "such completely synthetic competition."

Apart from the court decisions, how do we know that the FCC's rules deliberately tilted in the direction of encouraging new competitors? Because Reed Hundt, FCC chairman at the time the rules were written, said so in his 2000 memoir, You Say You Want a Revolution-A Story of Information Age Politics. In light of the discretion conferred upon the agency, Hundt wrote, "we could aspire to provide the new entrants to the telephone markets a fairer chance to compete than they might find in any explicit provision of the law." He boasted the commission's rules, in fact, had created 250 new telephone companies!

The problem is, even under rules requiring facilities-sharing at what the incumbents claim to be below-cost prices, most of these new companies that attracted so much investor capital and that Hundt took credit for creating, never generated any profits. And they showed no reasonable prospects of doing so, even if regulatory policy were tilted even further in their favor. A September 2002 study of a representative sample of 24 of these new entrants from 1996 to 2001-by my Progress and Freedom Foundation colleagues Jeffrey Eisenach, Larry Darby, and Joseph Kraemer-showed that only one of the 24 turned a profit over the five-year period.

Scott Cleland, with the independent research firm the Precursor Group and one of the most widely quoted telecom analysts, wrote in his Oct. 2, 2002, newsletter that the FCC's current sharing regime "is economically unsustainable." He characterized the current regulations as creating "fraudulent competition and below market pricing" that has the effect of "devalu[ing] existing infrastructure," the overall impact of which is to "poison[] the entire telecom food chain." Cleland predicted that the FCC, led by Bush-appointed Chairman Michael Powell, soon will change course.

Indeed, the commission presently is considering cutting back on the sharing requirement in a proceeding it expects to conclude around year-end. Based on Powell's long-standing deregulatory rhetoric and some recent remarks, Cleland's prediction may prove true. On Oct. 2, speaking at a Goldman Sachs conference, Powell directly acknowledged the FCC's responsibility: "No matter how weak or shoddy the fundamentals or poor business models were, and no matter how irresponsible the debt levels or exaggerated the growth expectations were, policy promised that all competitors could be salvaged in the name of competition."

So, the overly intrusive regulatory regime put in place by the Reed Hundt-led FCC contributed to the dire situation in which the telecom industry finds itself. But the Michael Powell-led agency is also fairly subject to criticism for not moving more quickly to end the unsound policies.

A policy change that makes survival more difficult for the new entrants who have based their business model almost entirely on the FCC's current regulations may well mean even more bankruptcies and painful consolidations, in the short run, as the government withdraws its protection. As Nobel Prize-winning economist F.A. Hayek reminded us in 1968, "the generally beneficial effects of competition must include disappointing or defeating some particular expectations."

But there will still be effective competition for the incumbent wireline companies. There are already more than 120 million wireless subscribers, and more of them every day are abandoning their wireline service. And cable operators rapidly are eating into the market share of the wireline incumbents. The two leading providers, AT & T Broadband and Cox Communications, already have signed up 1.7 million telephone customers and are adding 60,000 to 70,000 more each month. And Internet telephony, e-mail, and instant messaging increasingly threaten the revenue base of the traditional telephone companies.

Back to Powell's rhetoric: In a 1998 essay, he wrote that, in an era of rapid technological change facilitating new forms of competition, policy-makers "are fast approaching moments of truth" in which they must decide whether to abandon traditional regulatory models. More than four years later, in the most severe telecom downturn in history, the FCC should act quickly to spur a turnaround by implementing some real deregulation.

Randolph J. May is a senior fellow and director of communications policy studies at the Progress & Freedom Foundation in Washington, D.C. The views expressed are his own and do not necessarily reflect the views of the foundation. He may be reached at rmay@pff.org. His column, “Fourth Branch,” appears regularly in Legal Times.

© 2002 ALM Properties Inc. All rights reserved. This article is reprinted with permission from Legal Times (1-800-933-4317 • subscriptions@legaltimes.com • www.legaltimes.biz).



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