TCS Daily

Broadband Access - Competition, Regulation, and Consumer Welfare

By James K. Glassman - July 12, 2001 12:00 AM

Remarks of James K. Glassman to AEI New Economy Forum, July 12, 2001

New Economy Forum At the American Enterprise Institute

Thank you, Chris [DeMuth], for urging us to do this program.

One of the many wonderful things about AEI is that it does not always speak with one voice.

Most of us share a philosophy about the role of government in the economy and about the importance of competition, transparency and deregulation -- but when applied to specific matters of public policy, that philosophy produces different results for different scholars here.

It was not long ago, for instance, that I appeared on this same platform with Tom Hazlett of AEI at my side. We were arguing that the government was wrong in its attempts to break up Microsoft. Opposing us was Bob Bork, our good friend and colleague, of AEI.

The issue before us today is particularly compelling, and its outcome will have a profound effect on the American economy.

It comes down to this: how to bring a sector, dominated for a century by a monopoly nurtured and protected by government, to deregulation? I think every member of this panel, and most of you in the audience, would agree on the sort of equilibrium we should aim for. We want a competitive situation, where companies operate efficiently, entry is relatively easy, consumers benefit from low prices and high quality, innovation is rewarded and the economy grows more quickly with technological tools in the hands of citizens and businesses. A monopoly cannot provide this kind of equilibrium - nor will a duopoly.

Make no mistake. Deregulating a monopoly is not easy - as we are learning in the electric-utility sector and as we will soon learn in the pension sector, with the imminent (I hope) de-monopolization of Social Security. Transitions are important. They cannot be glossed over.

A relatively successful transition occurred after the 1984 breakup of the Bell System, which was structurally separated into a prospectively competitive long-distance company and seven (now, through mergers, four) regional Bell Operating Companies or BOCs. The BOCs continued to provide local access and telephone services as regulated monopolies.

In the mid-1990s, it became evident that, to encourage higher quality and lower prices (the result achieved in long distance), deregulation of local telephony was required as well.

In the case of local service, simply to say, "Let her rip!" and allow the BOCs immediately into any business they chose and let competitors fall where they may - that was no answer. It was not feasible either politically or economically.

The current extensive local networks owned by the incumbents represent billions of dollars in sunk investments, much of it subsidized by a variety of implicit and explicit mechanisms. In the face of an entrenched and uncooperative monopolist, the economic barriers to entry are simply too high for local competition to establish itself outside a few major metropolitan areas.

The last mile is an essential bottleneck reality facility, and the inevitable result of immediate deregulation would be that the Bells, blessed with the infrastructure they developed under monopoly protection, would squash any competition flat and would almost certainly extend their current monopoly into long-distance and Internet services

Congress understood that very well. The Telecommunications Act of 1996 was a careful blueprint to get from monopoly to competition since everyone knew it could not plausibly and fairly be done all at once with a snap of the fingers.

The Act did two things: first, it mandated that the incumbent local companies unbundle their networks and provide resale of retail services at non-discriminatory, cost-based, wholesale rates, and that the incumbents negotiate fair interconnection agreements with the competitive local exchange carriers, or CLECs, to facilitate the exchange of traffic. In other words, the Bells had to open up their local networks to competitors, which could either lease whole systems from them or pick and choose among unbundled parts - at reasonable rates.

Eventually, many of these firms, once they had acquired customers, would build out their own facilities - just as Sprint and MCI did in long distance, spurring AT&T to improve its network. But the requirements to open the local loops had no teeth. No deadlines were set, and no large fines threatened non-compliers.

Which brings me to the second part. Instead of serious punishment, the Act offered the Bells a carrot - immediate access into long distance in states where the opening was sufficient for real competition - so-called 271 certification.

The Telecommunications Act was not perfect, but it was an excellent roadmap. It passed the House by a vote of 337-80 and the Senate by 91-5. Yes, votes came from every free-market conservative in Congress, including Rep. Dick Armey, Sen. Connie Mack, Rep. Chris Cox and so on. The most avid deregulators in Congress voted for the bill because it would lead to deregulation.

The law helped launch 300 CLECs, established on the law's promise to allow them at the chance to compete with a monopoly that controlled just about every phone line in America. At their peak, these CLECs would have a market cap of well over one- quarter trillion dollars.

The bill was widely applauded by the participants, including key Bell management.

Just a few quotes...

Ed Whitacre, chairman of SBC: "We have achieved landmark federal legislation.... The law is good for consumers, it is good for SBC, and it is good for our shareowners."

Raymond Smith, CEO of Bell Atlantic (now part of Verizon): "The bill President Clinton signed today sweeps away the old regulatory boundaries...between long-distance and local exchange companies.... It heralds an exciting win-win era for the consumer and the telecommunications industry as well."

Yet within only a few months, the lawsuits from the Bell companies began flying. SBC asked a federal court in Wichita Falls, Texas, to declare critical provisions of the Act unconstitutional. Whether they had planned it from the start, I cannot say, but the incumbents adopted a strategy of foot-dragging, noncompliance and legal action against the very law they had earlier supported. They were repeatedly fined (fines against the Bells totaled more than $300 million last year), but to little effect. What was at stake was greater than the fines. As The Economist magazine reported in a thorough study of worldwide broadband policy:

"Unbundling is not sufficient to get broadband going...since it is dependent on the cooperation of the telecom's incumbent. In both Britain and America, incumbents have hindered adoption of DSL by being deliberately unhelpful towards new entrants, many of which have given up or gone under. Regulators in America can impose only puny fines, which incumbents regard as a price worth paying to keep the market to themselves."

What happened? Why did the attitude of the Bells change after the adoption of the Telecom Act?

My own view is that the incumbents saw the lay of the competitive landscape, and they didn't like it. They were being realistic. The best kind of business is an unregulated monopoly, second best is a regulated monopoly (especially if you have a relationship of decades with regulators), worst of all - way down the list - is an unregulated competitor.

Being a regulated monopoly is no bad business. SBC, for example, last year earned $7.7 billion and had cash flow of an incredible $15 billion on $53 billion in sales. Return on equity since the Act was passed has been between 25 percent and 30 percent. Between April 1996 and April 2001, Verizon's stock returned 106 percent and Bell South's 122 percent - well ahead of the Value Line average of 93 percent, not to mention Sprint at minus-3 percent. Total market capitalization for the four Bells: $300 billion. As regulated monopolies, they are not hurting.

But as deregulated competitors, they might be. They had only to look at what happened to AT&T, down to a market cap of $78 billion, to realize that, for some companies, competition is not so joyful. This was the specter staring at the Bells, and they reacted with complete rationality.

They stalled, they obfuscated. They ran up multi-million-dollar fines. It was so bad that they have so far opened their local loops enough to get 271 approval for long distance in only five states, and each has its own special story. And then they began to advocate legislation that would remove the most important provisions of the Telecom Act.

The Tauzin-Dingell bill makes three big changes. First, it removes the carrot by allowing the Bells immediately into the data part of long distance. Data is where the growth is, where the margins are higher. Voice has become a commodity business, as the fiercely competitive long-distance companies learned to their chagrin. Second, it allows the Bells to deny interconnection, required by the Telecom Act, to certain parts of their system, if they upgraded. The Telecom Act was clear: It called for unbundling at "every technically feasible interface" and it gives the FCC authority to establish pricing guidelines. And that's the third part of the Tauzin-Dingell bill: It would impose limits on the FCC's ability to set pricing guidelines, thus preempting a review of the legality of the TELRIC pricing standard in the Supreme Court in October. In other words, Tauzin-Dingell would gut the Telecom Act. What the Bells will do is strategically upgrade to block out the CLECs.

In a paper I wrote with William Lehr of MIT, we showed how the stalling of the Bells - and then the threat of the passage of the Tauzin-Dingell bill itself - helped destroy the market capitalization of the CLECs. We constructed an index of the major CLECs and found that, from March 2000 to May 2001, their market caps dropped from $242 billion to just $38 billion - a decline of 84 percent. Yes, the Nasdaq fell too over this period, but only by 48 percent. The CLEC index suffered a loss three-fourths greater. The S&P dropped only 9 percent.

We also conducted a careful "event study" - a standard academic exercise -- that looked at nine days of positive news about the progress of the Tauzin-Dingell bill. During those days, the market cap of the CLEC index fell $95 billion - nearly half the entire loss the CLECs suffered. The argument supported by these data - and by common sense - is that the Tauzin-Dingell bill would destroy what was left of the CLEC industry.

Originally, Rep. Billy Tauzin, chairman of the House Commerce Committee, had hoped to pass his bill by the July 4 recess, but, in the wake of a negative report from the Judiciary Committee, the House leadership surprised many observers by delaying consideration indefinitely. That decision provided us with a way to test our thesis again - this time by looking at the market reaction to negative Tauzin-Dingell news.

We found that on the two key negative-news days, the index shot up by 3.7 percent and 3.8 percent. As an example, McLeodUSA, a CLEC whose price had dropped from a high of $34 to a low of $2.30, bounced back 67 percent in two days. Meanwhile, SBC dropped 3 percent and the broad S&P Index rose about 2 percent. Using the methodology of the first study, this important out-of-sample test showed that a negative event day produced a move of about two standard deviations.

Tauzin-Dingell has been sold as a way to speed the deployment of fast, broadband Internet connections - and this, in a more narrow sense, is the public-policy issue that many in Congress are seeking to address. Only about 5 percent of Americans now have broadband, and the rollout has been slower than some expected. Widespread broadband would allow education, banking and health-care services, high-quality video, the downloading of movies in a few minutes instead of a few hours. "Speed is important for e-commerce," said Tom Tauke of Verizon Communications at a congressional hearing. "Consumers love buying online, but get frustrated when they have to wait too long for the picture of the dress to download. So they give up on the purchase." The broadband delay is undoubtedly hurting individual companies and the economy.

But it is hard to see the Tauzin-Dingell bill as a remedy. It asks us to trust the monopolist to roll out broadband, but monopolists do as little investing as they can. Remember that the Bells had fast DSL technology for 10 years before they started to deploy it. That deployment came only after cable companies began to compete with their own broadband technology, and cable companies came to broadband because they were pushed by their competitors - direct broadcast satellite and overbuilders, which now control 20 percent of that market. The Bells make so much monopoly profit when they sell you a second phone line for a 56K connection that they have little incentive to invest heavily in capital to speed you up. They have only started to do so because of competition.

There are two essential questions, then, when we look at the Tauzin-Dingell approach to solving the broadband rollout problem:

First, will passage of the bill kill, or severely damage, the CLECs? There can be no question that this is the case, as our study shows and common sense would dictate, and as CLEC executives have testified.

For example, Clark McLeod, Co-CEO of McLeod USA, said in testimony last month: "I would ask the Judiciary Committee to oppose H.R. 1542 [Tauzin-Dingell], take it off the table. It's very destructive. It's moving our industry toward remonopolization. It's causing financial markets to go away completely. We have no access to capital today to build new networks."

What lender or equity investor could conscientiously commit funds to an industry that would be left with highly dubious access to the last mile, linking virtually every home in America?

Second, does it matter that the CLECs die?

Won't cable, which currently has more broadband subscribers than DSL provide enough competition?

Based on some of his published statements, I assume that my colleague Tom Hazlett will probably make that argument in a few minutes. But imagine a world in which the only competitors are giant local phone companies and giant cable companies - in essence, a duopoly.

(Don't expect the Bells to compete against each other, even though some of them promised they would when they were merged. Reed Hundt, then chairman of the FCC, in a paper delivered here at AEI in August 1997, said, "If our local telephone companies thought that markets were truly open, it stands to reason that at least one of them somewhere would be going into its neighbor's market. For all intents and purposes, virtually none is doing so." That's still true.)

In such a world, where would innovation come from? In other words, how would we get from duopoly to the competitive equilibrium we all want? In my opinion, that transition is highly unlikely. Once they have used foot-dragging and Tauzin-Dingell to destroy their competitors in local telephony, the Bells will extend their monopoly end to end, into long-distance and Internet services. The inevitable result would be a re-regulation of the entire telecommunications sector, a return to pre-1984 days.

Congress will not sit back and watch the Bells - or a Bell-giant-cable duopoly set prices and determine the extent of service. We already saw in the Commerce Committee a successful amendment to Tauzin-Dingell setting timetables for broadband deployment. That's because members of Congress know that, without regulation, deployment will be driven, not by market forces, but by the monopolist's own timetable. Thus, a federal timetable - and it is only the first of many requirements.

In 1996, Congress, by a huge majority, decided to put the CLECs in business - and for a very good reason. The competition provided by companies like NorthPoint and Covad -- it was expected -- would drive down prices and improve quality. This is just what happened in long distance where prices have fallen 40 percent since 1984 while both consumer prices and local phone service have risen 60 percent.

The Tauzin-Dingell bill betrays these firms. More important, it will establish, perhaps for the next 100 years, an uncertainty principle for any potential competitors of the incumbents. The Bells fully understand the power of uncertainty in a business like telecommunications, which requires huge, irreversible investment. By injecting uncertainty - through lawsuits, lobbying and, now, the Tauzin-Dingell bill - the Bells have deterred investors from committing more capital to the CLECs. It was a brilliant strategy.

In fact, if there is one point that emerges above all others from our study it is the power of uncertainty. As Reed Hundt put it: "Investors no longer know the direction of policy. They no longer know what to bet on, so they are taking money off the table." Like Tom and (I think) Harold, I would characterize myself mainly as a libertarian. But libertarians understand the importance, in Richard Epstein's phrase, of "simple rules for a complex world." The rules under the 1996 act may not have been as simple as some of us would like liked, but they were as simple as they could be. But they were rules, and investors committed tens of billions of dollars, smart people left big companies to start small ones, huge risks were taken, relying on their immutability.

I will admit a prejudice: When it comes to innovation, I have a preference for small, nimble, feisty companies over large firms that have spent a century as regulated monopolies. It was MCI and Sprint that blasted open the long-distance market; but it would not have happened if the court had not structurally separated the Bell System in 1984 and ordered the leasing of long-distance lines by AT&T at discounts of up to 55 percent.

Now, prices: I know that many people here do not like policies that rely on governments or courts setting prices, but sometimes such steps are necessary. The foundation of the 1996 Act was reasonable wholesale pricing by the Bells. Except in isolated cases - and New York, at last, is a good example of how this system can work - we have not seen wholesale prices at anywhere near the level where effective competition can take place.

Discounts offered by the Bells to their competitors are about 10 percent for local residential service. In Massachusetts, the average basic local rate for consumers is slightly less than $20, yet the average wholesale rate is $28! The first step in any serious effort to make the Telecommunications Act work is to get wholesale prices where they ought to be.

That is why competition thrived in long distance after the 1984 divestiture. Another reason was that the equal-access rules were enforced.

"Is the Telecommunications Act of 1996 Broken?" asked an AEI study based on papers written, believe it or not, in 1997. There was a wide variety of views, just as in this room today, but it seemed to me, anyway, the sensible position at the time was: It hasn't had time to work, and it hasn't really been enforced. That remains true today.

In New York, competition is working, and penetration by Bell competitors is substantial because of decent wholesale prices, a system that allows interconnection and enforcement that slapped a $13 million fine on Verizon when it misplaced 250,000 change orders. New York could be a model.

But I am not certain that enforcement will actually work. If it does not, then very soon, we need to move to the obvious solution: structural separation, the "Break Up the Bells" alternative. Given recent developments, many of us are beginning to believe that this may end up as the only logical answer.

Greg Sidak of AEI described the alternative in 1997. He called it "velvet divorce." The Bells would spin off their operating companies completely and "create a separate entity that will hold all unregulated or non-local exchange carrier activities. Those non-local exchange carriers are then able to buy resale and unbundled elements on the same pricing terms as AT&T, MCI, Sprint and others. Then, those pieces of the former local exchange carriers immediately enter the interLATA market. The local exchange operations remain as some highly regulated activity that cannot get engaged in other lines of business."

This seems to me an elegant solution if the Act does not work. There is a strong argument to be made that the "last mile" wire from your house is just as much yours as it is the Bells, or maybe it is a public utility. The Bells can continue to own it but as a separate wholesale company that is forced to deal with all retailers - including its own retail arm -- on the same basis. Or maybe they shouldn't own it. It doesn't really matter. As Robert Willig, professor of economics at Princeton, who responded affirmatively to Sidak's velvet divorce alternative put it, "The problem of who owns and operates a local loop is solvable, and it would not have to be the government.... I continue to think that such an alternative is very workable." So do I.

What is not workable is an unenforced Telecom Act. And what is even less workable is a Tauzin-Dingell law.

Let me go back to the question I raised at the start:

What is the best public policy for bringing the kind of equilibrium we all want, with innovation, efficiency, low prices for consumers, high quality and wide availability of services?

It is not a policy of trust the monopolist.

In a new paper that we will release Monday and post on the TCS website, Bill Lehr of MIT and I evaluate the medium-term impact of the sharp decline in CLEC prospects on the U.S. economy. We find that aggregate output is likely to be reduced by 0.5 to 0.7 percentage points, at an annual rate - conservatively by 2006. We also estimate that continued monopolization of local services by the BOCs is likely to cost consumers over $108 billion in lost consumer surplus over the next five years.

Competition is what will bring the equilibrium we all desire.

But you can't have competition without competitors. Non-enforcement of the 1996 Telecommunications Act has wounded competitors deeply. The Tauzin-Dingell bill will kill them off. That is why we need to adopt a policy that will encourage competition - a policy that will, for a short period, require rules and FCC decisions on pricing. But without such policies, we will continue the reign of a powerful regulated monopoly, a situation that hurts consumers and hurts the U.S. economy.

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