TCS Daily

Supply-Side Irony

By Jerry Bowyer - July 11, 2002 12:00 AM

XO communications is seeking bankruptcy protection; Williams is doing the same, as is MacLeod, Ltd. Qwest is in trouble. Adelphia is starting to miss interest payments, and Banc of America Securities has gone on a downgrading binge this week, lowering its ratings for multiple firms in the telecom sector such as Ciena, Cisco Systems, Oni, and Juniper Networks; Lucent Technologies and Nortel Networks also have been downgraded but from higher levels. AT&T stock is off 50% this year, and WorldCom has dropped like a stone around the resignation of its CEO, Bernie Ebbers and a growing accounting scandal. This follows upon a virtual killing field environment for small Competitive Local Exchange Carriers (C-LECs) last year.

The market indices overall are down this year, but no other sector -- with the possible exception of the 9/11 racked airline industry -- has racked up as big a record of losses, bankruptcies and heartbreaking stock declines as telecommunications. Why?

Up until recently some supply-side economists claimed to have the answer. Before we examine that explanation, though, it is useful to reacquaint ourselves with the principles of supply-side economics.

Take a Walk on the Supply Side

Supply siders differ from demand siders in that they stand with the tradition of classical economics, which focuses on the production, that is, supply, of goods. This is in contradistinction to Keynesian economists who focus on the demand for them. Supply-side economists recognize that an economic transaction requires both the supplier of goods and a buyer, or demand, for them. But they go on to say that supply is more crucial. Demand is easy; the trick to a good economy is not in figuring out ways to get people to demand more, because human demand is infinite. The trick to successful economic growth consists in creating an environment in which incentives are provided to produce new goods and services.

Supply siders believe that government policy is best focused on eliminating disincentives toward or disruptions of the processes by which entrepreneurs produce their products. They focus on taxation, monetary policy and regulation. Although the supply-side school is principally associated in the public mind with tax cuts, supply-side economists recognize that monetary and regulatory policy can be every bit as detrimental to the process of wealth creation as high taxes.

So what do supply siders say about our recent economic maladies? Two of them have been rather outspoken about the debacle in telecommunications: Jude Wanniski of Polyconomics and George Gilder of the Gilder Technology Report. They blame deflation. This explanation, up until recently, possessed a certain surface plausibility; there is significant evidence (in the price of gold and other commodities, in bond yields, and in an unusually strong dollar in international currency markets) that the late 1990s demonstrated deflationary tendencies. In fact some supply-side economists, such as Brian Wesbury, successfully used the deflationary signals to accurately forecast last year's recession. Wanniski and Gilder, however, went much further, arguing that a major deflationary cycle was responsible for the horrific declines in telecommunications companies.

They argued that telecommunications companies, as most businesses that are heavily invested in infrastructure, were heavily in debt. Just as it pays to be a debtor in times of inflation, because debtors pay back less valuable dollars than the ones they borrowed, so it hurts to be a debtor in deflationary times, because debtors pay back dollars that are more valuable than the dollars that they borrowed. Another way to look at it is this: In the deflationary cycle, prices (especially of commoditized services such as long distance phone calls or Internet hookup time) go down and revenues go down along with them; debt service and unionized labor costs do not. If deflation is bad enough, that squeeze can suffocate a business to death.

But all this leaves a lot unanswered; lots of businesses, in many sectors, are also in competitive industries and carry a great deal of debt, for instance non-communications oriented utilities, such as electric or natural gas companies. Why have those companies not seen the same level of decline as the telecoms? For that matter why have the regional Bell operating companies, the so-called Baby Bells or R-BOCs, maintained their economic viability and stock valuations with far more vigor than the other firms? Why have the Internet-oriented firms (dot.coms) been decimated utterly despite the fact that they were equity funded and therefore nearly debt free? However, the biggest question of all is this: Why now, after several months of reflation, when we should be seeing recovery, are we in fact witnessing the worst and largest telecommunications bankruptcies yet?

Looking for Love in All the Wrong Places

Maybe these supply-side economists were looking in the wrong place.

Supply-siders focused on those government policies that had potential to disrupt the process of entrepreneurial planning and wealth creation. These are taxes, money and regulation.

Taxes, the typical culprit of supply-side economics could not have been the explanation; tax rates had dropped in the 1997 capital gains tax cuts and the cut in marginal rates was accentuated by a decline in prices that made the effective rate even lower. In addition, marginal tax rates were the same for businesses that were in the Internet and telecommunications sectors as they were for those who were in manufacturing or the service economy. Monetary policy was an easy scapegoat; Gilder had made some very bad market calls in the telecommunications and Internet block, and he also had been an outspoken defender of the regulatory regime that allowed the Baby Bells to monopolize local phone service.

If taxes weren't the cause, and the regulations were largely what you wanted them to be, and yet, the stocks you recommended were falling all around you like hailstones, then, I guess, there must be a monetary problem. However, the monetary problem, if it ever existed, was over and the Gilder stocks were continuing to fall.

Misleading Regulatory Signals

Let's look for a more plausible explanation. The late 1990s did reflect a massive misallocation of capital, not because of misleading monetary signals, but because of misleading regulatory signals. In 1996, Congress passed the Telecommunications Act. It promised that there would be a new wave of competition in the communications field. The telephone grid, which was owned by a series of local monopolies after the breakup of AT&T in 1984, was supposed to become the on and off ramp to the information superhighway. Local telephone companies, which were anxious to get into data services and long distance, were told that the price of admission was opening up to local competition. An entire generation of entrepreneurs was told that they would be given access to the telephone lines that led into the homes of every man and woman.

That generation of entrepreneurs, a great many venture capitalists and some risk tolerant shareholder investors believed what the government told them, and the gold rush began.

But something went wrong: The Baby Bells managed to get the principal decisions pushed down to the state-level regulators where their lobbyists possessed undisputed superiority of influence. The competitors, the C-LECs, were able to persuade the federal government to give them a shot at reaching customers through the local phone grid; but in Harrisburg and Albany and Columbus and Sacramento, the Baby Bells were, until just recently, in charge.

The C-LECs, like the Cuban nationals on the beach of the Bay of Pigs, were promised air cover from the national government, but it never came. They found themselves utterly overwhelmed on the ground. The analogy may seem a bit strained, but the casualty rates are right on.

Supply-Side Irony

These supply-side economists were right about some things; bad monetary policy can send the wrong message to markets. Too much money creates a false impression of prosperity, driving down interest rates and causing over investment. But that's not what happened here, otherwise the effects would have been similar in deflation sensitive industries, and reflation would have solved it.

The telecom meltdown occurred because the federal government sent pro-competitive signals to telecommunications industry, while the states steadfastly defended the monopolies. When the market saw that the states-level regulators would not be going along with the program, the viability of hundreds of businesses suddenly evaporated and the market did the only thing it could do -- it liquidated those businesses and is currently in the process of redeploying those assets in other fields.

Now, as many state regulators - in New York, Michigan, Illinois, Ohio, Indiana and California -- have finally caught on that opening up the local loop would help consumers, federal regulators and the Congress are considering measures that would let the Bells off the hook, keeping the industry in a financial wilderness.

It is ironic that it is supply-side economists who have been slowest to see the tremendous anti-supply effect of the government's schizophrenic regulatory regime.

Jerry Bowyer is the Chairman of Impact Mutual Funds and a radio and television talk show host. You can reach him through his web page:

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