Regulators' Revenge

(Cato Institute, Tom W. Bell & Solveig Singleton, eds., 1998)

Note: This HTML text comes from a file that was to constitute the text of the final, print version. The two texts ought therefore to conform, though I have not double-checked their consistency. Notation such as "[p.1/p.2]" indicates the print version's pagination. Print version (C) 1998 Tom W. Bell & Cato Institute; reproduced here with permission. HTML derivative work (C) 1998 Tom W. Bell. All rights reserved.


1. Introduction

Tom W. Bell and Solveig Singleton

Great Expectations

President Bill Clinton signed the Telecommunications Act of 1996 into law on February 8, 1996. The act is now over two years old. By most accounts, the 111-page act has proven something of a disappointment.

Consider some of the inspiring claims made about the act at the time of its birth, in early 1996: President Clinton, at the lavish signing ceremony for the act, said. "Today with the stroke of a pen our laws will catch up with our future. We will help to create an open marketplace where competition and innovation can move as quick as light."[1] Vice President Al Gore rhapsodized that the act charted "a new flight path to an entirely new world, a world in which we use technology to put us more directly in contact with each other, a world in which our ability to create and receive information will be limited not by the bounds of our technologies but only by the infinite boundaries of our imagination."[2] Such claims about the 1996 Telecom Act now sound a bit like Eisenhower-era predictions that atomic power would soon cost too little to meter and that we would commute via jetpacks. At the act's signing, Reed Hundt, chairman of the Federal Communications Commission, greeted it with a more revealing sort of enthusiasm: "The bill vests serious responsibilities in the FCC to make competition a reality in as many markets as possible. . . . The workload the bill will generate will require a significant commitment of Commission personnel and will stretch our limit."[3]

Not everyone held a rosy view of the 1996 act. An editorial in the Wall Street Journal opined that "the stuff of hopeful press releases "would not become reality for several years. The editorialists added that "the more immediate impact of the legislation will be more prosaic: It will spawn a lobbying frenzy at the doors of the FCC."[4] In retrospect, the Wall Street Journal seems to have gotten it right. [p.1/p.2] One commentator claims that consumer dissatisfaction with the act made it an "albatross" around the neck of former South Dakota senator Larry Pressler, effectively forcing him out of office.[5]

Perhaps competition, deregulation, and the expected benefits for consumers are coming, albeit more slowly than originally predicted. Telecommunications regulations have grown so incredibly complex over the last several decades that we can hardly expect overnight deregulation. What, then, can we reasonably demand of telecommunications reform?

First, going backward or sideways will certainly not do; markets should always move toward greater freedom. The elaborate universal service mechanisms established by the act contradict that goal. Some of the contributors to this book attribute a similar flaw to the act's interconnection provisions. Second, we should see some light at the end of the regulatory tunnel--however distant. Spectrum privatization would offer a critical first step. So would true deregulation of pricing at all levels--local residential service, access charges, everything. Third, serious regulatory reform must include long-term plans for closing down the FCC and returning most or all of its functions to the states or to the private sector.

By those standards, the Telecommunications Act of 1996 falls short of adequate deregulation. A review of funding and staffing trends at the FCC (Table 1.1) adds a quantifiable edge to this sharp assessment of the act: [p.2/p.3]

Table 1.1
FCC Funding and Staff,1995-99

Fiscal Year Funding Personnel
1995 $184,232,000 2,130
1996 $185,709,000 2,060
1997 $189,079,000 2,032
1998 $186,514,000 2,100 (estimated)
1999 $212,977,000 (requested) 2,100 (requested)
Sources: For FY95: Office of Management and Budget, Budget of the United States Government, Fiscal Year 1996--Appendix (Washington: Government Printing Office, 1994), p. 975 (budget); Budget of the United States Government, 1997--Appendix, p. 978 (full-time equivalent personnel). For FY96: Federal Communications Commission, 62nd Annual Report, FY 1996 (FCC: Washington, 1997), p. 18 (funding); Budget of the United States Government, Fiscal Year 1998--Appendix, p. 1039 (full-time equivalent personnel). For FY97: Budget of the United States Government, Fiscal Year 1998--Appendix, p. 1038 (budget); Budget of the United States Government, Fiscal Year 1999--Appendix, p. 1074 (full-time equivalent personnel). For FY98: Budget of the United States Government, Fiscal Year 1999--Appendix, pp. 1073-74. For FY99: Budget of the United States Government, Fiscal Year 1999--Appendix, pp. 1073-74.

Simply put, recent funding and staffing trends do not indicate that the FCC plans to close up shop and let the market blossom.

Or do they? Gigi Sohn of the Media Access Project criticizes the assumption that a growing FCC means that deregulation has stalled. The notion is that the FCC needs to do more now so that it can do less later. Analysts enjoy embracing paradoxes. Perhaps they will fasten their hopes to this one--the alternative is to admit that the act is failing and that the hard-fought battles that created it will have to be fought all over again.

We take a less forgiving view of the act, however. The FCC has not been trimming and cutting. Its regulations, not to mention its budget and staff, keep growing. No sunset of any sort looms for the FCC. Under both Commissioners Reed Hundt and William Kennard, the FCC has not only continued pursuing old missions but eagerly embraced new ones. Consider, for example, its recent ambitious inquiries into children's educational television (resulting in costly new shows that, it turns out, children do not much care to watch), [p.3/p.4] liquor advertising, and, now, free campaign advertising for politicians--a generous offering to the only people capable of threatening the regulatory status quo.

That leaves it up to us to revisit the Telecommunications Act of 1996, to critique it, perhaps even to praise it, but at any rate to fix it. Because proponents of the act described it as "deregulation," both apologists for and critics of the act now mischaracterize its salient flaws as market failures rather than government ones. For example, rising cable rates--a predictable response to loosening price caps that starved the industry of capital--have raised calls for new regulation. Similar misapprehensions lie behind the outcry over recent mergers in the telecommunications industry--mergers that simply reflect the need for capital to compete in global markets and the drive for economies of scale and scope. By deregulating impartially and imperfectly, the act threatens to invite a revenge of the regulators.

The Transition to True Deregulation

The papers in Part I describe alternative general frameworks for free telecommunications markets. The authors focus on pitfalls that regulators should avoid, assess the role of antitrust law, and examine how radical deregulation has proceeded around the world.

In chapter 2, Alfred E. Kahn, the Robert Julius Thorne Professor of Political Economy, Emeritus, Cornell University, describes the circumstances that allowed regulators to deregulate the airline industry quickly and with minimal interference. The airlines had indulged in a binge of acquiring new capacity, just as demand became sluggish because of the 1973-74 recession, so all that was needed was for regulators to get out of the way and watch prices fall. So the first lesson of deregulation, for Kahn, is to be lucky. The second lesson, drawn from his experience with airline and trucking deregulation, is that opening the markets to new entry made little sense unless pricing was also deregulated, and micromanaging the process creates more distortions than it cures.

Telecommunications, Kahn argues, will require somewhat more regulatory intervention because incumbents in local telephone markets control facilities essential to their competitors' success and because rate regulation and universal service obligations continue. [p.4/p.5] So he believes that regulators will have an essential role in telecommunications. On the other hand, the role tempts them to indulge in political opportunism by making rules that will yield a quick crop of live "competitors" regardless of whether those rules handicap competition and heavily subsidize new entrants. The FCC, he concludes, has fallen into the trap in pricing both resale and unbundled network elements.

For Kahn, prices ought to be set as they would be in a market, that is, on the basis of the actual costs of the incumbent companies. That encourages and rewards new entrants who can provide services by building their own lower cost facilities. The FCC's heavily discounted pricing regime eliminates both the incentive and the reward and simply allows the new entrant to buy facilities from the incumbent.

In chapter 3, Peter W. Huber argues for a comprehensive reassessment of the justifications for federal regulation of telecommunications. Huber's powerful statement makes clear that he regards the regulations, enforcement efforts, and very existence of the FCC as constitutionally suspect. Given such a dubious pedigree, it comes as little surprise that the FCC has issued swarms of meddlesome rules that interfere with private conduct and freedom of speech.

Huber calls for abolishing the FCC and relying on common law processes to regulate the rapidly growing world of telecommunications. Huber would have courts apply not only the familiar tenets of contract, tort, and property law to telecommunications disputes, however. He also would have courts interpret and apply the legislation that created antitrust and copyright laws. In either case, it matters most that courts build the law from the bottom up, from general principles to specific rules. Only that sort of flexible and decentralized process, Huber argues, will allow the evolution of the law to match that of telecommunications.

Pablo T. Spiller's and Carlo G. Cardilli's view on the proper role of general antitrust principles in moving toward free telecommunications markets, expressed in chapter 4, contrasts markedly with Huber's. Spiller and Cardilli describe the radical telecommunications reforms that have taken place in Chile, New Zealand, Australia, and Guatemala. They conclude that leaving interconnection disputes to be resolved in the courts under general laws results in delay and burdensome regulation. They favor instead the type of regime chosen by Guatemala, under which interconnection regulation rules [p.5/p.6] are established by a telecommunications regulatory agency that has much less discretion than the FCC has in the United States. Disputes over the terms of interconnection are to be resolved under final-offer arbitration, to discourage companies from using lengthy appeals to regulators and to the courts to beat out the competition, as is often done in the United States.

Spiller and Cardilli draw other lessons from their extensive knowledge of the deregulation process in other countries. In particular, they note that, even with the delays caused by litigation in Chile and New Zealand, facilities-based competition in the local exchange has increased enormously, especially in Chile. That, they note, shows that the local exchange is not, as skeptics claim, a natural monopoly.

They also make clear that other countries have been well aware of the dangers of giving new entrants into the local exchange too generous rights of resale and interconnection. Guatemala, in particular, will try to encourage rapid new entry into telecommunications markets by allowing new entrants to sell unbundled elements of the incumbent's networks--but the unbundling rights will last a limited number of years. The idea is to have the best of both worlds--rapid new entry, but not at the expense of facilities-based competition.

Interconnection and Infrastructure in a Free Market

The papers in Part II assess the interconnection rules established under the Telecommunications Act of 1996--not the acrobatics of pricing calculus performed by the FCC but the general principles underlying the FCC's deliberations.

Tom Tauke, senior vice president for government relations with Bell Atlantic, provides in chapter 5 an overview of the way to proceed toward competition without changes to the Telecommunications Act of 1996. Tauke attributes the perception that the act is a failure partly to impatience and unrealistic expectations. But he also points to the need for rate rebalancing, particularly in the local exchange, as new entrants will shun markets where prices are held low. Tauke also argues that Congress intended interconnection relationships between incumbent phone companies and new entrants to be negotiations and notes that many such negotiations have been concluded successfully. Sometimes, though, negotiations have deteriorated into regulatory posturing. [p.6/p.7]

Tauke concludes by describing four regulatory principles to help move the regulatory regime under the Telecommunications Act of 1996 toward free markets. The third of those is of particular interest; he recommends that regulators keep innovative new services free from the old regulatory apparatus.[6]

Henry Geller of the Markle Foundation expresses in chapter 6 his view that telecommunications reforms in the United Kingdom and Canada "call into question the course of interconnection regulation taken by the United States and militate strongly for a modest course correction at this time."

Both Canada and the United Kingdom have accepted that resale and interconnection are important to new entry into local phone markets. But each country also has recognized that too generous interconnection and resale rights can discourage facilities-based competition. Thus, the United Kingdom has not given new entrants unbundling rights. Canada will mandate unbundling of local loops only for a limited time.

Geller encourages regulators in the United States to recognize that too expansive interconnection policies can deter the build-out of new infrastructure. He views section 706 of the act, which allows the FCC to use forbearance to encourage the deployment of advanced networks, as an opportunity for the FCC to refrain from drawing advanced and innovative services into the interconnection regime.

In chapter 7, Solveig Singleton, director of information studies at the Cato Institute, asks about interconnection in the long run. The current consensus that mandatory interconnection is necessary to promote new entry into the local exchange hides fundamental disagreements about the nature of competition in telephone services. Will it ever be possible to do away with mandatory interconnection entirely?

She next argues that the substantial drawbacks of mandatory interconnection policies suggest an answer to that question. Those drawbacks include the inescapable problems of pricing interconnection "correctly," and the ill will the regime fosters between different sectors of the telephone industry. Because interconnection now and in the future promises thickets of thorny regulation and little free-market fruit, we should begin to consider now how mandatory interconnection rules should be eliminated. She concludes with some suggestions for scaling back the rules. [p.7/p.8]

Peter K. Pitsch of Pitsch Communications argues in chapter 8 that political constraints mean that the only way to deregulate telecommunications is for the public and policymakers actually to see new entry into telephone markets. He supports this by noting the history of deregulation in long-distance telephone markets. And he concludes that the surest road to new entry is unbundling and rate rebalancing.

Pitsch further argues that the prices of the unbundled network elements should be based on forward-looking cost estimates. The estimated costs should be those of the "incumbent local telephone company's network, assuming current wire center locations," rather than the costs of a hypothetical network. He advocates allowing carriers to recover common costs (the overhead costs the incumbent accrues by offering unbundled elements) by charging each subscriber using the incumbent network (either the incumbent's customer or the reseller's) an end user charge. To minimize regulatory interference, he urges that the prices for unbundled network elements be placed under price caps, allowing negotiations to proceed under those caps.

Speculating in Spectrum: The Future of Property Rights

In chapter 9, the first chapter of Part III, Thomas W. Hazlett describes how the Telecommunications Act of 1996 largely sidestepped the hard work of deregulating the wireless sector. Although economists roundly deride the FCC's present methods of allocating rights to the electromagnetic spectrum as inefficient and anti-competitive, reform will not come easily. Hazlett attributes the problem to the very structure of the regulatory system, which legally obligates agency personnel to allocate spectrum in the "public interest," via administrative procedures.

Only fundamental reform will save wireless telecommunications from a regulatory chokehold. Hazlett calls for opening the spectrum to free access and use, subject only to a bar on interference with existing transmissions. He thus criticizes as too restrictive the current practice of auctioning off mere licenses to use certain portions of the spectrum in certain ways. Such auctions not only give the FCC too much control over spectrum allocation; they also encourage lawmakers to artificially restrict spectrum access to inflate receipts. Hazlett recounts how politics has likewise corrupted regulation of [p. 8/p.9] the broadcast industry. Real deregulation of wireless telecommunications, he concludes, must cut Washington out of the loop and treat spectrum like any other resource developed, sold, and used in the free market.

In chapter 10, Stanley S. Hubbard gives a lively first-hand account of his family's struggle to develop the broadcast spectrum. Their pioneering efforts amply demonstrate that spectrum has no value in the abstract. Broadcast television, for instance, at first met widespread skepticism and indifference. It took entrepreneurs like the Hubbard family to risk their fortunes, devote their labors, and make broadcast television what it is today: a hugely successful industry and a staple of American culture. A similar combination of public doubt and private vision has driven Hubbard's development of the direct broadcast satellite spectrum.

Hubbard argues from practical experience that settlers on the frontier of the electromagnetic spectrum deserve property rights no less than settlers on America's terrestrial frontiers did. In each case, assuming the risks and burdens of developing an unused territory should suffice to win good title to it. Spectrum developers have an even stronger case for homesteading rights, in fact, since they neither displace natives nor upset ecosystems. Rather, they turn something that has no intrinsic value into services citizens can hardly imagine living without.

In chapter 11, Evan R. Kwerel and John R. Williams offer a comprehensive overview of how to implement a market-based spectrum policy. They call for the FCC to license spectrum to specific parties in perpetuity and then get out of the way, leaving the licensees free to use spectrum in any noninterfering manner or reassign it, in whole or part, to third parties. Kwerel and Williams counsel the government not to reserve spectrum, reasoning that private parties will buy up and set aside spectrum if doing so makes economic sense. The authors would moreover apply their market-based reforms to nearly every bit of spectrum, across all frequencies and geographic locations.

Kwerel and Williams describe several steps that the FCC has already taken toward a market-based spectrum policy (as well as a few missteps away from it). Do market failures stand in the way of further reforms? The authors examine the question and generally find the risks of market failure inconsequential, less worrisome than the risks of government failure, or subject to relatively easy remedies. [p.9/p.10]

Eli M. Noam argues in chapter 12 for a paradigm shift in how we think about deregulating spectrum allocation. Whereas the current policy debate pits a regulatory assignment model against an auction model, Noam argues for an "open access" model in which those who need spectrum buy access to it piecemeal, rather than buying exclusive licenses to entire spectrum bands. He likens this system to a toll road that sells access on a per vehicle basis and controls congestion by moderating prices.

Noam defends open access as more constitutionally sound than systems that exclusively license access to the wireless media. While he recognizes auctions as an improvement over regulatory assignment of spectrum, Noam argues that auctions inevitably put revenue receipts before considerations of economic efficiency and freedom of speech. He describes some historical precedents for the open access alternative, outlines the main features of a modern implementation, and advocates that we begin experimenting with that promising new approach to deregulating the spectrum.

Information Have-Nots and Industrial Policy

Part IV begins with Gigi B. Sohn, director of the Media Access Project, arguing in chapter 13 that government involvement in the form of universal service subsidies can make markets work better and therefore help free markets to succeed. Sohn claims that the main item of expense for schools, libraries, and other groups that need more access to telecommunications is not hardware but service.

Sohn argues that government involvement is necessary to support access to telecommunications services because of the cost structure of telecommunications markets. The market will provide service only where there is profit to be made; the costs structure of telecommunications markets makes it unlikely that markets will provide universal service without government help. She adds, "I agree strongly with libertarians that subsidies must not be hidden. If government is going to give out money, it should be subject to public disclosure, not buried." She concludes, however, that universal service subsidies do make us all better off, even though there is some misallocation.

Lawrence Gasman, a senior fellow at the Cato Institute and president of Communications Industry Researchers, in chapter 14 strongly disputes the justifications offered for universal service subsidies. [p.10/p.11] He describes the interest-group politics behind the spread of support for universal service, and he shows how the FCC failed to check that political dynamic by declining to place any limiting principles on the growth of universal service.

Gasman then refutes traditional justifications for universal service. First, he notes the high penetration figures for advanced telecommunications technologies in low-income households, suggesting that even low-income families can afford telecommunications services by careful budgeting. Gasman then attacks the "network externality" justification for universal service and the peculiar idea that urban and rural users should get the same phone service for the same price while in other respects urban and rural areas differ markedly.

Gasman offers an alternative to government universal service subsidies: freeing markets to spur innovation and competition. If entrepreneurs are freed to pursue profits, they will innovate to find new ways of lowering costs and serving underserved markets, for example, those in rural areas.

In our final chapter, 15, Bill Frezza of Adams Capital Management describes the conflict between innovation and universal service. The 1996 act's universal service regime creates a massive network of more or less hidden taxes, inefficient pricing, and complicated distribution mechanisms. Yet policymakers agree that the Internet and other advanced technologies should remain unregulated. Frezza predicts that the natural result of that will be a flow of capital and innovation to unregulated technologies.

Thus, for Frezza, innovation will always conflict with any attempts to establish a fixed regulatory structure for universal service. But the spirit of the process will remain the same: "an armed and surly mob of rural homeowners, underpaid librarians, and teachers' union shop stewards prepared to knock you over the head and yank a buck out of your wallet every time they want to make a phone call."


What lessons can we draw from this collection of papers? The contrasting views of Huber and Spiller present a fork in the road to telecommunications deregulation. We could proceed toward free markets under general antitrust rules and the common law, leaving courts to resolve interconnection and other complicated issues. Huber suggests that sort of path, which New Zealand and Chile [p.11/p.12] have actually taken. Or we could follow Spiller's model of allowing competition to grow under a regulatory agency that has much less discretion that the FCC, the sort of path that Guatemala chose. Even Spiller's data suggest, however, that despite their reliance on relatively slow judicial processes, New Zealand and Chile eventually developed vigorously competitive telecommunications markets.

Both Huber's and Spiller's models thus deserve serious consideration. Each model requires far less regulation than the FCC currently administers. Each likewise counts on a legislature more committed to free markets and radical reform than Congress can boast of being. Lacking those prerequisites to real deregulation, the United States continues to wallow in outmoded regulatory models. Meanwhile, more innovative countries blaze new paths to free telecommunications markets.

From the interconnection panel, we garner more clues about how to deregulate telecommunications. Interconnection remains a stubborn problem--an assessment that Kahn underscores with illustrations from airline and trucking deregulation. Pitsch strongly argues that deregulation will follow only after new entry and rate rebalancing. But does luring new entrants require interconnection terms as favorable as those offered under the FCC's current scheme? Examples from Britain and Canada suggest not; facilities-based entry still merits encouragement. In the long run (say, 10 years), however, we must decide whether we want mandatory interconnection indefinitely. Answering yes will cast us into a losing battle of price regulation, manipulation of the regulatory process, extraordinary ill will between competitors, and--worst of all--the prospect of entire networks and systems of switches designed in response to regulation, either to support it or to subvert it. We should thus say no to long-term mandatory interconnection.

The spectrum panel thoroughly discredits the notion that the FCC should parcel out tightly limited rights to the spectrum on the basis of vague public interest standards. That consensus should come as no surprise, since most economists and many policy analysts have come to hold similar views. Somewhat remarkably, however, the panelists also roundly criticize spectrum auctions--the reigning fad in telecommunications deregulation--as too timid. Hazlett and Kwerel and Williams call for the FCC to put spectrum on the market and then step out of the way. Hubbard asks why those who develop [p.12/p.13] unused spectrum should not win good title to it, while Noam asks whether we could do without licensing exclusive rights to whole bands of spectrum. Taken together, these approaches to deregulating spectrum allocation would give more play to market forces, show greater respect for common law property, tort, and contract principles, and decrease political control of the wireless media.

The universal service panel presents a conflict between Sohn's vision of what subsidies aim to accomplish and the political and market realities described by Gasman and Frezza. Gasman's arguments cut to the heart of the justifications for universal service. Subsidies have garnered support for political, not logical or economic, reasons. The universal service emperor wears no clothing. Its primary economic justification (the network externality) falls apart on close scrutiny. Because telecommunications markets do not have immutable cost structures, the best answer to the problems of high-cost areas and services is to let innovation proceed. Competition is the consumer's best friend, and price averaging and subsidies are the enemies of effective competition.


1. White House, Office of the Press Secretary, "Remarks by President Bill Clinton and Vice President Al Gore at Signing of Telecommunications Reform Act of 1996, February 9, 1996."

2. Ibid.

3. "Statement by FCC Chairman Reed E. Hundt Regarding Passage of the Telecommunications Act of 1996, February 8, 1996," available at .

4. "Mr. Bell's Legacy," editorial, Wall Street Journal, February 7, 1996, p. A14.

5. Kirk Victor, "Call Waiting," National Journal, January 31, 1998, p. 234.

6. See Lawrence Gasman and Solveig Bernstein, "A 'Firewall' to Protect Telecom," Wall Street Journal, March 27, 1997.[p. 13/p.14]

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"Introduction," REGULATORS' REVENGE - - v. 07/99