December 12, 2001

 

 

The Honorable Donald L. Evans

U.S. Department of Commerce

14th & Constitution Avenue & E St. NW Washington, DC  20230

 

The Honorable Lawrence Lindsey

The White House

1600 Pennsylvania Avenue, NW

Washington, DC  20500

The Honorable Paul H. O'Neill

U.S. Department of Treasury

1500 Pennsylvania Avenue, NW

Washington, DC  20220

The Honorable R. Glenn Hubbard

The Honorable Randall S. Kroszner

The Honorable Mark B. McClellan

Council of Economic Advisers

The White House

Washington, DC  20502

 

 

Dear Sirs:

 

On December 4th, you received a letter from eight economists offering a policy roadmap that they believe would revitalize the country’s telecommunications sector and the overall economy.  While we agree completely with these goals, we believe that the policy prescriptions proposed in the letter would not accomplish these goals.  We believe that the best way to restore the nation’s telecommunications sector as an engine of technological and economic growth is to continue and strengthen the pro-competitive policies that were adopted overwhelmingly by Congress in the 1996 Telecommunications Act—not to dismantle these policies as proposed by the authors of the December 4th letter.

 

The December 4th letter suggests that the principles of free-market economics dictate the removal of the provisions of the Act that constrain the actions of the existing dominant phone companies.  Like the signatories of the December 4th letter, we believe strongly in relying on open markets to manage the allocation of resources.  Because the Act is intended to promote such free markets, it is a major step toward attainment of efficient advanced local telecommunications services, and should not be undone.

 

The December 4th letter argues:

1.      Growth of the IT sector was crucial to the economic expansion of the late 1990s, and its decline is a key element of the current slowdown.

2.      Current Federal Communications Commission rules create substantial disincentives to needed investment in the telecommunications infrastructure.

3.      Upgrades of the telecommunications infrastructure are important for the IT sector because they will allow it to create and market “next generation” products and services that can only be made available over broadband connections.

4.      The Administration should promote steps to eliminate disincentives to investment by accelerating telecom deregulation as rapidly as possible.

 

Points 1 and 3 are fully supportable:  the investments of all IT firms (and not just the Bells’) both have and will contribute to the sector’s growth.  But, we disagree with point 2 and urge you to reject the interpretation of deregulation offered in point 4.  The balance of this letter explains how the actual cause of the slowdown in investment in the nation’s telecommunications infrastructure differs from that suggested in the December 4th letter, and indicates the appropriate corrective steps.

 

Point 2 asserts that “regulations imposed by the Federal Communications Commission impose substantial disincentives to investment in the telecommunications infrastructure.”  The only economic principle that the letter adduces in support of this assertion is the claim that if a firm is not permitted to capture the full fruit of its investments, it will underinvest.  But the Act does not deprive the Bells of appropriate returns on their investments—rather, it only permits new competitors to enter local telecommunications markets and protects their investments from being fully appropriated by the Bells.  Further, as is well documented in the literature of economics, monopolists do not invest the full amounts required for economic efficiency when they are provided with monopoly returns on their investments.  In particular, a monopolist will resist investing in new technology if its introduction will undercut the value of its existing assets.  Such is exactly the case in broadband telecommunications.  Because the Bells remain monopolists over the last mile facilities that are critical to all local telecommunications services, their embedded copper networks have huge value.  Over the years before the 1996 Act, the Bells kept their network modernization investments low, did not undercut their current services and, thus, kept their profits high.

 

But upon passage of the 1996 Act with its requirement that loops be unbundled, the Bells began to face broadband competition from a host of new competitors—Covad, Northpoint, Rhythms—who invested billions of dollars in the electronic infrastructure that, once added to these loops, allows them to carry broadband services.  The Bells countered these and other competitive pressures in two ways.  The first was to accelerate their own investments in similar electronics, and the second was to resist providing unbundled broadband-capable loops to competitors and to increase effectively the prices they charged for these loops.  This strategy succeeded in thwarting the new competitors.  Freed from the threat of competition, the Bells once again cut their rates of investment in new broadband facilities.

 

 

The unbundling and pricing principles that the December 4th letter opposes are designed to harness the power of competitive markets to create potent incentives to invest in new generations of technology and services.  The local networks of the Bells appear to be natural monopolies in all but the densest areas.  Thus, the Act properly envisages partial facilities-based competition whereby entrants build services using Bell networks together with their own complementary inputs.  The key feature of the Act in this respect is the requirement that the Bells lease unbundled elements to competitors at cost-based rates─which include the profit necessary to compensate the Bells appropriately for their investments.  This allows new competitors to combine their own modern network electronic facilities with only the minimum portions of the Bells’ networks they require in order to offer broadband services to customers–and not be saddled with either unnecessary purchases of extraneous Bell facilities or the payment of excessive lease fees.

 

Although the December 4th letter characterizes these unbundling and pricing regulations as the product of “the previous administration,” they are actually well thought out precepts that are codified in the Act.  Overwhelming majorities from both parties supported the Act.  The FCC that developed the precise wording promulgating these precepts did so unanimously and after careful study.

 

Point 4 of the December 4th letter suggests that, if deregulation of the Bells is accelerated, incentives for telecommunications investment will be enhanced.  Without strict adherence to the pro-competitive precepts of the Act, further deregulation of the Bells will not induce increased investments from the Bells or from their competitors.  This is most obvious in the case of the competitors.  Because of the natural monopoly character of most local loops, unless these facilities can be leased by competitors on the same economic terms as the Bells provide them for their own use, competitors will have lessened incentives to invest in the electronic and other systems that would permit them to offer broadband services to customers.  But neither would further deregulation induce any increments in investment from the Bells.  As both history and economic theory have taught us, deregulating a monopoly without genuine prospects of competition does not induce it to deploy more infrastructure, only to exploit more severely the infrastructure that it has already in place by limiting its use and raising its price.  Furthermore, if, contrary to their business instincts, the Bells really do intend to accelerate their broadband infrastructure deployment should they be deregulated along the lines of H.R. 1542, the Bells would have offered build-out guarantees to secure this accelerated deregulation.  But they have not, and H.R. 1542 imposes no such requirement.

 

That unbundling and competitive pricing promote rather than discourage local telephone infrastructure deployment has been noted worldwide.  On October 29th, the OECD issued a report on The Development of Broadband Access in OECD Countries in which it makes the following observations.  “Initiatives to open the local loop are viewed by most OECD governments as being fundamental to promoting a fast roll out of broadband services. … To date the major criticism of unbundling or line sharing are that such policies allegedly discourage investment in new infrastructure.  No evidence has been forwarded to substantiate such a claim.” (p. 15)  “Policies such as unbundling local loops and line sharing are key regulatory tools available to create the right incentives for new investment in broadband access.  The evidence indicates that opening access networks, and network elements, to competitive forces increases investment and the pace of development.” (p. 4)

 

While the foregoing helps us to understand the forces that have contributed to why both the Bells and new entrants have reduced substantially their investment activities over the last 18 months, it also suggests the solution.  The most important thing that the Administration can do to reinvigorate investment in advanced telecommunications networks and services is to improve Bell compliance with the 1996 Act.  When entrants could rely on strict enforcement of the unbundling and pricing precepts of the Act, they invested hugely in advanced telecommunications infrastructures—and, facing this competitive challenge, so did the Bells.  But as the Bells grew bolder in resisting the Act’s provisions, as regulators slackened their commitment to its enforcement, and as legislative threats to the Act such as H.R. 1542 loomed, competitive investment understandably evaporated.  When this occurred, the Bells also scaled back their own investments in broadband.  In contrast, if the Administration were to send a clear signal that it intends to enforce vigorously the pro-competitive features of the Act, we are confident that renewed competitive investment will occur, and will be met by increased Bell investment.

 

We all agree that it is vital to restart the nation’s information economy.  What we disagree on is the method.  The signers of the December 4th letter rely on the generosity of the Bells to undertake investments when their profit incentives lead them to do the very opposite.  In contrast, we believe that the surest path to a robust and efficient telecommunications infrastructure is reliance on markets that really are competitive.  We urge the Administration to support competition over monopoly in our critical telecommunications markets.


 

We appreciate the opportunity to provide you with our views, and are happy to discuss or clarify any of these important issues.

 

Respectfully,

 

 

William J. Baumol

Professor of Economics

New York University*

Professor of Economics, Emeritus

Princeton University*

 

B. Douglas Bernheim

Professor of Economics

Stanford University*

 

Robert E. Hall

McNeil Joint Professor of Economics and Senior Fellow of the Hoover Institution

Stanford University*

William Lehr

Associate Director,

Research Program on Internet and Telecoms Convergence

Massachusetts Institute of Technology*

 

John W. Mayo

Professor or Economics, Business and Public Policy

McDonough School of Business

Georgetown University*

Janusz A. Ordover

Professor of Economics

New York University*

former Deputy Assistant Attorney General for Economics, Antitrust Division,

U.S. Department of Justice*

 

Frederick R. Warren-Boulton

MICRA, Inc.*

former Deputy Assistant Attorney General for Economics, Antitrust Division,

U.S. Department of Justice*

 

Robert D. Willig

Professor of Economics and Public Affairs

Princeton University*

former Deputy Assistant Attorney General for Economics, Antitrust Division,

U.S. Department of Justice*

 

 

*Affiliations listed for identification purposes only.

 

cc:        Hon. Tom Daschle

            Hon. Trent Lott

            Hon. Dennis Hastert

            Hon. Richard Armey

            Hon. Richard Gephardt

            Hon. Michael Powell

            Hon. Kathleen Abernathy

            Hon. Michael Copps

            Hon. Kevin Martin