I. Introduction

Stunning advances in technology enable us daily to communicate in real time from any location across any distance, whether we wish to talk with a loved one or to transmit reams of data. The software, satellites and fiber optics that make all this possible would be amazing enough for the power they put at our fingertips. That we also enjoy unparalleled choice among various technologies and service providers makes modern telecommunications all the more remarkable.

For all the productivity and convenience made possible by telecom innovations, the industry is mired in a financial crisis that threatens further progress and jeopardizes U.S. competitiveness. The value of publicly traded telecom stocks on the NASDAQ index soared by 446 percent between 1997 and 2000,[2] but those gains are now just a sweet memory for many stockholders. The index has plunged by 80 percent in the past three years, with devastating consequences: a $2 trillion reduction in the value of publicly traded telecom firms, a $1-trillion increase in corporate debt, and the loss of 500,000 jobs.[3]

Myriad factors have conspired to undermine the telecom sector. Flawed public policy certainly ranks as a principal culprit. This report chronicles some costly regulatory missteps, documents the consequent policy failures, and recommends solutions grounded in sound economic principles. Failure to institute reforms will inhibit technological innovation and economic growth, as well as undermine the reliability and security of our communications network.

Michigan is a key state in the reform calculus by virtue of its use of technology and its sheer economic muscle. The number of high-speed[4] lines statewide increased eightfold in the past four years, from 81,223 in 1999 to 640,766 today — the ninth largest number in the nation.[5] Moreover, the number of local telephone lines billed by competing service providers is exceeded only by New York.[6]

Yet the degree of broadband penetration in even top ranking states like Michigan still lags those of global frontrunners such as Korea, Hong Kong and Singapore.[7] Policy reforms at the state level would nurture deployment of advanced technologies and positively influence the entire Midwest region. Such leadership is particularly important as the Federal Communications Commission (FCC) devolves key elements of telecom regulatory authority to the states, a move under challenge as unconstitutional.

Ironically, the crux of the current problem — the Telecommunications Act of 1996 — was intended as an instrument of reform to increase competition in local calling services. In a major departure from six decades of federal telecom policy, Congress sought to end the monopoly franchise system in local calling.

Unfortunately, lawmakers overrode basic principles of property rights and opted for central planning by prescribing a tortuous regulatory regime to “manage” competition in local calling. The FCC ultimately issued more than 10,000 pages of do’s and don'ts. This created uncertainty in the industry and unleashed seemingly endless litigation.

In testimony earlier this year before the House Committee on Energy and Commerce, economist Robert Crandall of the Washington, D.C.-based Brookings Institution characterized the 1996 act as “a vast new system of wholesale-price regulation,” adding that the subsequent regulations made the telecom sector “a treacherous environment for investment.” Merrill Lynch analysts, meanwhile, judged the U.S. telecom sector as having “the worst combination of structural, regulatory and other adverse factors of any major market.”

The most problematic aspect of the act was the requirement that incumbent wire line companies such as Verizon, BellSouth, SBC and Qwest allow rivals to use their networks at regulated rates. Such forced access — a regulatory taking of private property — was necessary, Congress reasoned, to allow new entrants to gain market share. Once this business base was established, competitors were expected to construct independent facilities.

The FCC devised a complex formula to set access rates. The rates would be calculated based on the cost of operating and maintaining a hypothetical network built in the future. This hypothetical network would presumably feature the most advanced technologies and operate at optimum efficiency.

Of course, no such network actually exists. And with no market confirmation of these hypothetical network costs, regulators set the access rates artificially low. Because these access rates fail to cover operating costs in many instances, the network owners are effectively subsidizing their rivals.

Anna-Maria Kovacs of Commerce Capital Markets calculates that access rates fall “radically” below actual costs by some 50 percent to 60 percent. J.P. Morgan Securities likewise reports that incumbents lose about 60 percent of line revenue when a competitor woos away a customer, but retain 95 percent of the service costs.

Predictably, network access subsidies have skewed investment incentives. As the findings of this study document, most competitors have not invested in new facilities as Congress intended. Most are simply reselling the network services they obtain at a discount, compliments of regulatory fiat.

In essence, this forced-access regime has done little more than allow new entrants to put their names on existing services and call it competition. It is a policy misstep that has forfeited vast opportunities. Investors dedicated billions of dollars in start-up costs, but competitors have produced little in the way of new technologies or applications that would constitute meaningful competition. Incumbent firms, meanwhile, have been forced to curtail network upgrades and R&D as access subsidies to their competitors erode operating revenues.

Simply put, federal telecom policy and the substantial state regulation it spawned have proved to be a failure. As stated earlier this year by securities analysts with Fulcrum Global Partners LLC: “The fact that we are no closer to a deregulated market than we were in 1995 speaks volumes for how ineffective the law was in the first place. The incremental social burden that the Telecom Act of 1996 has placed upon the industry, consumers and the country overall cannot begin to be measured.”

It is instructive to note that the most rapidly expanding sectors of the telecom industry — wireless and cable telephony — are also the least regulated. This is more than coincidence. As history has repeatedly shown, technological progress thrives in the absence of centralized authority. Both alternatives represent significant competitive challenges to major wire line carriers — without subsidies or onerous regulation.

As the Fulcrum analysts noted: “It should be clear by now to all, that cable telephony, wireless substitution as well as broadband overlay devices represent the most realistic proposition for long-term competition.”

There will continue to be special interests that insist on government control of the wire line market. But this study provides ample evidence that the current regulatory framework — obsolete, ineffective and wasteful — is in need of reform.