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Where the 1996 Telecom Act Went Wrong

By Steven Rosenbush Conventional wisdom maintains that the Bells, the nation's giant local-phone companies, made out like bandits once the Telecommunications Act of 1996 was signed into law. After the change, the seven Bells merged into four big outfits and stymied the upstarts and long-distance telcos that tried to compete with them. Today, most of the upstarts are bankrupt, and the long-distance industry is in a shambles, reflected by the bankruptcy and alleged fraud that have torn WorldCom (WCOEQ) apart.

Yet, a group of legal and economic scholars who gathered in New York Dec. 9 argued that the real problems with the Telecom Act run much deeper than the Bell's alleged failure to comply with it -- and why rivals complain they couldn't gain a toehold in the business. The underlying problem is decades' worth of arcane regulation that preceded the new law, warping the industry's economics and discouraging true competition.

BANKRUPTCY IS BEST NOW. Economist Alfred E. Kahn says he thinks the industry can support competition -- as long as the government doesn't try to force the Bells to sell their services at below-cost rates. "It should not be an excuse to reregulate," he says. "The best thing to do let bankruptcy take its course." He was the keynote speaker at the Dec. 9 symposium sponsored by think tank Manhattan Institute for Policy Research.

It's ironic that bankruptcy may be the most workable policy in the near term for a telecom industry that's currently in disastrous shape. And the debate over what caused the mess continues to rage. "Yes, deregulation was at fault. But it's equally true that past regulations created distortions.... Regulators were determined to maintain a rate structure known for 30 years to be unsustainable," Kahn, 85, says.

Speaking in a wood-paneled, portrait-lined hall in the Harvard Club, Kahn argued that the supposedly free-market Telecom Act caused an awful reaction when it was combined with consumer-protection policies from the monopoly era. A former chairman of the New York Public Service Commission, Kahn has been a major voice in the debate over deregulation of telecom and other industries. He ran the Civil Aeronautics Board during the Carter Administration, where he oversaw deregulation of passenger air travel. He also advised Carter on inflation and served as chairman of Carter's Council on Wage & Price Stability.

TOO-LOW RATES. Kahn points out that lawmakers, after passing the watershed '96 legislation, never eliminated the rules that require the Bells to sell basic phone service to many consumers at below-market rates. That discouraged newcomers from entering the local residential phone market because they couldn't compete with a service that was already priced below-market. The policy problems actually got worse during the last six years, Kahn says, because the government -- in its efforts to remedy the upstarts' inability to compete with the Bells -- forced the Bells to sell basic phone service to rivals at below-market rates.

Under President Bill Clinton, the Federal Communications Commission had required the Bells to establish wholesale local-phone prices based on what their networks would cost if they were constructed anew with modern equipment. And the Bells say they suffered because the pricing system had no mechanism for them to recover the costs they had already incurred to build the networks.

Kahn thinks that if the Bells had been able to recover their sunk costs, they would have cooperated with their rivals in the way electric-power concerns cooperated with competitors after they were allowed to recover their sunk costs.

SLOW CHANGE. Ultimately, the Bells were required to sell rivals local-phone service at deep discounts, as much as 50% below the retail rate. But those discounts came too late for many of the upstarts, which either failed or are now struggling to emerge from bankruptcy. "Nothing is more abominable before my eyes," Kahn says. "The telecom act was supposed to encourage people to invest in their own facilities, but they're never going to do that as long as we have that stupid [system of] pricing."

It's unlikely the rules will change anytime soon. The Bells have argued that the pricing system is hurting them, and CEO Ed Whitacre of SBC (SBC) has even suggested that the rules could bankrupt his outfit. Based on comments by FCC Chairman Michael Powell, who was appointed by President Bush, the agency may be sympathetic to the view that the Bells have been put upon.

Powell is said to be reviewing telecom policy, and changes in the rules could be proposed in February. But few expect him to make dramatic moves, and anything that the FCC does is subject to years of court challenge. In fact, Richard A. Epstein, a professor at the University of Chicago law school, thinks the industry's legal and regulatory morass may thicken.

The Bells already face numerous lawsuits filed by upstart telcos, charging that the Bells failed to implement their responsibilities to open their networks to rivals under the Telecom Act. And the federal courts could soon decide whether customers have class-action status to file lawsuits over alleged damages. Such a decision would clear the way for massive class-actions similar to those filed against asbestos and tobacco companies, and could produce rules even less hospitable to the Bells.

"TOO MUCH TO ASK." Epstein, who has done work for Verizon (VZ), says no one should have ever expected perfect justice from the Bells. "It was too much to ask, given our Hobbesian nature, to expect people to cooperate with people who wanted to clobber them over the head," he says.

He argues that the Telecom Act was probably a mistake and that it would have been better to maintain a more heavily regulated local-phone monopoly, while encouraging the development of alternatives like wireless, cable, and satellite. "If higher concentration is the equilibrium, you should let it happen and deal with the consequences in other ways (such as fines)," says Eli Noam, an economics professor and telecom expert at Columbia University. "Maybe it's the natural inclination of the industry to be...some form of regulated oligopoly."

That's going too far for Kahn, though. While he faults the FCC's implementation of the Telecom Act, he won't go so far as to say it was a mistake. Meanwhile, the market-imposed discipline of bankruptcy is deciding who the winners and losers are in this high-stakes battle. Rosenbush is the telecommunications editor for BusinessWeek in New York

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