The Great Telecom Implosion


It's not just individual companies that are going bankrupt. The industry as a whole has gone from market reform to market ruin.

By Paul Starr
The American Prospect, September 8, 2002

The dimensions of the collapse in the telecommunications industry during the past two years have been staggering. Half a million people have lost their jobs. In that time, the Dow Jones communication technology index has dropped 86 percent; the wireless communications index, 89 percent. These are declines in value worthy of comparison to the great crash of 1929. Out of the $7 trillion decline in the stock market since its peak, about $2 trillion have disappeared in the capitalization of telecom companies. Twenty-three telecom companies have gone bankrupt in a wave capped off by the July 21 collapse of WorldCom, the single largest bankruptcy in American history.

And the storm is not over. Many other firms, including some of the biggest, are teetering under a heavy load of debt. Altogether, the industry owes a trillion dollars, "much of which will never be repaid and will have to be written off by investors," Federal Communications Commission Chairman Michael Powell told the Senate Commerce Committee on July 30.

To be sure, some of the vanished stock-market wealth consists of -- quaint expression -- "paper" profits. But a trillion here, a trillion there and soon you're talking about real money. Long-term growth depends on capital flowing to productive purposes; when it is dissipated in such vast quantities, the costs affect the economy as a whole -- not just those unlucky enough to see their investments and jobs vanish.

Almost as staggering as the economic losses, however, is the general unwillingness to acknowledge that something has gone wrong with the policies adopted in recent years to reform telecommunications. "There has yet to be a serious acceptance of the idea that recent events compel us to do anything different," says Andrew Schwartzman, director of the Media Access Group, a public-interest law firm.

For many of the parties involved, the possibility that reform was based on false and unrealistic premises is simply inadmissible. Ideological investments are sometimes even harder to write off than financial ones. In addition, the telecom crisis overlaps with the recent spate of corporate scandals, and most of the attention has fallen on criminal misconduct. The stories about accounting fraud and insider deals at WorldCom, Global Crossing and Adelphia may suggest that if only their executives were more ethical, things would be fine.

But the scandals are just one expression of the general crisis affecting telecom companies no matter how ethically managed. That crisis did not happen all by itself. Reforms adopted during the 1990s were supposed to create a deregulated telecom industry with large numbers of firms generating entrepreneurial innovations and economic growth. A new consensus held that an industry once thought to be a natural monopoly would actually flourish under competition. The policy has had some successes. But now that the industry is imploding, it is time to re-examine the original vision and ask whether there is a better guide to the future.

How Boom Turned to Bust

The great conceit of the 1990s was that previous experience counted for nothing: "The Internet changes everything." All the old rules needed to be torn up. But history has a way of taking revenge on those who think the past is irrelevant.

When it first broke into public view, the Internet seemed like an economic as well as a technological miracle. As consumers, Americans came to expect that the information and services they found online would be free, while as investors they believed that the Net would generate billions of dollars in profits. A miracle is exactly what it would have taken to realize both those expectations.

Right after the Internet changed everything, the dot-com boom collapsed in the classic pattern of a stock-market bubble, and many of those who had explained to old-timers why companies with no earnings could be worth billions were shocked to discover that the old rules still applied.

Although the Internet mania helped to set it off, the telecom boom differed in several ways. First, compared with fizzy dot-coms, telecom companies seemed to be developing tangible assets that had to be valuable in the information age: fiber-optic networks, routers and other telecom equipment, satellites, wireless systems, and upgraded telephone and cable TV networks capable of providing high-speed Internet connections.

Second, the telecom industry was not only well-established but had long been the very embodiment of stability and guaranteed returns. Even after the breakup of the Bell system in 1984, AT&T and the regional Bell operating companies (the "Baby Bells") had remained bulwarks of the economy.

Third -- and this was the key distinction between the dot-com and telecom booms -- governments all over the world, led by the United States, were opening up their telecom markets to competition. Public policy was inviting new entrants to jump in. Competition meant that returns were no longer guaranteed, but the simultaneous rise of the Internet and advent of deregulation created an unprecedented opportunity to make money -- and, as many discovered, to lose it.

After congress passed the telecommunications Act of 1996, capital flooded into telecom, as existing firms and new ones began building networks over land, undersea and in the air. "Business plans all looked alike," one industry insider recalls. "Massively parallel systems were being built up."

By 2000, however, companies began to realize that there simply wasn't enough business to go around, and they raced "to gain market share" in a burst of "hypercompetition" and "vicious price wars" that drove down revenues, as Powell explained it in his July 30 testimony.

Around this time, some executives started to engage in the practices that have since led them to contemplate long prison terms instead of the "long boom" predicted for the New Economy. To inflate their profits, some counted operating expenses as capital investment. Or two companies with excess capacity would sell each other the right to use a share of each other's networks. In such a swap, for example, each firm might book $150 million in revenue from the transaction when, in fact, there was no real revenue at all. Not only did such a swap allow each firm to deceive investors about its business, it also created the impression that the industry as a whole was $300 million larger than it actually was.

But such gimmicks couldn't sustain the illusion of growth and profitability indefinitely. While telecom firms were expanding, they had taken on enormous amounts of debt; one firm after another began having difficulty repaying these obligations and went into bankruptcy. Today, throughout the industry, demands have failed to match expectations, businesses are losing money, stocks have plummeted and a radical consolidation is in the offing.

Repeating the Past

None of this ought to have been surprising. The collapse of competing networks is a familiar pattern in the history of telecommunications -- or at least it was before the industry became subject to regulation.

The telegraph emerged as a highly competitive industry after Samuel F.B. Morse first successfully demonstrated the technology on a federally financed line between Washington and Baltimore in 1844. As of 1851, there were more than 50 different telegraph companies, often competing along the same high-traffic commercial routes. Most of these firms failed, however, and were consolidated into larger systems until one of the emerging giants, Western Union Telegraph, took over its last two major rivals and, in 1866, became the first nationwide monopoly in the United States.

Competing networks were also a transitional phase in the early history of the telephone. For roughly two decades after the 1893–1894 expiration of Alexander Graham Bell's original patents, there was intense rivalry among competing telephone companies. By 1904, 60 percent of American cities with more than 5,000 people had two phone networks -- a Bell system and an independent one -- that did not connect with each other. As in the early years of the telegraph, competition in the United States resulted in more rapid deployment of the technology than was the case in Europe at the time, where state-run or state-licensed monopolies prevailed.

But telephone competition proved unsustainable. Around 1907, AT&T began to consolidate control and to signal its willingness to accept state regulation. After an antitrust settlement in 1913, which limited AT&T's ability to take over independent phone systems and forced it to give up a controlling share of Western Union it had recently acquired, the industry evolved into a highly stable, regulated monopoly. The antitrust limits on AT&T's growth strategies had the indirect effect, moreover, of directing it toward investments in technology that could help cut its costs and expand its services, and for the next half-century, through its support of Bell Laboratories, AT&T became the undisputed leader in telecom innovation worldwide.

Competition collapsed in telegraph and telephone service for fundamental economic reasons. To provide any service at all, telecom networks have high fixed costs, but the marginal costs of serving an additional customer are relatively low. As a result, economies of scale and scope are enormous, and rival networks typically race to get big fast to enjoy those economies. Furthermore, the output tends to be a "commodity" -- a relatively undifferentiated product -- and thus customers choose among alternatives primarily on the basis of price. If such an industry is genuinely competitive, the pressures to cut prices to gain market share are overwhelming, and the losers in that process typically go bankrupt or get acquired unless they occupy a specialized niche.

According to fcc Chairman Powell, the "hypercompetition" and "vicious price wars" that precipitated today's bust stemmed from the exaggerated forecasts of demand from the "Internet gold rush." But far from being historically abnormal, what happened is the standard pattern. The real trouble is the inability of enthusiasts for deregulation to recognize its limits in communication networks. Competition within the same mode of communication ("intramodal competition") may have a transitional function during technological upheavals, but it is unlikely to be sustained full-throttle over the long run. Consolidation is inevitable; the only question is under what rules.

Deregulation's Early Returns

Although the passage of the 1996 telecom act was the landmark event in telecom deregulation, the process began earlier. During the 1970s, a growing conviction that the scope of AT&T's monopoly had become more of a hindrance than a stimulus to innovation led to a new antitrust case against the company. The resulting settlement produced the Bell breakup in 1984, the artificial division of the industry between local and long-distance calling, and the opening of the long-distance market to full competition.

In the early 1990s, Congress adopted two other, less heralded measures that also pointed in the same direction. One of these opened cable television to competition from direct-broadcasting satellite TV; the other authorized the fcc to conduct auctions of spectrum for additional cellular-telephone services.

As of the mid-1990s, these policies seemed to be working. In the wake of the AT&T breakup, hundreds of long-distance companies had sprung up and rates were falling (as they had been beforehand). Most important, the loosening of AT&T's grip had permitted the emergence of a variety of new services and firms (including Internet service providers) that the old Ma Bell might have obstructed. Cellular service, after considerable delay compared with its growth in Europe, was also finally becoming cheaper and more widely available. Popular anger about cable-TV rates had led Congress to reimpose regulation in 1992 (previously abandoned during the Reagan era), but satellite companies offered the possibility of a competitive alternative.

By 1996, the idea of extending telecom competition enjoyed support from both major parties. Presumably, if competition worked in long-distance, it could work in the "local loop." Local and long-distance companies could be allowed into one another's markets to increase competition and consumer choice. Cable could be given the right to compete with the telephone companies and vice versa. Competition was fine with consumer groups if there were lots of alternatives.

The only real debate in Congress was between those who wanted to end regulation immediately (mainly Republicans) and those who wanted a new, transitional form of regulation to ensure that the existing local phone monopolies opened themselves to competition (mainly Democrats). Different sectors of the industry lined up with the parties according to their particular interests.

The legislation passed in 1996 was a political compromise that gave the major interest groups what they wanted. In a notorious giveaway, Congress handed broadcast owners additional spectrum worth billions of dollars, ostensibly to introduce high-definition television, though no one expected it to be used that way. The legislation also deregulated cable-TV rates on the assumption that satellite TV would restrain cable prices, but without requiring any proof that such competition was working. The local phone companies, however, received the right to enter the long-distance market only when they were certified as having opened up local phone service to competitors. This provision -- along with a telephone surcharge to support Internet access for schools and libraries -- was the Democrats' main victory in a Congress dominated by Newt Gingrich and Bob Dole.

From Reform to Ruin

The interest groups that eagerly sought the Telecommunications Act of 1996 might have remembered the saying, "Be careful what you wish for." In place of the old regulatory regime, which had ensured that no one in telecom went broke, investors and firms in the industry celebrated the arrival of a system in which many of them would go broke. Ordinarily, business interests do not invite their own bankruptcy, though perhaps there was a masochistic streak in the telecom industry that no one detected at the time. Like the Internet enthusiasts, some information-age gurus were saying that communication would cost practically nothing in the future, and telecom companies could make huge profits by achieving that result. It was an intoxicating idea; there seems to be no other explanation for why so many people believed it.

Looking back on the 1996 act, some of its progressive critics argue that even though the industry may now be a wreck, the promise of competition has been unfulfilled. They point out that satellite TV has not restrained increases in cable rates, telephone companies are not competing with cable in the delivery of video, and cable systems have not gone into traditional voice telephone services to any great extent.

The biggest early disappointment was the fate of the "raiders of the local loop," as Reed Hundt, Bill Clinton's first fcc chairman, called the new companies founded to compete in local telephone service. Deciding to fight rather than open their switches, some of the Baby Bells used litigation to delay the entry of new competitors, and in 2001 such "raiders" as Covad, Focal Communications, McLeod, Northpoint and Winstar went bankrupt in one of the first signs of telecom's troubles. Nonetheless, that was not the end of local-phone competition. As the Baby Bells, particularly Verizon, have finally opened their networks in order to get approval to go into long distance, AT&T and other companies (including some emerging from bankruptcy) have taken about 10 percent of the nation's local telephone business.

The early delays and continuing disappointments should not obscure the big picture: Competition in telecom has become a powerful force, with both positive and destabilizing effects. As in the early stages of telegraph and telephone development, competition has accelerated the deployment of new networks and the introduction of new services, but it is also driving the industry's implosion.

The great benefit of competition has been a rapid rollout of new technology. Companies in the long-haul fiber-optic, cable-TV, satellite, local-telephone, wireless and other sectors of the industry have undertaken massive capital expenditures to develop and upgrade networks. As a result, cable companies (through cable modems) and telephone companies (through digital subscriber lines, or dsl) are both offering high-speed digital access to their subscribers in most areas of the country. Cable systems are now also beginning to offer video-on-demand, delivering a specific program in response to a viewer request, a system that may substantially replace broadcast programming. Thanks to huge investments in spectrum and technology, wireless service has dramatically improved and charges have fallen.

The level of investment in networks makes sense only in light of the threats and opportunities posed by competition. This is the case even for cable, typically a monopoly in each community it serves. Satellite TV may not be restraining cable rates because its primary market has been in rural and semirural areas where cable systems are weak. Nonetheless, in eight years, satellite has taken nearly 20 percent of the video market, and it faces no incremental capital cost in extending its signal into urban areas. Cable-TV systems have maintained their edge over satellite, but only because they have invested about $60 billion during the past five years in order to offer cable modems and other service upgrades.

Build and Burn

The flip side of the story is that what has led to network expansion has also led to huge overcapacity. Many companies have built networks and burned cash. Fiber-optic networks costing billions of dollars remain unused because there is no prospective demand for them, and the companies that built them are broke. And partly because much of this investment was vendor-financed -- that is, capital came from manufacturers such as Lucent, Nortel, Motorola, Alcatel and Cisco, which were anxious to sell their products -- the collapse has extended to the equipment sector.

Some conservatives say excessive regulation is responsible for the condition of the industry. Supposedly, high-speed Internet access (broadband) has been slow to develop because of requirements on the Baby Bells to share their network with competitors. This argument simply doesn't compute. About 80 percent of households now have the option of obtaining broadband either through cable modems or dsl, but only 10 percent of households subscribe to one of them. While broadband has grown, it just hasn't grown as fast as forecasted. The constraint was originally supply; now it's demand. Not only are most consumers passing up offers, but when they do buy, they often drop service soon afterward. Speedy downloads aren't enough to get most consumers excited; it will probably take some combination of new functions and lower prices to persuade the majority of people to pay for broadband.

One sector after another in the industry has made capital investments that they have yet to recoup. Satellite TV still has not turned a profit. Even the cable industry, staggering beneath the burden of its capital expenditures, has been losing money for years -- an extraordinary record for a monopolist. Fortune magazine puts last year's drop in the market's valuation of the cable industry at 68 percent. Wireless companies, despite rapid growth in customers, will run through $10 billion in cash this year, according to a report by Morgan Stanley. Investors have been giving up: The 89 percent decline in the Dow Jones wireless communications index for the two years ending Aug. 7 is particularly shocking for an industry that now has more than 100 million subscribers and should be harvesting the fruits of its growth.

The more traditional telephone companies are also far from the picture of health. The entire long-distance business is in deep trouble. People are substituting e-mail, instant messaging and wireless for conventional long-distance calls at a time when there is a glut of long-distance capacity. Declining long-distance revenue was a principal factor in the bankruptcy of WorldCom, which owns mci. Many in the industry are convinced that the long-distance companies -- including AT&T -- cannot survive as separate businesses and will be absorbed by other firms, most likely by the Baby Bells. Not so long ago, AT&T and Lucent (the old Western Electric) were the core of the American telephone industry; both may be gone in a few years.

The Baby Bells face serious difficulties too. Last year, the total number of local phone lines dropped by 9 million, or 4.7 percent, the first decline registered since the Great Depression. The recession was only partly responsible. Two million households discontinued second phone lines after getting cable modems or dsl, about 600,000 subscribers switched to telephone service offered by their cable companies, and another 3 million decided that a cell phone was enough and that they could do without conventional service. This last development has ominous implications for the Bells' future because young people are the ones most inclined to go wireless. Though they have a strong presence in wireless, the Bells own a smaller share of it than of the wired business, and they lose revenue if customers give up conventional service altogether.

Other threats to the Bells loom on the horizon. Competitive local exchange carriers are cutting into the Bells' traditional business. Although cable systems have generally been reluctant to get into telephony because of the cost, their interest is increasing as costs decline, and cable telephone service is growing rapidly, though from a small base. One of the obstacles to cable entry has been that subscribers could not take their old telephone numbers with them, but "number portability" is on the way. The Baby Bells' control of customers has been a great commercial advantage, but those relationships are almost certainly going to loosen up.

In the long run -- which may not be as long as many imagine -- conventional phone service (that is, via a circuit-switched network) may not survive. The alternative is a digital, packet-switched system, essentially a voice version of instant messaging with the quality of a telephone call. While Internet telephony still has its drawbacks, services based on "voice over IP" (Internet protocol) are improving. It is already possible for anyone with a broadband connection to obtain unlimited, flat-rate telephone service from a company that offers customers a phone number with any area code they want. The implications of this kind of development have yet to be absorbed. For the old telephone industry -- and for the hundreds of thousands of people who work for it -- voice over IP is the ultimate gale of creative destruction.

Reinventing Regulation

Out of the chaos of the telecom industry will come consolidation. Exactly how far and how fast it will go in each sector is unclear; the outcome depends in part on decisions by the fcc and the courts, as well as the companies involved. During the Clinton era, the fcc tilted policy toward competitive entrants. Under Chairman Powell, who seems devoted to the biggest corporate interests, the fcc is unlikely to stand in the way of remonopolization. Powell favors unnecessary and dangerous changes in policy permitting more concentrated ownership of TV stations and other media; he'll likely support far more justifiable consolidation in such areas as telephone service. The entrepreneurial phase in this latest cycle of telecom development is coming to an end, just as it did in the history of the telegraph and telephone. The big question is whether consolidation will come with or without regulation in the public interest.

Telecom regulation originally emerged from the realistic assessment that full-scale network competition is inefficient and unsustainable. From outside the industry came growing demands for public protection against monopoly power. From inside came the grudging recognition that a stable regulatory environment offers advantages for long-term recovery of investment, including investments in research. The spectacular losses of the past several years have been an expensive reminder that telecom needs regulation as much for investors as for the public. Ironically, capital has become so leery of telecom that regulation could play a role in bringing it back.

Regulation has historically provided the public with several different kinds of benefits. The oldest protection, going back to the 19th century, is the requirement known as "common carriage," which limits the ability of network owners to discriminate among those who want to transmit messages. As networks consolidate, the great danger is that a corporation dominating the critical pipelines will favor its own "content" and squelch alternatives; common carriage then becomes a vital protection of free speech. A second element, which dates to the early 20th century, is rate-of-return regulation, limiting prices charged to customers on the basis of a fair return on investment. And a third, which can be traced to the New Deal if not earlier, consists of subsidies built into the rate system designed to achieve "universal service" -- that is, to make service affordable to all.

For communications, the problem today is different than in the past because of the growth of intermodal competition -- alternative technologies offering the same consumer service. A century ago, only the telegraph offered an alternative to the telephone for instantaneous messages. Today, wire, wireless, cable, direct-broadcasting satellite and conventional broadcasting compete to some extent with one another. As consolidation proceeds within the sectors (and possibly between them), some in the industry will insist that the residual competition is adequate to protect the public. These claims should get the most critical scrutiny in light of the values at stake in communications: not just efficiency, but free expression, equality and the diversity of public life.

A century ago in America, the Progressives were divided in their response to the rise of big business. Some sought to restore the earlier entrepreneurial world of free-market competition, while others accepted the large corporation and called for regulation to achieve liberal ends. By the New Deal, the second viewpoint had decisively won out. Despite the romantic appeal of competition and the imperfections of regulation, that hard-won realism will have to win out again.

Copyright 2005 by The American Prospect, Inc. Preferred Citation: Paul Starr, "The Great Telecom Implosion," The American Prospect, September 9, 2002. This article may not be resold, reprinted, or redistributed for compensation of any kind without prior written permission from the author. Direct questions about permissions to permissions@prospect.org.