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July|August 2002
Under the Microscope By Brendan I. Koerner
Why Judges Rarely Change Their Minds By Edward Lazarus
Net Loss By Reed E. Hundt
History Lesson By Jack M. Balkin

Net Loss

The power of a few giant companies threatens innovation on the World Wide Web.

By Reed E. Hundt

Only a decade ago, the Internet was a back channel for academic techies, computer geeks, and weapons wonks at the U.S. Department of Defense. Today, the Net makes it possible for any user to get anywhere on the system, and to get almost anything that can be presented in words, pictures, sound, or digital data. The expansion of the Internet is astonishing—but its progress is also in jeopardy, as a result of the recent collapse of technology stocks and a newfound reluctance of the United States government to continue policies of the 1990s that stimulated the Net.

In the '90s, the government sought to spur advances in technology through a host of measures—spending on research and development, lowering the long-term cost of capital to make new investment more attractive, and rewriting the telecommunications laws to give advantages to startups rather than established companies. The government's general pro-technology and pro-competition policy helped unleash the fresh potential of science, which is enjoying a golden age in almost every field.

At the same time, the American economy became more efficient, was expanded by millions of new jobs, and had the wildest of parties on the Nasdaq, where many of the most popular new technology stocks were traded. During the boom, hundreds of millions of people around the globe presumably learned about the Internet from dot-com ventures and their web pages. The Net created brand names as fast as television had in its salad days: AOL, eBay, Yahoo!, and many others.

Then came the crash of the stock market—in two years, the average of the Nasdaq fell to about one-third its highest level. Hundreds of startups have gone bust. Even once-lustrous names like Amazon (down more than 90 percent from its stock-market high) and Priceline (likewise) may not survive as independent companies.

From the perspective of consumers, in the wake of the bust, big firms like AOL Time Warner and Microsoft may well define the face of the Net through their content and the software behind it. Most officials in the Bush Administration seem at ease letting these sumo wrestlers bang against each other in the marketplace, without the benefit of government referees. A bellwether of the current government attitude is the Bush Justice Department's recent settlement of the Clinton Administration's antimonopoly lawsuit against Microsoft: The department has shifted from pursuing in court a breakup of the company into competitive parts to advocating what appears to be a handslap.

Behind the screens that users perceive as the Net, however, another more disturbing picture is forming. The prospect of dangerous consolidation threatens the potential for innovation. The "Internet" initially referred to interlocking networks that constitute the guts—the so-called infrastructure—of what we now call the Net, which also includes the content and services available on it. This infrastructure includes the line from the house to the street, fiber-optic cables under the asphalt, downtown offices filled with computer servers, and long lines of fiber running parallel to railroad tracks between cities. In general, the Bell companies—part of AT&T, long known as the Phone Company because of its monopoly, until the Justice Department broke it up in 1984—own most of the network facilities for homes and in metropolitan regions. And the long-distance companies, principally WorldCom-MCI and AT&T, carry most Net traffic between cities.

Under the sanction of the 1996 Telecommunications Act, in the late '90s, WorldCom, AT&T, Sprint, and hundreds of startups called CLECs (competitive local exchange carriers, offering voice and Internet service mostly to small businesses) and ISPs (Internet Service Providers, basically CLECs that offered Internet access, but not voice service, to residential users and others) began to compete against the Bells to offer innovative technologies for voice and Internet links to businesses and homes. At the same time, startups like Level 3 and Global Crossing, as well as a dozen or so others, built city-to-city networks over which Internet data could travel, in competition with the long-distance companies. Congress and the Federal Communications Commission constrained the Bells from entering the long-distance or interstate businesses until their monopolies in local markets were eroded by competition.

In this golden era, the new competitors in both the long-distance and local markets raised more than $100 billion to build data networks, which included what consumers know as the Internet and also what businesses recognize as the private, Internet-based methods of communication that have transformed organizations and radically increased productivity. Compared with the making of content, like the design of web pages or the production of movies, the construction and control of this infrastructure is technical and taken for granted by most users. But what happens in this space is crucial to the Net's evolution. It's here that the future of the Internet is at risk.

The premise of the 1996 telecommunications law and the shift in policy to promote competition was that competition would lead to more investment in innovative technologies, which in turn would produce new services, new jobs, a bigger economy, and then more competition. This was considered a virtuous cycle, and it spun its magic through the '90s. By contrast, without competition, innovation slows, offerings of services diminish, economic growth declines, job growth shrinks, investment goes down, and competition diminishes even more. In short, a vicious cycle emerges. That's what we are experiencing now. For the user, the consequence is that the Net is visibly slow and applications—ranging from software to music downloads to videoconferences—are of inferior, limited quality. Basically, the world is duller and poorer than it should be given the potential of the Net.

Meanwhile, reduced competition allows those with cash to expand their existing shares of the market and dominate in new markets. In the case of the Internet, the cash-rich companies are the Bells. By contrast, WorldCom's stock price has dropped more than 80 percent in the past two years largely because of concern from investors about its ability to pay off its debt. AT&T's debt load became so burdensome that it shattered the company into pieces: The giant's cable assets are now being sold. In the downturn, the Bells are having feeble years by their standards, but no one questions their survival. In the wake of other Net-builders' collapses, the Bells have the potential—through acquisition or construction—to own many of the essential pieces of the Internet's infrastructure. If they become the owners of this infrastructure, the Bells may be able to exercise dominion over the software that operates the Internet and the Net's content as well.

If a regional phone company happens to own pipes through which web pages pass, how might it affect the Net's growth, much less shape the 11 billion pages of information available on the web? History holds the answer. In the 19th century, the railroads influenced retail and manufacturing in virtually all the cities and towns that were linked only by that new means of transportation. Businesses as big as Carnegie Steel and as small as local grocery stores were dependent on the railroad industries. History, then, suggests that the carrier can be more powerful than the company making the thing carried. In retail terms, distribution can be king. The power of the railroads was so great in the 1880s that the Interstate Commerce Commission was created to redress the perceived imbalance. But today Congress and the F.C.C. are not concerned with the emerging power of the Bells. They are moving in the opposite direction, strengthening the Bells' market power through changes in law and regulation.

The most recent evidence is the passage of the Tauzin-Dingell bill by the House of Representatives. The bill would repeal portions of the 1996 Telecommunications Act that were designed to promote competition with the Bell companies in local data networks—the parts of the local phone businesses that carry the code, or bits of data, making up the words, pictures, and sounds of the Internet.

Advocates of the bill contend that if the Bells invest money to build innovative data networks, they should not have to share the networks with their rivals. They've won many supporters. Only a few senators stand in the way of this bill's passage into law—chiefly, the longtime Bell nemesis Senator Ernest F. Hollings, a Democrat from South Carolina. Senator Hollings argues that until a Bell's monopoly market share in the local market is eroded by competition, it should continue to be obliged by F.C.C. regulations to lease its networks to competing rivals, as required in the 1996 Telecommunications Act. Inside the Beltway, the competing sides in the Tauzin-Dingell debate use television advertisements to present their positions; for most of the country, the legislative fight is less well-known. Yet if the Senate majority shifts to the Republicans in the midterm elections this fall, the bill may well pass next year, and the 1996 act would be repealed in significant part.

Yet the 1996 act has already proved its value for the Internet. Internet access in the United States achieved about 10 percent penetration in only two years of widespread availability. Already, less than a decade after it became generally available, the Net is not far from reaching the same number of households that are connected to cable T.V.—almost two-thirds of American households—though cable T.V. has been around for about 50 years.

How did the Internet get so big so fast in the United States? The answer is that with the powers of the 1996 act the F.C.C. issued regulations to permit CLECs and reaffirmed rules to allow ISPs—including, for example, a young company called AOL—to lease pieces of the Bell networks at very low cost in order to provide Internet access. At the same time, the F.C.C. and the state utility commissions used regulations to keep the Bells from charging anything extra to consumers who used a telephone line to connect to the Internet—or, more precisely, to ISPs like AOL. (This so-called narrowband access is what you can hear a PC dialing for in about half the homes in America.)

American CLECs and ISPs enjoyed low costs in providing service, and vigorous competition ensured that these low costs were passed along in the form of very low retail prices. Two results followed. In America, consumers signed up for the Net much faster than in any major European country. By comparison, Net access costs through the national phone companies of Europe were about five times as high as in the United States, and retail prices for Internet access were much higher. Not surprisingly, penetration rates were about half as high.

Next, the Bells were not able to use their ownership of the local network, and the crucial link to the home, to gain significant market share among providers of Internet access. That's why AOL Time Warner and other large ISPs are independent from the Bell companies. (A counterexample is the market structure of the American cellular phone industry, where the Bells got the early licenses, the early lead, and the control of the majority of customers.)

A fast-growing, affordable, and competitive market of Internet access was the intention of the 1996 Telecommunications Act. The Clinton-Gore White House and legislators like Congressman Edward Markey, a Democrat from Massachusetts, and Senator Hollings called for that policy, and when I was chairman of the F.C.C. the commission consciously applied it. By contrast, in Europe and in Japan the local telephone company monopolies were permitted to charge high prices to their rivals for connecting to their networks, and to charge high prices to consumers for Internet access, limiting and controlling the growth of the Net. In many countries (the leading example is Germany), the national telephone company became the largest Internet service provider. With its strong and rapidly growing Internet market, the United States took the lead globally in most Internet-related businesses. English became the Net's mother tongue, and America became the hub of cyberspace.

Meanwhile, through the '90s the rising stock market meant that long-distance companies such as AT&T and WorldCom, but also hundreds of CLECs and ISPs, were able to sell stock and issue debt to fund their construction of data networks. But in the '00s, the falling stock market has led to a capital crunch, which has left many new data businesses without enough money to support their business plans. Without the revenue of the Bell companies (in their markets, about 90 percent of residential telephone lines are controlled by the Bells, which earns them a reliable stream of cash), the Bell rivals are no longer able to be powerful sources of lower prices and greater innovation. In the ranks of CLECs alone, more than 150 firms have gone bust, taking with them more than $100 billion of capital investment. (I'm on the board of a CLEC and have experienced both the rise and fall of its stock.)

Part of the reason for these failures was that entrepreneurs and investors misjudged the marketplace and started too many Net-centric companies. But a major factor in the failures has been reversals in regulatory policy. Since 2000, for example, the F.C.C. has reversed a traditional rule by which a phone company that sent a call to a different phone company (such as when you call through your Bell company to someone in a different region served by a different Bell company) would pay the company receiving the call. Calls to the Internet always generated payments from Bells to CLECs and indirectly to ISPs; in effect, these payments subsidized the growth of the Internet. Changing this rule took money away from the Bells' rivals.

A dozen other examples exist of government withdrawal of support for innovation in the Net, most quite arcane yet in all shaking the belief of investors that competitors of the Bells can survive the downturn in this sector of the economy. Without access to capital, since the Internet's infrastructure can be expensive to build, few if any of the rivals to the Bells will be able to survive.

Most recently, the F.C.C. has raised doubts about the most important of the regulations implementing the 1996 act's competition policy—namely, its regulations letting rivals of the Bells lease parts of the Bell network and connect to that network. Without this right, and lacking the Bells' power in the local market, firms that seek to build local networks competing with and also connecting to Bell networks would be severely damaged. The Bells would be very likely to control many essential elements of the Internet's infrastructure.

The triumph of the bells over rivals in data networks would be dispiriting if it led to decreased innovation and entrepreneurial experimentation in the Internet—whether the Net is regarded as a network of data networks, as a forum of new content, or even as a medium of new business models, all of which it was in the 1990s. For almost a decade now, legions of technologists at startups have worked to invent software and hardware to improve the Internet. Tech geniuses of our country (and the world) have reveled in solving the intricate problems of data communication so that lay users could enjoy the pleasures of the Net. Other entrepreneurs have emphasized content: organizing web pages (Yahoo!) and developing Internet-based business models (Expedia). These entrepreneurs have worked around the clock for fun as well as profit.

The essential motivator of the 1990s tech boom was that when inventors invented something cool, they could find a way to sell it. Some have pitched directly to consumers, whether selling communications services as CLECs do or engaging in e-commerce like Amazon. But for entrepreneurs inventing the software and hardware that constitutes the infrastructure of the Net, the customers have been the rapidly changing, heavily investing communications industry of the '90s: the Bells, the big long-haul data companies like WorldCom, and their startup rivals like Level 3, the CLECs, and the ISPs.

But when the customers shrink to a consolidating few and the more daring innovators disappear—and when consolidation occurs at the same time as an economic downturn—the total amount of buying shrinks. That was revealed during the past year in radical cuts by telecommunications companies in their plans for capital expenditures, which will decline by an estimated 35 percent this year from 2001. The Net result is that the Internet-building entrepreneurs are no longer inspired by an abundance of buyers for their creations. Without an audience, a singer stops making music. Without buyers, sellers vanish—especially sellers of new ideas for a new medium.

For the Internet, the contraction of competition among buyers could mean the end of an age of exceptional creativity. It's possible that in the laboratories of not-for-profit academe, invention about data networking might continue. But that would return the Net to the experimental medium of the Net of the '60s, '70s, and '80s—an intriguing, elitist medium more for dropouts than change-agents—as opposed to the red-hot, mass-market Net energized by the competition policies of the '90s. This government flip-flop in policy, in effect from being pro-Net and pro-technological change to being anti-entrepreneur and anti-change, is profound. The new policy reflects a bias against economic growth led by investment and business innovation that enhances productivity. It runs counter to the culture that has made our economy the most powerful in the world, and the Net one of its most positive revolutionary creations.

Reed E. Hundt is a former chairman of the Federal Communications Commission and author of You Say You Want A Revolution: A Story of Information Age Politics.

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