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Weathering the telecom storm

Reed Hundt, former chairman of the FCC, explains why the future still looks good for the telecommunications industry. What does he know that nobody else knows?

Deregulating US telephone services has been the holy grail of free marketers for decades. In the wake of a stock market bust that has hit telecommunications stocks particularly hard, The McKinsey Quarterly talked to Reed Hundt, a McKinsey adviser and recent chairman of the US Federal Communications Commission, about the future of the telecommunications industry and how to make deregulation work.

Hundt took over the FCC chairmanship in 1993, under President Bill Clinton, after a career practicing law. The biggest event of his four-year tenure was the passage of the 1996 Telecommunications Act, the first major legislative reform of the industry since the 1934 Communications Act, which made AT&T a regulated monopoly and established the principle of universal coverage. Hundt and the FCC designed the regulations to implement this reform and to translate its procompetition goals into reality.

Q: What do you think about the telecommunications industry today and about the progress of deregulation?
A: Looking at the industry right now reminds me of Snoopy, when he writes the first line of his novel in the cartoon strip Peanuts: "It was and dark stormy night." The big companies are burdened by debt; the new competitors are starved for capital; the equipment providers are on thin ice; and the component providers are seeing their revenue expectations unmet. It?s a brand new experience for communications companies, which have been protected from downside risk as well as denied the upside of growing markets and rewards for innovation. But that?s our brave new world: Now the old communications companies are supposed to face more competitive pressure and to become more innovative and efficient as a result.

The Clinton administration, Congress and the FCC supported the 1996 act in order to increase competition and to promote investment in the most important activity of the country: the information sector. This part of the economy was then about 7 percent of the whole, and five lanes of the information highway ran toward the future: broadcast, cable, wire, wireless and satellite. Since the passage of the 1934 Communications Act, these had been legally separate industries; for the most part, none was permitted to compete with any of the others. Each was regulated so as to work well and to earn steady but unspectacular profits. FCC rules drew the dividing lines and kept the monopolies intact. The 1996 act busted this old world apart.

That increased competition has made for some rough sledding. ICG Communications, Iridium, NorthPoint Communications and Winstar Communications, for example, are in bankruptcy and others might follow. If the whole industry goes bust, it?s not good for anyone.
I?m not sure that?s true. For the most part, the boom in building data networks will benefit the entire economy for years to come, but maybe not all shareholders. This sort of evolution has happened many times before. And the whole industry is far from bust, although I do think we need to see capital providers stepping up to the plate for new companies that are innovating and developing new technologies. The Bells? share of business customers has dropped. The new competition is forcing the Bells to respond.

Deregulating US telephone services has been the holy grail of free marketers for decades. Technologically, we have made vast improvements and discoveries. Some companies may have managed their investments poorly, but now there are countless miles of fiber that have been laid, and tower sites on hills, and satellites up in the sky that will be useful assets for decades. That?s what competition was supposed to do.

If you were to do things again, would you have tried to insist on another factor to get the former Bell companies to open their local markets, in addition to the "carrot" of entry into the long-distance market?
If you want competition in a hurry, you should minimize litigation. The 1996 legislation was written vaguely because Congress wanted to please everybody. As it was, instead of giving the national regulatory agency the power to set interconnection prices, the statute was ambiguous, so the authority of the FCC to determine the prices for new competitors to interconnect with the Bell local loops was challenged. This cost methodology is the same policy the United States has argued for in trade negotiations globally. In fact, it?s easier to convince France than Mississippi, easier to get 69 countries to agree to a WTO treaty than to get 50 states to accept FCC rulemaking.

In any case, the market is getting more competitive. Long distance is the best example. Deregulation was started in the early 1980s, when AT&T had the entire market. By the mid-1990s, AT&T?s market share was down to less than 50 percent in the enterprise market but still 70 percent in the consumer market. That?s what we are seeing in the local communications market: competitors are now making inroads in the enterprise space.

The only real question is whether government procompetition policies will remain consistent.

What do you mean?
The appellate court ruled that NextWave still owns the spectrum it bought in auction from the federal government but hasn?t paid for. I don?t want to debate the merits of that decision. But the fact is that the spectrum has been slow to be put into use and to offer customers more choices, such as different types of wireless communications devices, because the companies involved are mired in litigation. Auctions are currently on hold. The federal government has to make the rules very clear and then enforce them.

Looking at the industry right now reminds me of Snoopy, when he writes the first line of his novel in the cartoon strip Peanuts: I am also concerned about the growth and development of the Internet. One of our primary policy goals when I was in government was to have the Internet become a mass-market phenomenon. That has happened with narrowband connections, but I?m not sure the current policy makers have the same commitment to making broadband universal. I think it would be a major mistake and a cause of great regret if we didn?t make the commitment to low-cost, high-speed Internet access that is always on, for everyone and everywhere in this country.

Some might call that more of a luxury than a right.
A right to information is essential. It is not unusual for a new medium to be embraced by government so that the medium will become universal. Bell Labs was funded partly to develop new low-cost methods to extend telephone access. Transistors were developed to replace vacuum tubes as part of the research seeking an electronic switch to replace manual or mechanical switching in telephone systems. It is ironic that the transistor, which grew out of research into improved telephone switching, eventually spawned the Internet, which will overturn the Bell companies? local monopoly. But the point is that a government policy ensuring universal coverage forced innovation that was of benefit to everyone, including the many businesses that sprung up as a result of the policy.

Although the 1996 act didn?t mandate universal Internet access.
Reed Hundt: It wasn?t mandated, but we tried to make the Internet universal in two ways. Number one, let?s put it in every classroom where the next generation will be trained on it, using government money. The country went from 3 percent of classrooms with an Internet connection in 1994 to 77 percent today. It?s been the fastest-growing innovation in education since chalk. Second, we wanted competition to rule the Internet. By promoting competitive ISPs, we kept the price of Internet access low. Today everyone thinks it?s a God-given right to be on the Internet. In my view, that?s great. I?d like everyone to have the same view of broadband--because that would spur massive investment, job creation, productivity gains, and, I hope and believe, advances in health care and education.

We have 55 percent household Internet penetration--twice that of Europe and three times that of Asia. Yet this version of the Internet is like black-and-white TV compared with color TV. This is narrowband; broadband is next.

Does government have a role in sponsoring broadband?
Broadband will take off and enable new content, new revenue streams. The same thing happened when television started. It was essential for the development of black-and-white TV that the government sponsored it, making every local market have its own broadcaster, thereby developing local businesses and advertising markets. The government granted licenses in every city and limited how far a station could broadcast. As a result, networks became necessary, but enough value was transferred to local stations to drive the rapid development of local broadcasting businesses. This was one of the most adventurous, risk-taking enterprises of the 20th century, and it wouldn?t have been so successful if government policies hadn?t supported it.

We have 5,000 Internet service providers today because we, at the FCC and in the rest of the government, rolled out the red carpet for them. Not all of the ISPs will keep going, and there will be a lot of consolidation. In the end, it will be like the radio stations: Thousands of individual stations are now owned by only a few big, efficient companies. That?s the way innovation works. Given time, broadband will be universal because we jump-started this competition.

You might not want to be a shareholder in any one of the ISPs, but at least a handful will be winners. The whole process has been good for the economy and the population at large. And the Internet created a platform for fantastic experimentation with business models. Not all of them work. It?s like laboratory experiments; some of the animals die and some live. Broadband is going to be the same but more so. Given time and leadership from government, Wall Street and business, it will be universal.

Some critics say that it doesn?t look as if we?re going to have a world where every home and business has two wires attaching it to voice or data networks to give it a real choice. Market share for high-speed Internet access is being divided among incumbents, such as the Bell companies with DSL and the cable companies. New entrants such as Covad Communications, NorthPoint and PSINet are failing.
There is some competition in the broadband space. If you look at the marketplace as your test, telcos and cable companies are competing at similar price points. DSL is running behind cable in market share but is provisioning at a faster rate.

When the capital markets get over their self-induced depression, they will fund another generation of providers. I?m talking about wire-based technologies that would be compatible with wireless technology in the home or local-area networks. These are greenfield builds, involving new fiber-optic cables going in around the country, that are being put together by companies such as Gemini, Western Integrated Networks, WOW and Carolina BroadBand. These companies exist, but they are underfunded. Given the bandwidth these guys are installing, they will be able to deliver voice, video and data and to compete for voice traffic with the Bells. I?ve been meeting with these new companies, and I believe they will provide a catalytic third force.

There are two pieces here: the connection, or pipe, to the consumer and the content that goes through it. The U.S. Justice Department insisted on an in-house adjudicator at AOL Time Warner to assure that other Internet content providers were not disadvantaged. Is this enough to ensure competition on the content side?
When the capital markets get over their self-induced depression, they will fund another generation of providers. I think having open access to Internet content from other providers is something that most cable companies will volunteer to do because they will want to have the largest possible audience. However, there will be a trend toward consolidation on the content side. There are so many providers of digital content, and the number will grow when broadband becomes ubiquitous. But I don?t think the market is at great risk of anticompetitive consolidation resulting from an attempt to keep a vertical lock on customers through proprietary content.

The FCC has never rejected a merger that the Department of Justice has approved. What the FCC has sometimes done is to change its regulations to accommodate an approved merger or to mitigate potential negative consequences, as it did in this case. If the FCC were in the business of rejecting mergers after they were approved, it would be a real problem because it would be a true double gate.

Would you regulate cable more closely, in retrospect?
If I had been the "master of all," I would have passed the Satellite Home Viewer Act in 1992 instead of the 1992 Cable Consumer Protection Act. When the satellite act was passed in 1998, it allowed, in effect, satellite companies like EchoStar and DirecTV to include local broadcast stations and to compete more effectively with cable. It would have been good in the beginning of the ?90s to say that "we want satellite to compete with cable" and "we want the satellite firms to have all the content they need to compete." That would have made home-TV access prices lower through competition, not through regulation. We?ve never found anything that works better than competition to set prices.

Telecommunications stocks are down as a group by 70 percent, and the bankruptcy courts are crowded with failed new entrants. Can or should the government do anything to restore the industry and to keep competition and innovation moving?
It is ugly out there. Right now, the government should encourage a return to normalcy in the investment markets. There are a lot of concrete things government could do to encourage business building and to shape the information sector in the long term. It could exercise more leadership and implement some national directives. One example is that the utility companies own telephone poles, and they charge an arm and a leg to anyone to put a line on those poles. I think it?s in the national interest to regulate the pricing of pole access at very low levels, so that new entrants in the high-speed Internet-access area can attach their wires cheaply.

To stimulate investment in telecommunications, the FCC also could deregulate depreciation schedules for the telcos. Telcos should be able to write down their investments as fast as they want to, but no one in state government is interested in this, because state governments want to keep prices down. Depreciation is an expense. If it were increased, the rates the telcos are allowed to charge customers would go up. So state regulators have kept depreciation schedules slow and depreciation amounts low. If this were changed, it would make a huge difference. Prices might go up by a modest amount, but in my opinion prices should be set by competition, not by regulators. The important thing is that more realistic depreciation schedules would unleash billions of dollars of investment. To do this, the FCC should lean on the states. If you?re into federalism, you don?t want to do that. If you?re into pro-investment competitive policies coupled with deregulation, it?s the right thing to do.

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