How Bush and Michael Powell are killing the New Economy. And how to turn it around.

On the last Friday in August, President Bush, fresh from his vacation in Texas, was asked by a reporter about his plans to address the frustration so many Americans currently face trying to get high-speed internet access. The president didn’t appear entirely worried. “The technologies are evolving,” he said, with equanimity. His only concern was that “the economic slowdown will perhaps slow down some of the progress made, as far as high-speed access.” The possibility that the telecom industry’s collapse and the sudden scarcity of high-speed access might have been a major cause of the economic slowdown did not seem to have occurred to him.

Weeks later, America suffered a devastating terrorist attack in the heart of New York City’s financial district. It’s too early to know what the full economic effect of the attack will be. But it’s clear that the economy was already in trouble, and that the telecommunications sector was at the heart of the problem. Consider this: The drop in market value among telecommunications service providers and equipment makers accounts for more than 90 percent of the net loss in stock wealth since the spring of last year, according to an in-depth analysis by The Wall Street Journal.

To understand what’s really going wrong with the economy, and how he might help turn it around, Bush ought to talk with the folks at Rhythms NetConnections, an Englewood, Colorado, company that provides high-speed, high-capacity, always-on “broadband” Internet connections. Rhythms is one of dozens of firms that sprang to life and helped drive the boom economy of the late 1990s, after Congress had passed the Telecommunications Act of 1996, which sought to replace monopoly regulation of local phone service with the sort of competition that Rhythms and its many contemporaries represented. The telecom bill mandated that the regional monopolies known as the Baby Bells—currently four behemoths: Qwest, SBC, Verizon, and BellSouth—sell access to what industry types have dubbed the “last mile”—literally, the copper wires connecting each business and home to the public network. Rhythms planned to access these wires and increase their network’s speed and capacity through Digital Subscriber Line (DSL) technology, giving customers Internet access far superior to the dial-up access most were accustomed to using. In 1999, a year after it began providing service, Rhythms had one of the most successful IPOs in history. It quickly grew to 2,000 employees, expanding its service to 75 markets. Rhythms had customers, growing revenues, a real business plan, and—unlike most dot-coms—a product for which people were eager to pay.

Unfortunately, the company quickly ran into a problem it couldn’t control: the Bells. In order to operate its business, Rhythms needed the Bells’ cooperation on matters such as letting Rhythms install equipment in the Bell “office”—the local hub of the Internet’s vast hub-and-spoke system. But Rhythms, as a Bell “customer,” was also a competitor; the Baby Bells had their own, pricier broadband services they wanted to sell to customers. Cooperating with Rhythms, as the telecom act requires, would mean cutting into their own revenues. So, perhaps not surprisingly, customer service wasn’t always spectacular. Rhythms says the Bells repeatedly delayed or cancelled appointments to connect customers—costing Rhythms $150 each time it sent a truck to a customer site. Sometimes, Bell service people would wire up a new customer but somehow forget to pass that information on to Rhythms, causing infuriating delays for customers. The Bells also charged through the nose for Rhythms to set up equipment in its local offices. For their part, the Bells claim competitors like Rhythms also made mistakes and broke appointments. “It’s a two-way street,” insists one Verizon spokesman. Nevertheless, while the Bells are among the most profitable companies in America, their behavior drove up Rhythms’ costs and scared off potential customers. In early August, Rhythms filed for bankruptcy and informed its customers it would discontinue all service.

That wasn’t bad news just for Rhythms, but for companies across the country that relied on its service. One of them is Technology Service Corporation in Trumbull, Connecticut, a 15-person employee-owned engineering firm that helps governments and large companies install radar and other sensor equipment. TSC uses broadband every day—sending and receiving, for instance, huge data files containing the images of future airports in Canada or Taiwan. Until it installed a $300-a-month DSL connection from Rhythms, TSC did very little international business because shipping reams of technical data overseas was too cumbersome and expensive. Now, 15 percent of TSC’s business is international, and operations manager Allan Corbeil doesn’t think the company could “do any business without it.” Hearing that its broadband company went bust was “like hearing the mail man isn’t coming.” Corbeil scrambled to find another broadband supplier. But when we spoke in early September, Corbeil was still worried. The new supplier couldn’t guarantee that its service would be up and running by the time Rhythms’ went dark—and there were troubling signs that even this new company might go out of business.

If cyber-geeks selling their BMWs were the most visible sign of the dot-com crash, then the failure of companies like Rhythms signals a much more important collapse in high tech. Scores of such companies have closed up shop, and DSL prices have risen substantially After several years of exploding growth, deployment of DSL actually slowed in the second quarter of this year, helping to set off a chain reaction. As broadband services failed to take off, companies stopped buying new computers and software, which hurt suppliers and left massive inventory on the shelf or in the ground.

Over the last few years, companies such as MFS-WorldCom and New Edge Networks have spent $90 billion to dig up the nation’s streets and lay millions of miles of fiber-optic cable (the “superhighway” of data networks), while companies like PSINet have installed the equipment along the line that directs Internet traffic. That, incidentally, is the massive project responsible for creating the endless traffic jams and muffler-busting ruts in the road we’ve all had to endure. All of it would have been worthwhile if it had enabled millions of small and medium-sized businesses to get broadband, and allowed services dependent on broadband, like video conferencing, to take off. Unfortunately, the way to get to the new data superhighway is through the old “last mile” of copper wiring, which the Bells control and resist sharing. As a result, most of the $90 billion in new fiber-optic cable lies dormant in the clay; according to a Merrill Lynch study, only 2.6 percent is in use. Meanwhile, PSINet declared bankruptcy in May. And millions of Americans whose mutual funds invested in companies like PSINet are significantly poorer.

The telecom industry’s collapse has been a major source of our short-term economic woes. By some estimates, the decision of many companies to forego spending on new telecommunications equipment accounts for nearly one-quarter of the drop in economic growth.

Though the popping of the dot-com bubble has been the favorite media angle, The Wall Street Journal estimates that many more jobs have been lost in telecom. Analysts predict that the telecom industry could default on as much as 20 percent of the $700 billion in debt it has accrued in the last few years. Banks and other lenders holding that debt are tightening their lending practices. That hurts the ability of other companies to get financing and for the economy as a whole to rebound.

The telecom collapse threatens equally serious long-term effects. The economy boomed in the late ’90s largely because productivity—output per worker—nearly doubled to 2.6 percent annually, from an average of 1.4 percent in the ’70s, ’80s, and early ’90s. Booming productivity, after all, led to the lower unemployment and inflation and higher economic growth that distinguished the “new economy.” And according to Federal Reserve Chairman Alan Greenspan, productivity shot up because companies began using new data networks to get efficiencies out of the computers they’d bought. But now that the rollout of these data networks is slowing, productivity growth rates are threatened. Speeding up the spread of broadband could give the economy the lift it needs.

The telecom crisis is a problem that government largely created and one that only government can fix, by changing the law to create real market-based competition. Unfortunately, instead of taking on the Baby Bells and their monopoly power, some in Congress are trying to tilt the law further in their favor while the Bush Administration remains firmly seated on its hands. Though the president urgently convened a task force to address an uncertain energy situation, he hasn’t set up a similar body, or even chosen a point-person in the White House, to deal with the telecom crisis.

How can the administration remain so passive in the face of a shriveling industry so vital to the nation’s economy? The answer seems to be part anthropology, part ideology, and part politics. The president and the vice president know energy. They have firsthand experience of what oil, or the lack of oil, can do to an economy—in Midland in the 1980s and nationwide in the 1970s. When it comes to energy, they are government activists. They want billions of dollars in industry subsidies and enhanced federal power to override state and local governments to get more electric generating plants and power lines operating.

When it comes to industries it’s unfamiliar with, however, such as telecom, the administration reverts to its default ideological position, which is that government should get out of the way and let market forces work. Also, the big-name CEOs most concerned about telecom’s collapse and the slow spread of broadband are the high-tech leaders of California—a blue state on the electoral map. As we saw in the grudging federal response to California’s electricity crisis earlier this year, the Bush administration has limited enthusiasm for reaching out to a state that it’s almost certain to lose in 2004.

Instead, Bush has left the fate of the telecom industry—and by extension, the U.S. economy—in the hands of someone ideologically opposed to action: Michael Powell, chairman of the FederalCommunications Commission(FCC) and son of the Secretary of State. Powell, who graduated from law school in 1993, is very smart, but less seasoned than his Clinton-era predecessors, Reed Hundt and William Kennard. That hasn’t prevented him from passionately defending his firmly held views. Whereas Hundt and Kennard saw their jobs as promoting competition, innovation, and industry growth through government action, Powell has staked out a hands-off program of deregulation, at times appearing to welcome the massive disinvestment in the industry he oversees. In May, he stated, “I think if there’s one very good thing that will come out of the current conditions, I hope, is greater sobriety in thinking about what could be expected.” He has also said that he is “not the grand master chef of competition,” suggesting the market will produce competition.

The problem with such views is that without action the outlook for the struggling U.S. economy could be grimmer still: slower or negative economic growth, slower productivity growth, higher unemployment, an even weaker stock market, and higher inflation.

For most of the last century, Ma Bell was a regulated monopoly, stumbling along making huge profits even as it missed numerous opportunities to innovate. Only in the 1970s, thanks to what is known as the FCC’s “Carter phone” decision, could people buy their own phones and plug them into a “jack” in the wall. Prior to that, wires came out of a hole in the wall and went directly into the back of the black Bell phone.

Then, in the 1980s, the FCC required the phone company to allow firms with private data networks, like Prodigy, CompuServe, and EDS, to connect to the phone network. The FCC also exempted these data providers from paying into the Byzantine cross-subsidy system that sloshed money around within the monopoly. This kept down the cost of the emerging data networks, and later, Internet access provided by companies like AOL.

In 1984, Federal Judge Harold Greene ordered AT&T to divest itself of its regional monopolies and required these regional bell operating companies (BOCs) to allow long-distance competitors access to their local networks. After divestiture, companies such as MCI and Sprint invested in fiber-optic cable and, with surprisingly effective ads about such things as pins dropping, forced AT&T to follow suit. Investment in fiber increased 82 percent in 1985 alone. The cable which these companies laid became the cross-continental Internet “backbone,” and long-distance prices have since declined steadily.

The ’96 Telecommunications Act took the next step, mandating that the Bells open up their networks so that competitors could lease parts of, or in some cases the entire, system. More than 300 new competitors came into existence—companies such as Rhythms, Covad, Allegiance, and Northpoint. Their rise stirred the Bells from their slumber. Before the 1996 act, overall investment by the Bells was declining. Afterwards, investment in the local network doubled, and even the Bells started investing more.

The new local competitors created by the act offered Internet access, web site hosting, and DSL connections. With the addition of DSL equipment in the local hub (or office), the Bell wires can carry more traffic, 20 to 30 times faster, providing the advantages of a dedicated fiber-optic connection over shared, existing copper wires. The Bells could have done this earlier, but absent the spur of competition, they didn’t. Now they, too, have begun offering DSL service. Today data represents about 75 percent of all network traffic, up from 50 percent in 1998.

The rest of the story is familiar to anyone who reads the business pages. Firms throughout the economy reorganized the way they did business to take advantage of the new, fast networks, developing just-in-time inventory systems, on-line industry market places, and countless other strategies that have helped them become more efficient. These efficiency gains led to the near doubling of the growth rate of output per worker, which in turn has increased overall economic growth, lowering unemployment and checking inflation.

Productivity gains have slowed over the last year, but not because the broadband market has been saturated. In fact, 90 percent of small- and medium-sized companies still don’t have it. This suggests that there is still vast untapped potential in the economy. Moreover, new products—video conferencing, voice-recognition software and integrated voice-data-video services that can make possible, for instance, electronic doctors’ visits—are teed up and ready to soar the day that a critical mass of homes and businesses have broadband. But thanks to the telecom crisis, that day now looks to be years further off than anyone thought.

Though Bush the policymaker seems unaware of what the telecom collapse means for the economy, Bush the worker-in-chief has grasped the advantages of the new technology. In August, he had fiber-optic lines installed at his ranch in Crawford, Texas.

By allowing new competitors into the local phone market, the 1996 telecom act helped create the new economy. But it contained a fatal flaw. It allows the Bells to control new entrants’ access to customers, even as the two compete for these same customers. The competitors are akin to the Gingerbread Boy of the fairy tale, riding across the river on the nose of the hungry fox. Their sole means of transportation has every incentive to do them in.

The act did offer the Bells one enticement to cooperate: If they would open up their markets to competitors and play fair, the FCC would grant them permission to get into the business of providing long-distance service. But that market that has become less desirable as prices in long distance have dropped. The Bells still control more than 90 percent of the local lines in the country, but have opened local markets sufficiently to obtain FCC approval for long-distance entry in only five states.

Broadband competitors and customers tell of nightmares similar to those experienced by Rhythms and TSC. Consider the case of the Philadelphia Eagles. The City of Brotherly Love’s beloved National Football League franchise normally gets what it wants, when it wants it—from vendors, the media, or government officials. But it had a very different experience when it tried to obtain broadband so that architects in California, designing its new stadium, could share construction documents with its contractor, Turner Construction, in Philadelphia. Suddenly, the Eagles felt like nobodies at a crowded, fancy restaurant who hadn’t called ahead for reservations, with the local Bell monopoly, Verizon, playing the role of the snooty maitre d’.

In April, the Eagles asked broadband provider Allegiance to bring high-speed Internet access to the construction site. But when Allegiance contacted Verizon, the company said it had no record that such an address existed—even thought it had recently laid more than 100 phone lines at that very site. For weeks, Allegiance, Turner, and Verizon argued back and forth over the issue of the address. Finally, Verizon confirmed that, yes, there was indeed such a place. But Verizon then claimed it didn’t have the technical equipment in the area to support a broadband line to the site and that it would be months before service could be up and running. Meanwhile, John McCulloch, the information systems manager at Turner, began to feel the heat from the Eagles’ front office, which was afraid the delay would hit the press. Finally, Verizon ran an extra line for broadband out to the stadium. After further delays, Allegiance was able to provide service at the end of August. Verizon says that its first record of the project is in July and that these processes are extremely complex. Allegiance says that its records show it contacted Verizon in May, and that it can’t understand why the project took three months. All John McCulloch of Turner knows is that he was left to use painfully slow dial-up connections to transfer files, slowing the project and increasing costs.

The government has taken a few steps to rein the Bells in. Between December 1999 and April 2001, the FCC and state regulators fined Verizon $233 million, SBC $175 million, Qwest $78.6 million, and BellSouth $805,000. Powell has asked that the fines the FCC can impose be increased to $10 million.

But for companies with annual revenues of tens of billions of dollars, such fines are a drop in the bucket and not nearly enough to save the competitive market. Since November 1999, more than 25 local competitors have filed bankruptcy. The trade publication DSL Reports inaugurated a DSL deathwatch list. To be sure, some of this carnage was the result of the telecom competitors’ own extravagance and hubris. PSINet, for example, probably had no business paying $100 million to put its name on the Baltimore Ravens’ football stadium. Still, the competitors never had a chance so long as the Bell monopolies raised their costs and prevented them from serving their customers and bringing in revenue.

The Bells are consolidating their position (they now control 75 percent of the DSL market) and in an information sector where prices tend to fall, they have recently raised the price for their residential DSL from $39.95 to $49.95 a month. And in many parts of the country, the only robust broadband option they offer small businesses is a T-1 line—at costs of $1,000 and up.

The Bells’ hammerlock on the market is not only slowing the spread of broadband, but raising legitimate concern that the Bell’s restoration to power may slow future innovation. Just as Microsoft can leverage its monopoly in operating systems to control web browsing, word processing and other desktop products, the Bells are already leveraging their monopoly in DSL into Internet access. Soon they’ll be able to constrain choices at the next layer up, the content layer. One day, you may access the Internet through your Bell DSL and be directed to certain favored sites—sites with which the Bell has a financial agreement. That could be perilous for numerous new technologies, such as software that transmits voice data over the Internet, a technology that threatens the Bells’ highly profitable local telephone business.

The Bell restoration is frustrating even the ultimate tech monopolist, Bill Gates. In early September, Gates urged the government to solve the broadband problem, which he said is limiting a “miracle environment” of new applications, thanks to ever-increasing computing speed, power, and video-display capabilities.

The Bells do not dispute that the lack of widespread broadband deployment is costly to the economy. Indeed, they cite Brookings Institution economist Robert Crandall’s estimate that wide deployment is worth $500 billion to the economy. Instead, they argue that they have no incentive to invest in broadband if they’re forced to share the network with competitors. And they insist that the phone industry is already facing plenty of competition from other technologies.

In the long run, that will probably be true. But, well, you know what Keynes said about that. For the moment, the Bells’ only serious competitor is the cable industry. Cable currently enjoys a greater share of the residential broadband market than DSL, and it’s extending broadband access to over 70,000 new customers a week. Unfortunately, many of the small businesses that need broadband the most can’t get it through cable because these companies generally haven’t laid cable in business districts. Also, businesses need to be able to send more data back and forth than cable broadband can typically handle, and expanding cable broadband’s capacity will take years and be hugely expensive.

In the future, other technologies might provide business and consumers with broadband, bypassing the Bells altogether. One possibility is satellite technology. Satellites can deliver Internet to sparsely populated areas, often more effectively than phone or cable. But they require rooftop transmitters that are expensive to buy and install, and they allow users to send data back “upstream” only at relatively slow speeds. Another possibility is “fixed wireless”—sending data over radio waves from a transmitter to fixed locations like homes or businesses. Like satellites, fixed wireless may be a boon to rural areas. Unfortunately, the data-flow is poor if trees, hills, or tall buildings are between the transmitter and the receiver. A third option is mobile wireless, a broadband version of the service that brings you cell phones and Blackberries. This, too, is a technology impaired by obstacles. But the bigger problem is a lack of available spectrum. The radio frequencies needed are already in the hands of the military and television broadcasters, and so far the federal government has been unwilling to take those frequencies away.

Eventually, some combination of these technologies will probably make it possible for most small businesses and individuals to receive broadband. But prices will likely be higher, service spottier, and, worst of all, it could take five to 10 years to become a reality. In the meantime, $90 billion in fiber optic cable will sit largely unused in the ground. Business managers will be frustrated. Productivity will suffer. And the economy may lack all the things that made the past few years so much fun: high growth, low unemployment, rising incomes, low inflation.

With the administration largely absent, the battlefield over telecom is in Congress. On one side are lawmakers who maintain that the policies to promote competition in the phone industry have failed and that the Bells require as much power as possible to let them vie with their true competitor, cable. This camp supports the “Tauzin-Dingell” legislation, which would allow the Bells to close their networks to competitors. On the other side are those who think the 1996 telecom act can work if only the federal government would enforce it. Neither approach has a prayer of solving the problem.

But there is a way to give each side what it claims to want—competition and deregulation—while leading to faster diffusion of broadband and greater economic growth. The solution is to end the Bells’ stranglehold over the “last mile” of wiring by forcing them to divest themselves of the physical wires, much as AT&T was forced to divest itself of its local phone monopolies.

The beauty of divestiture is that it would create all the proper incentives. The companies that own the wires will be eager to cooperate with the providers of retail services—including DSL, Internet access, or local voice service—because neither could serve the customer alone. Divestiture would turn the Gingerbread Boy into the fox’s life jacket. Government wouldn’t have to be in the business of constantly enforcing complex rules of fair conduct. It would only have to regulate the prices that the owners of the wires charge. Divestiture of the local monopolies spurred enormous innovation as well as higher investment and lower prices in the network’s long distance sector. The same would likely follow divestiture in the local market.

Of course, divestiture (or “structural separation”) faces serious administrative and political challenges. But the idea will get a serious hearing now that Senate Commerce Committee Chairman Ernest Hollings (D-S.C.) has introduced legislation that would require the Bells to establish separate wholesale and retail divisions—and some state regulators are also actively looking at separation.

To bring more competition to the market, Congress and the Bush administration must also free up more of the radio spectrum for “third generation” broadband mobile wireless, which will entail recovering unused television broadcasters’ spectrum, or transferring military users to other parts of the spectrum in a way that protects readiness.

Even with these changes, there will remain low-income and rural communities where the market will not support broadband deployment. In those areas, the government should provide outright subsidies. The Rural Electrification Administration (REA) subsidized deployment of electricity, and we should now offer technology-neutral subsidized loans through REA’s successor, the Rural Utility Service. Three billion dollars (less than the “clean coal” subsidy in the House energy bill) would fund enough loans to effectively solve the problem.

Korea has the highest broadband deployment in the world because it has subsidized a build-out to the tune of $7.5 billion over five years. John Chambers of Cisco says, “I’d like to see the administration and Congress, both the Democrats and Republicans, make this a major project, like putting a person on the moon. Let’s give broadband to every American home by the end of the decade who wants it.” Of course, such a program would be a boon to Chambers’ company. But it might also help recharge the economy.

Government needs to take up the difficult challenge of opening up the “last mile” once and for all. With the right policies, businesses and homes can get access to the broadband network, and the virtuous cycle that drove the economy in the ’90s could begin anew. It’s time for the Bush administration to pick up the phone.

Karen Kornbluh

Karen Kornbluh is a Markle Fellow at the New America Foundation. She was Director of the Office of Legislative and Intergovernmental Affairs at the FCC and Deputy Chief of Staff at the Treasury Department in the Clinton Administration.