Letting Go: Deregulating the Process of Deregulation.

By Alfred E. Kahn.

East Lansing, MI: Institute of Public Utilities, Michigan State University, 1998. Pp. iv, 146. $19.95

The Telecommunications Act of 1996 (TA96) was the largest and latest in a series of deregulation statutes from the United States Congress that sought to decontrol prices and entry by phases, subject to regulation in each phase, eventually to achieve a soft landing at the competitive market equilibrium. It was the largest on many dimensions--the amount spent by special interests in lobbying, the length of the statute, and the extent of the mandate given to the Federal Communications Commission (FCC) to implement phased deregulation--to name just three.

Emeritus Professor Alfred E. Kahn, the senior visionary in the economics of regulation, takes the position in Letting Go that since TA96 there has been no substantive deregulation of telecommunications. Instead, the industry has been put on a trajectory by the FCC of increasing costs in local exchange, so as to add token carriers but not competitors, while sustaining high regulatory barriers to entry in long distance.

That was Professor Kahn's vision 18 months after passage of the statute. Now five years after passage, one incumbent regulated local exchange carrier, in one state, has met the FCC requirement of underpricing the services of its network elements to entrants in order to be allowed itself to enter long-distance services. In this process, that carrier involved both state and federal regulatory agencies in setting the terms and conditions of its service at every, switch in its statewide network. So much for deregulating while phasing in the TA96 prescriptions in local and long-distance markets.

This book is important for those concerned with new federal policies for reducing regulation by stages under agency jurisdiction. And it is of interest as well, so as to determine why Professor Kahn is so accurate in forecasting more regulation from such phased deregulation. One compelling reason is his enviable record for detecting and revealing administrative malfeasance; after all, as chairman, he redefined the level of "necessary" regulated entry at the Civil Aeronautics Board as whatever level resulted from free entry, and as a member of the White House staff, he redefined the Carter administration's dysfunctional inflation policies as "banana." But another, more immediate reason for reading Letting Go is that Professor Kahn has an economic theory of regulatory agency behavior that implies consistent failure for these types of partial deregulatory policies.

The FCC is configured in Chapter 1 as a "kleptocratic" organization, seeking to steal or snatch credit for dollars of price reductions for consumers wherever the deregulatory process opportunistically allows. This behavior pattern calls for micromanaging entry of competitors in local exchange, in Chapters 2 and 3, and of local carrier prices for access to long distance calls in Chapters 4 and 5. Taken one by one, Commission practices lead to its triumphant announcements of lower prices, or more suppliers, but together these practices result in a "marasmus" in Chapter 6.

The TA96 provided the framework by declaring intentions to open regulated local and long distance markets to competition. By eliminating "line of business" restrictions from the AT&T antitrust decree of 1984, AT&T (and independents) providing long-distance services could enter local calling areas and the Bell Operating Companies (BOCs), confined to offering services in these calling areas, could enter long distance. For a decade, the BOCs had sought court and congressional variances to the antitrust decree to enter long-distance markets in their multiplestate service areas. The incumbent long-distance carriers had shown no inclination to build wireline facilities to compete with the BOCs in local exchange. At that point, TA96 has added complexity to proposed entry by requiring that the BOGs comply with a "competitiveness checklist" showing that they have opened their local markets before they would be authorized by the FCC to enter long distance. Local entry was first, then long-distance entry, the opposite of what had been attempted by the carriers to that date.

Professor Kahn provides a stylized description of these markets as subject to a "structure of rates designed explicitly by regulators to subsidize basic residential service with monopoly markups [on] long distance and charges to business customers" (p. 8). He states that controversy on the extent of the subsidy has been "marked by a deplorable amount of casuistry insofar as the contentions are purportedly grounded in economics" but that the market test is there-"it has not been an accident that when telephone markets were opened it was to the latter [longdistance] markets that competitors flocked" (p. 8).

Prices below cost in the local exchange, where competitive entry had to take place first, has presented the most formidable barrier to entry. After all, a negative profit opportunity for the entrant is not conducive to "flocking" into local markets. The Kahn theory of the regulatory agency implies that the FCC would not, with the state agencies, take actions leading to increases in local prices in order to generate positive profit margins for any new local exchange provider to thereby foster competitive local exchange entry. That would hardly be agency kleptocratic behavior, since the agency cannot announce that its phased deregulation caused price increases. Instead, after unbundling the network elements of incumbent local exchange carriers for use by entering carriers, the FCC mandated that the state regulatory agencies price them below the current costs of providing that service. That would induce entry, since new carriers could price their services below the level of incumbent carriers using the network elements of these incumbent carriers (see "Telric-BS," Professor Kahn's term to describe this below-cost pricing of unbundled network elements that rivals the term "banana" in earthiness; p. 89 et seq.).

The sources of funds to subsidize local exchange services have been high price--cost margins on large business services and on access to calls for long-distance carriers. Significant erosion has occurred in margins for large business services as numerous specialized business carriers have entered central cities to provide just those services. The FCC has proceeded to implement TA96 by requiring the BOCs to reduce their access charges in a series of steps over the last three years; they have been "unaccompanied by any suggestion that the FCC combine the reduction in access charges with a further rebalancing between those rates and basic residential charges" (p. 107). The lack of any initiative of the commission "on settling on some alternative method of financing the cross-subsidization constitute[s] blatant invitations to kleptocratic behavior" (p. 107). Relieving the BOCs of the funds required to keep local exchange rates down while the state regulatory agencies prevent local exchange rate increases fits th e Kahn theory of beneficial behavior for the FCC.

But the third critical implication of the Kahn theory has failed to emerge. The three building blocks of reform in TA96 were local exchange entry, access pricing, and long-distance entry. Although local entry has been selective into the high-price business markets, local wholesale and access prices have been forced down by Commission decree. But there has been no substantial BOC long-distance entry; the BOCs have the facilities capacity and market expertise to gain one third of revenues in long-distance markets, and they could cause long-distance margins to fall to levels found in basic local exchange. The FCC could in triumph announce long-distance price reductions of 20% or more. In proceedings that have themselves been barriers to entry, the FCC has rejected all except one of the BOC petitions to provide in-region long-distance services. The Commission has not taken "the blatant invitation to demonstrate kleptocratic behavior."

There is another equally straightforward theory of FCC behavior that does offer an explanation for the existence of this missed kleptocratic opportunity. Even a cursory review of the economic impacts of the key FCC decisions indicates that the incumbent long-distance carriers have benefited. They pay the below-cost price for unbundled network element services; they pay lower access charges for long distance; they fail to realize price reductions from BOC entry forestalled in long distance markets by Commission proceedings. The theory would be that the FCC operates to generate cost and competitive advantage to those carriers it principally regulates: the long-distance carriers. All that did and did not take place since TA96 has been consistent with the simplest of Chicago capture theories.

The last chapter, "The Marasmus of the FCC," takes the position that "systems of economic regulation and commissions charged with their effectuation tend to become anti-competitive and excessively protectionist of the interests of the regulated companies" (p. 145). This follows more from Professor Kahn's experience in decommissioning the Civil Aeronautics Board (p. 146) than from his analysis of kleptocracracy at the FCC; it is more consistent with FCC decisions since TA96 having tipped the balance toward maintaining and even enhancing the market position of the incumbent long distance carriers. But "it is necessary...to recognize, one last time, that the ultimate responsibility lies not with [the FCC] but with a Congress and a public that demand massive investments in a modern telecommunications infrastructure, ubiquitously extended, along with increased competition for residential customers, all with no increases in basic residential rates" (p. 146). Nevertheless, Professor Kahn's prescription for reform i s that "the FCC's actions of the past two years strongly suggest that it either is or will soon be ripe for the Gaskins prescription" (p. 146), which is to send to Congress a five-year budget plan for the FCC that takes Commission expenditure to zero at the end of the fifth year. The five-year record is now such that whether kleptocracy reigns at the FCC or agency capture by the long-distance carriers, the Gaskins reform of telecommunications regulation seems necessary.