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Event Transcript
October 1, 2001


Telecom Deregulation: The Abominable TELRIC-BS

Speaker:
Dr. Alfred Kahn, Professor Emeritus of Political Economy, Cornell University
Author, Whom the Gods Would Destroy, or How Not to Deregulate

Introductory Remarks:
Peter Huber, Senior Fellow, The Manhattan Institute

Attached are the October 1st remarks of noted economist Dr. Alfred Kahn on what he sees to be the failure of telecom deregulation resulting from the FCCís adoption of irrational pricing policies. This event was held at the National Press Club in Washington, DC. We encourage you view the archived video of Dr. Kahnís thought provoking and entertaining presentation.

Dr. Kahnís address is particularly timely, as the Supreme Court will hear oral argument on the FCCís TELRIC (total element long run incremental cost) pricing rules on October 10th.

Dr. Kahn is one of the nationís foremost thinkers on this subject. He recently published Whom the Gods Would Destroy, or How Not to Deregulate, an exposť on the ďperverse propensities of regulatory agencies to regulate pervasively in the name of ĎderegulationíĒ, which he thinks is exemplified by the FCCís pricing rules.

Dr. Kahn is a Professor Emeritus of Political Economy at Cornell University and is also the author of the influential work, The Economics of Regulation. Widely known as the ďfather of deregulation,Ē Dr. Kahnís highly regarded work helped lead to deregulation of many industries, among them telecommunications and the airline industry. With years of experience in the deregulation of markets, we are pleased to have Dr. Kahn give us his unique perspective on TELRICís impact on the telecommunications competition, innovation and the deployment of new facilities and services.

All questions should be directed to Lindsay Young, Director of Communications, at 212.599.7000 or lyoung@manhattan-institute.org.

Transcription by Federal News Service.

MR. PETER HUBER: Good afternoon, I'm Peter Huber of The Manhattan Institute. It is a great pleasure and honor to introduce Alfred Kahn, our speaker today. He is the Robert Julius Thorne Professor of Political Economy Emeritus at Cornell University. He is also a special consultant to NERA an economic consulting firm.

Professor Kahn is surely the most respected and influential well-known intellectual force to have worked in the field of economic regulation in the past many decades. He is that rare breed of economist who has not merely preached the dismal science he has practiced it, too, hands on in the places where it can really make a difference, for better or for worse, which is to say at regulatory commissions themselves. Most of the rest of us, many of the rest of us anyway, write about regulators ought to do, and so does Fred Kahn, and so he has done throughout his very distinguished long career. He, unlike so many of us, also went out and did it.

I know nothing compares with today, but the transportation industry was in quite an economic mess when President Carter appointed Dr. Kahn as chairman of the Civil Aeronautics Board in the spring of 1977, granted a different kind of mess from the one we face now, but as messes go, it was a good one.

Senator Kennedy had been dramatically documenting the burden on consumers imposed by the economic regulation of airlines, and he asked Professor Kahn, together with an obscure young Harvard professor, I was in his class actually right around then, but by the name of Steve Breyer, to do something about it. And with very little leeway to combat the stagflation that was affecting the American economy at the time, that small team and a very few others seized the opportunity, took the initiative, and invoked competition as a discipline on prices to prod economic growth. And to their enduring credit, they ended up wiping the slate completely clean of the truly maniacal economic regulatory restrictions and encrustations on competition that had attached themselves over the years, maybe the decades, to airlines, and truckers, and railroads.

In the years before and since, Professor Kahn has been chairman of the New York Public Service Commission, chairman of the CAB, and advisor to the president on inflation, chairman of the Council on Wage and Price Stability; I could go on. He received bachelor's and master's degrees from New York University, and a doctor in economics from Yale, and served in the Army, eventually found his way to the department of economics at Cornell, which has remained his academic base ever since.

During his tenure at Cornell, Professor Kahn has served as chairman of the department of economics, member of the board of trustees, and dean of the College of Arts and Sciences.

He has served on an extremely long list of other committees and task forces, far too numerous to itemize. His list of honorary degrees and awards is longer still. His publications list includes many books and articles, and most recently The Economics of Deregulation: Letting Go. It's on your chair, as he says, at an output maximizing price.

In a radio show many years ago, there was this comic character named Baron Munchhaussen and his servant Charlie, and the Charlie would sometimes express doubt about the truthfulness of the Baron's tall tales, to which the Baron would always retort: ďwas you there, Charlie?Ē Alfred Kahn doesn't tell tall tales, of course, but no student of economic regulation should ever think to ask him: ďwere you there, Fred?Ē -- because the answer will almost invariably be: ďyes, I was.Ē

DR. ALFRED KAHN: Thank you, Peter. Sometimes I feel that all these things that I write are fundamentally dictated by Peter, and I'm in the happy position of often not understanding the technology he's talking about, but somehow, there's something he says that appeals to me, and I find a way of putting in other terms.

The subject of my talk is perhaps conveyed by an aphorism: a footnote scorned is like the wrath of a woman scorned -- and I am now eagerly anticipating vindication of Footnote 91 in my Economics of Regulation published in 1970. That's a rather egocentric view of what the Supreme Court is going to do, Peter and I think, Randy [May] is not so certain, but we'll take bets on it, Peter. But whatever they do, I'm going to regard it as a vindication of Footnote 91, which Irwin [Steltzer] permitted to remain while he supplied me with voluminous other suggestions for those two volumes. And, of course, what I'm talking about is the subject of oral argument before the Supreme Court in the next week. The [New York] Times tells me that these particular cases are consolidated under the heading Verizon v. FCC. I like to think of it as the AT&T v. The Iowa Utilities Board. But in any case, I'm going to celebrate.

Unfortunately, the oral argument will coincide with my 58th wedding anniversary, but not my 84th birthday, so I'm going to have additional cause for celebration, I'm absolutely certain.

I should disclose at once that the subject of the oral argument of that proceeding is one in which I've been involved for at least five years on behalf of Bell Atlantic, and now Verizon, in this central issue that is going to be argued. But it is, as I have already suggested, equally accurate to characterize this five-year feud that I've had with the Federal Communications Commission as a defense of Footnote 91, which was published 31 years ago. And, the intensity of my feeling about it has increased immeasurably by the fact that I cited Footnote 91 to the FCC in 1996 at a seminar that they called, to which they invited me, after they issued the NPRM, but before they issued their ridiculous decision, and so it's not only my footnote that's scorned, it's I that was scorned. They simply ignored it.

And what's additionally ironic is that in the NPRM, they cited the Economics of Regulation either six or seven times, as I've said, and besides who counts, but all they did was cite it in ultimate support of an absolutely ridiculous, ridiculous position. I'm going to have a good time, because I expect to have my revenge.

As you know, the 1996 Act adopted as our policy the opening up of the telecommunications industry to competition, and effectively deregulation as the best way of encouraging the fullest exploitation of a rapidly developing telecommunications technology. The difference from airlines is perfectly obvious. We have to give the FCC credit for recognizing, and Congress, that in contrast to the airline case, what was it necessary to hang on to. Dorias Askins once came to me and suggested we present to the [CAB] oversight committee a budget going down from 100 percent to 20 percent over a period of five years in order to demonstrate our sincerity in aiming for genuine deregulation. But that wasn't really because we did it. It's because as we started, the process took on such a momentum of its own, that really we couldn't have stopped it if we wanted to. I was happy that we didn't want to, but I must say that the course of events once we started had a cumulative effect, and deregulation was about the only thing you could do.

That simply is not available in areas like electric power, or telecommunications, because you do genuinely have facilities which, whether you call the essential facilities as you clearly will if you talk about transmission and distribution that works in the electric industry, or whether you are saying they are necessary to competitors, or inability to obtain them will impair their ability to compete, there is no question that the local wires would have been a substantial obstacle to competition.

But for one other coincidence, which is that the rate structure was so ridiculous that you might have gotten effective competition in the particular areas where you've got it, even if you didn't have access to the wires and, indeed, in which access to the wires was not terribly important. I'll come back to that in just a moment.

So, as you know, in exchange for removal of the interLATA ban, the deal was that you opened up the local markets to competition by offering the unbundled network elements to would-be competitors, those that are necessary to their competing, or the inability to obtain would impair their ability to compete -- the necessary and impair standard. And this is what's before the Supreme Court now, at rates "based on cost" which may, however, include, not however, but which may include "reasonable profit." And it's that, I'm awfully reluctant to tell so many of you here know exactly what I'm saying, so I don't even have to say it, but I'm going to sort of walk in the middle and probably satisfy neither of you, but that's the issue: What does it mean to say these charges for the unbundled networks must be ďbased on cost,Ē and ďmay include a reasonable profit?Ē.

Two major issues, one, the designation of the unbundled elements that are necessary for competitors, or the absence or inability to obtain which would impair their ability to compete, that was the subject of argument before the Supreme Court. The FCC took an extreme view which, in effect, said, anything that they ask for that can physically be interconnected or provided meets the necessary and impair standard. So that, in effect, the mere request satisfied the standard. And that earned the rebuke of the Supreme Court, I think it was eight to one, with I guess David Souter dissenting. And they said, no, you must give some substance to that. There were some mentions of the essential facilities doctrine, which is a great deal more demanding, but the Supreme Court certainly didn't insist on that, but they insisted that you make some showing that they really had to have access to it. So that rebuke was taken care of.

The pricing issue, I, through a series of arrangements that I don't fully understand, but I regretted at the time, the Supreme Court said was still being adjudicated, it was not yet being appealed, it was being adjudicated before the Eighth Circuit, which had already passed on the identification of UNEs that had to be made available, so that was put off for another three years. So that it's been an unconscionable five year period finally to get the end of something that should never have  I mean, here was a real case for abortion. In any case, it's now here finally before the Supreme Court.

There are two reasonable interpretations of this cost based on cost plus a reasonable profit. One, of course, would be book costs, or the costs that had been adopted for regulatory purposes, which in a highly capital intensive industry would include a large element of return on net depreciated historical book value of its facilities. And a reasonable case could surely be made that they should have simply adopted the costs that have been adopted for regulatory purposes: book or historical costs. After all, the telephone companies had been operating under a method of regulation which essentially said that unless your investments are demonstrably, or can be demonstrated to have been imprudently made, you are entitled to recover those investments plus a reasonable return. So that argument could have been made, and particularly in view of the historically low depreciation rates which inadequately reflect the dynamic nature of the technology, there was the same kind of stranded cost concern that we had in the electric industry. It's ironic, of course, that the stranded costs proved not to be stranded at all. That these heavy sunk costs, that had been acquired, accumulated as a result of some terrible mistakes made by the utilities, made by the utility commissions interpreting the public utility regulatory practices act, that expectation gave rise to the expectation that then if you deregulated, you'd have enormous, tens of billions of dollars, benefits conferred on ratepayers if the commissions let competition operate. That expectation itself was based on erroneous forecasts, and the moment they deregulated [the California electric industry], they found that instead of free market rates being below book costs, they have been above book costs, at least for the time being.

In any case, to come back here, one possibility would have been simply to let them charge their book cost plus a public utility [rate of] return to which it might be argued they were entitled.

By the way, this is all about money, and therefore it's really not very important. Before I'm through I'm going to try to talk about things that I think are economically important, but of course it's a hell of a lot of money, and in any case that was rejected.

The other point to make is that, yes, the level of the charges for these necessary facilities is itself unimportant from the standpoint of the purpose of the Act, which is to encourage efficient competition. I mean, there's enough development of the literature which I think clearly establishes that as long as the charges that the incumbent telephone companies [charge], whatever the absolute level of the charges for these facilities or leases to the competitors, as long as that same level is incorporated in their own rates, you have competitive parity, and you can have efficient competition. Competitors will thrive or fail depending upon whether their incremental costs are higher or lower than the incremental cost of the incumbents. So, you could have them at any absolute level, and still meet the purpose of the Act. But whether it's high or low, of course, is not a matter of indifference to the telephone company.

The alternative, of course, is to use incremental costs. And, I think it's hardly necessary for me to make the commonplace observation that efficient prices should be or must be at marginal level or incremental cost, except to the extent that the marginal costs are below some measure of average revenue requirements, in which event you have to markups sufficient to meet the regulatory goal of revenue adequacy. But it's perfectly obvious that economists would say, well, isn't there some way we could base it on incremental costs. Marginal costs, after all, are justified in terms of giving buyers the proper signals if buyers are confronted with prices that reflect the incremental costs of society, and then taking somewhat more than by their voluntary decisions they will properly decide whether more should be provided or not. And similarly, incremental costs measure the cost that society would save if they took somewhat less -- and then they are making a rational decision. If they take somewhat less, then society is better off. If they continue to purchase it, it means the value that it has to them exceeds the incremental cost to society. I mean, that's the obvious familiar case for marginal cost in pricing. And that's where, I guess, I should take a certain amount of pride that they had the six or seven references to my Economics of Regulation, in which I have two volumes devoted to expanding on that elementary notion without a single mathematical appendix.

But I never dreamed that they would adopt not the true actual incremental cost to the companies. I never heard anybody historically talk about charging incremental costs except actual incremental costs. The whole logic of the allocated efficiency case that I just made depends upon these measuring the actual costs that society will incur. And those, presumably, are the incremental costs to the people who are producing it. The actual cost that society would save if consumers or purchasers took somewhat less. I never dreamed that somebody would sell the FCC on the notion that that's not the efficient price, but instead that the efficient price would be the one at long-run incremental cost with long-run defined in the strict theoretical economic sense of the prospective in which all costs are variable. So, in effect, what they're saying is, no, the prices should be based upon the cost of an ideally efficient, omniscient, new entrant, writing, as it were, on a clean slate. Admittedly, hypothetical. Admittedly it would require estimates. I wish that some of you could have participated or observed the process by which states would convene interested parties, commissions, and sit for 12  I was in Texas where they did it for several days for 12-14 hours a day, arguing about, well, my cleaning woman can go out and buy that at a lower price kind of argument.

That "my cleaning woman" joke is not sexist, but it is one that I will tell you on your time rather than my time.

But, in any case, it's an error, of course. I am to my great satisfaction, forgive me for repeating it, I coined the phrase that this is writing on a blank slate, TELRIC-BS. And I've always thought that was particularly telling as conveying the scorn with which I held the FCC for not listening to my argument that that was economically wrong, and with that, of course, we're back to the famous scorned footnote.

It was wrong because, in an industry in which technology is rapidly progressing, no one will invest in the expectation of obtaining a price when the facilities are constructed that just covers the cost of capital and public utility rates of depreciation or obsolescence, knowing that the next day the return will fall below that level because of the dynamic technology. So, either an investor will withhold investing until the average total cost of new facilities declines sufficiently below price so that if they then invest they will make supra-normal profits, or supra-normal allowances for obsolescence sufficient -- so that with the constant progress of technology by something like midpoint they will have obtained a sufficient amount so as to make up for the subnormal returns that they earn thereafter. That was not coined by me, that was expounded by William Fehlner, who was a marvelous economist way back in the 1960s. He said investors will practice anticipatory retardation, and that's in my lovely Footnote 91.

Jerry Hausman has made the same point in a slightly different way, but it is the identical point. He said, given this rapid obsolescence which is to be expected, no one will invest at a price unless that price contains a gross rate of return two or three times typical public utility rates of return. Precisely, again, because of the necessity for earning supra-normal gross returns, supra-normal as compared with the ordinary public utility practice with gross returns, of course, including obsolescence and return on investment.

And my colleague, Tim Tardiff, has made it to me in a way that I find even more intuitively clear. He said, all you have to do is compare the price that you pay for buying a computer today. To make it comparable, assume that you're buying it on an installment plan so that you're making monthly payments over the course of buying it. Compare that charge if you sell the computer with the charge for short-term leases of the computer, where the latter charges will be much, much higher, because it's simply a question of who bears the burden of obsolescence. If you sell it, the burden of obsolescence is borne by the buyer. If you lease it, the burden of obsolescence is borne by the seller.

What the FCC has done by using something close to public utility rates of obsolescence, and weíre still talking about rates of return on invested capital in the 9 percent range or something like that, what it has in effect done is expropriated the companies by making them bear the burden of obsolescence, because these are prices for leases of their facilities, not sales of their facilities. And, it completely shelters the price paid by the purchaser, or lessee  I wish you lawyers would not have gotten ďorsĒ and ďeesĒ mixed up that way  but in any case, the lessee pays a price which totally escapes the cost of obsolescence.

So, one thing wrong with the FCC is that they were wrong. I mean, their economics was simply wrong. Second, and in some ways even more interesting at explaining these titles and particularly subtitles of my books  I mean, Letting Go, after all, is a pretty harmless title of a book; but Temptation of the Kleptocrats, which is one of my subtitles, or the Political Economy of Regulatory Disingenuousness, that was the other title of my Letting Go, and I'll come back to the disingenuousness for just a moment. Or the title of this new one, and I see that it's being charged to you at a price roughly equal to its value. In fact, it's below marginal cost. There must be some printing cost. But I think Bob Crandall is bearing that out of his endowment at Brookings. But, in any case, that one is called Whom the Gods Would Destroy. And I know that almost all of you will know that that comes from Euripides, and that Henry Wadsworth Longfellow added to that ďThey First Make Mad,Ē and I'm still talking about the FCC, all of the implications, of course, are Whom the Gods Would Destroy Tthey First Make Regulators.

So, number one, it's wrong in economic terms.

Number two, it displays the most incredible arrogance because the FCC is, in effect saying, we're going to set prices not at your actual marginal costs -- which by the way is not only the price that would be consistent with intelligent decisions on the part of, efficient decisions on the part of consumers, and efficient use of resources, but it is also the way competition works -- that competitors, prices in competitive markets or would-be competitive markets are generally set at something like the costs of the incumbents, or to the extent there is a monopoly power, above the costs of the incumbents. And then, that gives them the signal about whether they could enter or not. If their incremental costs are lower than those of the incumbents, they enter. And in so doing, they beat the price down. But, oh, the FCC, why should we bother with that messy, undependable competitive process, we can do it. We're smart enough. Why not, since we know what the price is going to be, we'll set it there right away. It saves an awful lot of trouble.

Absolute arrogance, of course. The consequence is that it sets them up for a trial by combat of different people presenting different models with different assumptions, hundreds, and hundreds of assumptions underlying the construction of these models. Anyone with any sense of history, as Steve Breyer actually did make the point in a dissenting opinion, or the part that is dissenting in 1999, remembering the old arguments about reproduction costs versus original costs complained of by Justice Brandeis down in the Southwestern Bell decision in 1977 you will know. But the endless exercises that were engaged in, there were engineers who were actually estimating the cost of rebuilding the existing facilities block by block and repricing them without paying any attention to the fact that the new facilities would be constructed perhaps in entirely different ways. So it was not only arrogant -- the very fact that regulators are themselves incapable of deciding what an efficient price will be is the essence of the case for deregulation, for leaving it to competition to tell you what the price will be.

Or, when regulators realize the inadequate incentives under an essentially cost plus regulatory scheme, they went over to incentive regulation. But what was incentive regulation? Essentially they took prices set on the basis of traditional cost of service determinations. They then estimated as best they could on the basis of the historical record what kind of productivity improvements could be achieved, and reset the prices on the basis of something like RPI in the case of England, an index minus X (the achievable productivity gain). And it was precisely because they could not themselves stipulate what the price would be, but they wanted to give the companies the incentive to maximize their efficiency. And, indeed, as far as we know it had that effect.

Finally, it was cynical. I mean, this is where I got into the political economy of regulatory disingenuousness. After he left the FCC, Reed Hunt said, you know, I never liked those models that are not based on the real world -- that was the way he put it. And itís not surprising, he advised Gore in his presidential campaign. Thatís a private political joke.

By the way, I have that deathless footnote here, just in case youíre avid Ė there will be a very low charge for it. And as I say, thatís not how competition works. Prices should be based on actual cost in some way, and then competitors have the proper incentives.

Now, up to now Iíve been talking only about money, and vanity. But, itís only money. But, it gets to a point where weíre now talking about something that is really economically harmful, counterproductive, and thatís when offering would be competitors access to the facilities of the incumbents without limit in the definition of what facilities qualify for that mandatory unbundling, at the hypothetical prices of the most efficient competitor building them., If you can buy them, or lease them at that rate, why on earth would anybody construct his own, his or her?

I mean, you have an absolute, in principle, you have an absolute barrier to any facilities based competition. Why on earth would anyone assume that responsibility if itís possible to acquire them under the aegis of the FCCís rules? So now it becomes really counterproductive. I was wondering whether I should save it for the question period. I guess I will, because Iím running over my time, but if you donít ask it Iím going to tell you anyhow. But, Iíll give you a chance to ask it first: It is why then are some people building their own facilities.

The fact is you have, in principle, no reason to build your facilities. And moreover, and youíre close to finish, not only is it in principle a fatal impediment to independent facilities based competition. Particularly when, in the interpretations pressed by AT&T, you can buy bundled facilities -- you can buy a platform, which is just another way of saying you can buy the services themselves at this theoretically low price, because it can all be assembled for you, these facilities. But, even more significant, it discourages risk taking innovation on the part of the incumbents, as well. And that becomes very important in another area that Iím not supposed to talk about, but that will clearly rise to the surface again in Congress, and that is the question of access to broadband, and on what terms.

And here we are talking about enormous new investments in a competitive environment, in which the DSL of incumbents has less than half of the market share of the cable companies, who are subject to no such unbundling, or mandatory access requirements, let alone at a TELRIC BS price. And theyíre facing making these huge investments in an atmosphere of extreme technological uncertainty. Now, you may not be able to document that as easily as I, because each year I was convinced by something I read in the paper that the technology was going to be this. I spent years representing Bell Atlantic in cases before federal district courts arguing the economic side of their case, that the First Amendment precluded or prohibited Congress prohibiting telephone companies offering cable service. They wanted the right, because the technology was clearly going to be  what do they call it? They were going to have combined fiber and cable facilities in order to offer both telephone and video services. And we won every case that was a violation of the First Amendment. The only case we didnít win was that it turned out to be the wrong technology, the wrong economics  but, here the same thing is true. Did I say the wrong economics? Not the wrong economic principles, thatís all I care about, but the economic assumptions about what would prove to be the technology.

We obviously donít know whether itís going to be cable modems, or whether itís going to be DSL, or whether as increasingly seems to be possible, wireless, whether fixed wireless or mobile wireless, or satellite wireless. And given that extreme technological uncertainty, to come back to a subject of the pricing formula that the FCC has adopted, observe what that means. If you must provide access to anyone who asks for it as TELRIC BS prices, if your investment, and these are huge investments, proves to be a bet on the wrong technology, obviously you swallow it, because nobody is going to ask you for it. If it proves to be the right technology, youíre going to be allowed a public utility rate of return on the hypothetical minimum cost of your competitor. Under the circumstances again, it seems to me you have a fatal obstacle to the kind of massive investment that we need in broadband, recognizing that is it less than 10 percent of the households have broadband access today.

So what you then have is a system that is not just a matter of money, itís not just a matter of insulting me, which is really what gets me mad. I mean, you can insult my wife, but not my Footnote 91. But also, itís a matter of distorting investment, and dampening investment incentive, which was the very purpose of deregulation, to create and to encourage. I guess weíre going to hear much more about this broadband issue in the weeks ahead, but right now, and Iíd better enjoy it before the Supreme Court comes down with its decision. Despite Peterís and my absolute confidence that theyíre going to vindicate both of them, Iím going to enjoy it now. Weíll talk about broadband another day.

Anybody have any questions?

MS. : Just so that you all know, we are going to be web casting this. So youíre going to be recorded and itís going to be available on our web site tomorrow morning. So if you have a question, please raise your hand, Iíll come over, and speak clearly into the microphone.

QUESTION: Fred, as I recall in footnote 91, which I think is on page 3 of the book, Iím trying to sort out  this may be the same question worded differently. Whatís the difference between prudently incurred costs, as you viewed them when you were regulating, and costs that reflect the latest or projected available technology? In other words, whatís the difference between prudently incurred costs and what the FCC did when you were deciding what you allowed in a rate base. And if there is a predictable downward trend in cost, not the magnitude, the direction, how does an incumbent in a competitive market induce customers to buy at his existing cost level when the anticipation is that costs next year will be lower?

DR. ALFRED KAHN: Let me make sure I understand. Are you asking whether if purchasers know that costs are going to be lower in the future why would they buy today?

QUESTION: What terms would they have to be offered to buy today? Wouldnít they have to be offered a price that reflects the anticipated lower cost of the newer technology?

DR. ALFRED KAHN: If you invest today knowing that the costs tomorrow are going to be lower, and the price that you get today is not sufficiently high to give you protection of a high return for obsolescence, because itís anticipated, then the price today has to be high enough to induce the investment to be made today. And the price yesterday had to be high enough to anticipate the obsolescence that would occur in the next couple of years. Thatís this anticipatory [retardation]  envision average total costs going down. If your average total cost, public utility rates of depreciation and return are just at that level, youíre out of your mind to sink your capital into an investment that tomorrow your costs will immediately fall below.

So what Fehlner said was the true competitor price would track the lower cost sufficiently. That is to say, the costs would go down, the price would be up here, and we track it down sufficient to induce people to make investments, sink their capital today, knowing that their return will progressively fall.

QUESTION: So thatís a question of the rate of return, then?

DR. ALFRED KAHN: Thatís what Jerry Hausman said, in effect. Even in what Fehlner said, and Fehlner didnít mention the rate of return, and heís so young he doesnít even know who Fehlner was. But, he translated it, and correctly, into saying, you would have to be offered a return in the 30 and 35 percent range for you to be willing to invest today, knowing that over the life of the facility that return would fall. And of course, in the latter portion of its life it would be below the average rate necessary.

QUESTION: So back to the first part, when you were regulating, and someone built a plant using an obsolete technology, a technology that you knew was not the optimum technology at the time, what would you have done  

DR. ALFRED KAHN: I did.

QUESTION: I know you did. How would you define the prudent investment? Wouldnít you define it in terms of future costs?

DR. ALFRED KAHN: Even if I knew, set aside the problem of regulatory ignorance, which is why we deregulated in the first place. Even if I knew that costs would be lower tomorrow, there would be technology progressively, Iím not talking about something discontinuous, but what could be reasonably predicted, I wouldnít say itís imprudent to invest today, because there is a sacrifice of investment, that if the price is high enough the investment made today its costs will already include the expectation of lower returns later. Then itís underproduction if you donít invest today. That is to say, if youíre at this point where the price is here, and the average cost is here, then thatís the time to be making the investment. My only point is, this is not the proper time to be making the investment. Thatís what Fehlner said. And Jerry said, either that or he said, only if thereís a rate of return sufficiently.

QUESTION: Iím Greg Sidak, from the American Enterprise Institute.

DR. ALFRED KAHN: I know that.

QUESTION: What sort of advice would you give the Supreme Court on how to write its opinion. In particular, do you see the court, or would you advise the court to decide the case narrowly, and look at statutory language and try to give content to the Telecom Act, or would you encourage the court to write an opinion that might be the next Hope Natural Gas or Duquesne?

DR. ALFRED KAHN: Well, Iíll leave the ďTtakingsĒ arguments to you -- I mean, essentially legal argument. Iím really admitting that in some layman sense they are engaging in takings. Iím hoping that it will go beyond  wait, Iíll be satisfied if they do as Peter said, affirm, period, because that Eighth Circuit decision was very good by my standards, and I think by yours. But, if they do go beyond, I hope they will use the occasion to talk about the proper deference due to the expertise of administrative agencies, because obviously the deference argument could justify them in simply reversing the Eighth Circuit. Fortunately, as you pointed out, they have to show deference to the Eighth Circuit, too.

I would hope that they would say something more along the lines of what I said. And, in fact, Steve Breyer has clearly said that, a lot of that, in his Ď99 decision. He talked about the history of reproduction costs. He talked about the regulatory quagmire. He talked about the economic reason, the Schumpterian reason for not trying to, in an area where innovation is important, subject such services, or methods of providing those services, to traditional public utility treatment. He talked about that the real competition is not in the shared facilities, but in the unshared facilities. And he has some really eloquent language there, and I find it hard to think that he would not rise to that temptation to go beyond and somehow rebuke the FCC for its arrogance.

QUESTION: Your allusion to a hypothetical question peaked this question in me, regarding facilities based investment. In the current financial distress in the telecom sector weíve seen a lot of the supposed beneficiaries of the TELRIC price in some distress themselves, and some point at this, and this, and so forth, a lot of them, at least in the popular press, and often the rehearsed explanation is that there was a tremendous  there was capacity built, and in fact there were too many facilities available, too much capacity, at least in places like Washington when we crossed the street we would, in fact, see what looked to be new facilities being laid, at least in certain areas. So my question would be if TELRIC has this effect of discouraging the investment in facilities, which I tend to think it does, reading all of your books like this.

DR. ALFRED KAHN: Say the same thing enough times, everybody believes it.

QUESTION: I even read footnote 41, or whatever. But, that being the case, how do you explain this, perhaps supposed, disconnect?

DR. ALFRED KAHN: Obviously, Iíve given that some thought, because the FCC mentions that in its brief. It said, there is ample incentive for competitive companies to be free of dependence upon their major competitor, the incumbent company. But, look where the investment has taken place. It has been preponderantly, overwhelmingly, in central metropolitan areas, in sales to business users, and by firms that began as competitive access providers. So what youíve had in the combination of those three circumstances was an enormous artificial incentive to investment created by the distorted rate structures, set by regulators, of the incumbent telephone companies, which has in those areas overcome the case  that is in the provision of broadband services in those areas. So you donít see it obviously in residential customer sales, because of the suppressed retail rates there, suppressed by regulation. You donít see it outside of concentrated metropolitan areas, where the suppression is extreme, because of the number of subscribers per mile. It gets progressively smaller and smaller. But, you do have this--

I remember, I was talking in Minneapolis when the Commission had found something like a $14 a month TELRIC charge proper for subscribers, in Minneapolis. MCI was coming into compete, but they werenít competing for the residential customers, whose rates were $16 or $17 at that time. They were competing for business customers getting the identical service, whose rates were $40 to $60 a month.

So you had, number one, artificially increased rates to business in order to subsidize residential services. Thatís number one. Historically, perhaps even earlier, prior, the access charges to long distance companies, were far, far above cost. And so notice that Teleport, and MFS, which were the two major CLECs in the cities in the cities building fiber optic cable, they both began as competitive access providers, just as a way of customers escaping these outrageous 10, 15, 20 cents a minute access charges imposed by the regulatory agencies. And I know Iíve testified in states where they depended on inflated charges for intrastate toll in order to hold down residential rates at $6, $7, $8 a month. Then you had the emergence of broadband technology, and the growing broadband market, and they can offer those services at a time when they were not really available, at least at comparable cost, from the local telephone companies. So I think those are the three principle reasons why you got it there, but you didnít get it anywhere else.

QUESTION: I guess itís me. I donít know exactly how the leasing of central facilities works. But, Iím a lawyer, and Iíve worked in the consumer finance area. Specifically Iíve worked in the area regarding automobile leasing. And one of the ways that they try to redistribute the risk of obsolescence is to, at the beginning of the lease term, a termination formula is set up, which is based upon some predicted obsolescence.

DR. ALFRED KAHN: Sure. But, thatís not what the FCC did. I mean, thatís what Jerry Hausman said. You set a rate that gives you  that transfers the risks and costs of obsolescence from the lessor to the lessee. And thatís exactly what youíre saying. Thereís not a word in the FCC decision about this.

QUESTION: So are the leases set up for some indefinite length of time, or are they set up over a specific length of time?

DR. ALFRED KAHN: I donít know the answer to that.

QUESTION: Or to have it for some length of time, and then have the termination formula set up that has some agreed upon  

DR. ALFRED KAHN: But, all the FCC ever said, to my knowledge, is we think the rates of depreciation are sufficient to take care of the obsolescence problem. I know of no evidence that theyíre anything appreciably higher than they have been in the last 10 or 15 years. But, as you say, and I think I say, a lease contract such as was not stipulated by the FCC, that did indeed provide a Jerry Hausman kind of estimated allowances for obsolescence would be unobjectionable.

QUESTION: Let me just ask Dr. Kahn, apart from their unconscionable desire to insult you, the FCC is full of intelligent people. Just as a matter of political economy, what do you think was going on in their heads?

DR. ALFRED KAHN: The only explanation I have, other than the fact that they were sold this by some cockamamie economist, who should be anonymous, is that if you say our goal is to have competition, and people start saying, where are the competitors, youíre going to feel some obligation to lean over on the side of seeing to it that competitors get a leg up. I mean, itís the old infant industry kind of motivation. Youíre there to produce visible results. And during the late Ď90s people were saying, where are the competitors, and where are the rate reductions. And as for the latter, of course, take the extreme case, thatís what California has succumbed to in the electric case. They all, hey, here are your rate reductions, and theyíre frozen there.

So I think what happens when a regulator is responsible for something -- in this case is responsible for an act whose goal it is to make sure you have competition. And people in the FCC always say, I know youíre going to say something about infant industry, but thatís really what theyíre doing. Thereís a whole section in the previous book where I talk about codes of conduct, the treatment, the relationship between a regulated utility, distribution company, and its affiliated, unregulated competitors, the terms on which you transfer assets, the terms on which you transfer goods and services. Typical arrangement, when it goes from the utility to the affiliated, unregulated competitor, anything thatís transferred that way, must be at book or cost, whichever is higher. And anything transferred this way must be at value or cost, whichever is lower.

Assets that are transferred whose value is below the book value will be transferred to the competitor at the book value. So, in effect, the competitor has the burden of making up the stranded costs. Assets that are transferred this way it would be the opposite. Itís simply regulatory opportunism, and a subtle effect of being responsible for something, responsible for results. You want rate reductions, by god, weíve got to get you some rate reductions. Even if it means we have to issue bonds with a state guarantee, any way we conceal the costs, but weíre going to get you rate reductions.

(Applause.)

DR. ALFRED KAHN: Now, Iím going to test the validity of the story. Renee DeCartes once went into a bar in Paris, and the bartender said, would you like an aperitif, and he thought for a while, and he said, I think not. And he disappeared.

 


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MANHATTAN INSTITUTE LUNCHEON

SUMMARY:
Transcript of the October 1, 2001 remarks of noted economist Dr. Alfred Kahn on what he sees to be the failure of telecom deregulation resulting from the FCCís adoption of irrational pricing policies.

SPEAKER:
Dr. Alfred Kahn, Professor Emeritus of Political Economy, Cornell University; Author, Whom the Gods Would Destroy, or How Not to Deregulate
INTRODUCTORY REMARKS:
Peter W. Huber, Senior Fellow, Manhattan Institute

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