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In retrospect, it s easy to see where the industry went wrong. The massive expansion of fiber-optic cable capacity and of cable s complementary components was accompanied by rapid technological progress that greatly expanded the economic capacity of that fiber-optic cable and those components. Meanwhile, growth in demand for telecommunications services turned out to be substantially lower than was forecast. These conditions were aggravated by a significant slowing of the U.S. economy in 2001 and 2002. The revelations of corporate governance and accounting misrepresentation problems that cropped up at several telecommunications companies have further exacerbated an already difficult situation. As a result, a great deal of capacity, representing hundreds of billions of dollars of investment, stands idle. Global Crossing, WorldCom, and Adelphia have already declared bankruptcy, and the industry isn t out of the woods yet. There are no magical, painless solutions to these difficulties. But the telecommunications industry is a key component of the U.S. economy, a contributor to national security, and a source of innovation. So as policy markers and investors grapple with how to deal with the fallout, and how to prevent further damage, there are important principles that both the public and private sectors can and should be following.
With All Deliberate Speed First, all parties involved must acknowledge and recognize the losses and pain and move on. Massive losses always accompany a large and expensive increase in effective capacity that is not matched by an equivalent expansion in demand. Those losses must be absorbed by someone. In the first instance, the owner-shareholders of the companies that made the ill-fated investments will absorb the losses. Following them will be the lenders and creditors to those companies. All things considered, it is better for these losses to be realized and absorbed sooner rather than later. Why? The more rapidly losses are recognized, the faster can companies and markets recognize the true prospective marginal costs of using these facilities for prospective services. And that will encourage lower prices, expanded demand, greater utilization, and overall greater economic efficiency.
Delaying this process can only put off the pain and the agony, not avoid it. And delay will mean inefficient decisions in the interim. To be sure, no manager of a public company likes to see the equity of his shareholders wiped out. But investors do not deserve a return on their investments. In a market economy, investors undertake investments that carry risks. Often, investments are successful, and investors prosper. Sometimes, investments are unsuccessful, and investors lose. This is the way a market economy should function. To prop up losing investors in such situations is to institute a policy of privatizing gains and socializing losses, which is a recipe for inefficient investment decisions and inequitable outcomes. The absorption of losses already has involved a number of sizable bankruptcies, which have been painful but unavoidable. What must be remembered is that these bankruptcies are the recognition of the changed climate and provide the processes whereby losses are absorbed by owners and creditors thus setting the stage for the sector to move on. Bankruptcies need not mean the shuttering of a company. If the products and services of the company and its brand name reputation are sufficiently desirable, a prospective owner, freed from some or most of the prior debt and contractual obligations, can find the operation of a more-or-less intact company worthwhile. Even when a company must be liquidated, its equipment will find its way into other hands, unless its economic value is zero. In all instances, speed of resolution is imperative. Further, it is important that employees, suppliers, and customers of companies operating under bankruptcy protection receive resolution of their uncertainties, so that they too can move on. The same is true with respect to companies that are tottering on the edge of Chapter 11. After all, lenders, suppliers and customers are frequently loathe to enter transactions with companies that may be heading into bankruptcy. Once again, speed of resolution is important. Bankruptcy is surely not an enjoyable experience for those who go through it; and it is not a perfect process. But it provides resolution, and an orderly mechanism for the settlement of claims.
Accurate Historical Parallels Many observers have drawn historical parallels between today s telecommunications glut and the over-capacity of the railroad industry in the late nineteenth century. The parallels are valid. In the 1880s and 1890s, a large amount of capacity had been built. But demand for freight and passenger service did not expand sufficiently to absorb that capacity at economic prices in many markets. As a result, the affected companies went into bankruptcy; surviving railroads emerged; and the rail sector became the core of passenger and freight transportation for the next half century. The infrastructure and routes laid down in the late 19th century remain central to freight transportation in the U.S. in the early 21st century. There are at least two more recent examples of the importance of rapid disposition of excess capacity. The first centers on the savings and loan (S&L) crisis of the late 1980s. It is now widely recognized that this debacle, and the parallel failure of almost 1,500 commercial banks, was largely the result of excessive investment in commercial real estate in the early and mid 1980s, combined with inadequate safety-and-soundness regulation. This excessive investment was driven by overly optimistic economic projections for the Sunbelt and elsewhere, much of it based on the expectations of the favorable effects of a high price for petroleum for the Southwestern economy and the favorable effects of the Economic Recovery Tax Act of 1981 for the economy at large. The excessively optimistic investments were funded by S&Ls and banks that were not subject to sufficient safety-and-soundness regulation by state and federal authorities. When the consequences of the excessively optimistic expectations first became apparent around 1985-1986, see-through office buildings became a common phrase in Sunbelt cities. By early 1986 it was quite clear that much of Sunbelt commercial real estate was over-priced and uneconomic at those prices, and that hundreds of S&Ls that had financed those projects were insolvent. Nevertheless, there were strong political pressures on federal regulators and on Congress to proceed slowly in taking any action that would pressure financial institutions to recognize and absorb the losses. Advocates against action frequently argued that, given time, conditions would turn around on their own. Real estate market participants feared that acknowledging losses and selling uneconomic commercial real estate to buyers who might put those properties to better use would cause prices to fall further. This was not good advice. Rapid action in recognizing losses was the best course of action in dealing with the S&L insolvencies and in dealing with the commercial real estate overhang. In both cases, the markets weren t fooled into believing that problems were not present. And the delayed action with respect to insolvent S&Ls meant that the owners and managers of those insolvent S&Ls might take risky and uneconomic actions in efforts at resurrection. Delayed action with respect to commercial real estate meant a continued overhang of uncertainty about prices and uses. Though the clean-up of the S&L problem took longer than it should have, it eventually did proceed in an expeditious fashion. Similarly, the Resolution Trust Corporation (RTC) moved swiftly to deal with the commercial real estate that it inherited from insolvent S&Ls. Rapid action in both dimensions helped both sectors emerge sooner and stronger. A second example involves learning from others errors, specifically those of the Japanese. For more than a decade, Japan has moved very tentatively in dealing with the difficulties of its banking sector. Once the Japanese stock market and real estate bubble burst in the early 1990s, the appropriate actions for the government of Japan would have been to force Japan's banks to deal quickly with the bad loans and other uneconomic investments on their books and to recognize their losses. The government could have helped insolvent banks by injecting public funds to protect depositors but not bank owners and by finding new owners who would inject fresh capital into the banks. Japan could thereby have established a rejuvenated banking system that could perform its role in making new loans to the rest of the economy. Instead, the government of Japan has taken few such actions. Banks, which were largely unwilling to force companies into bankruptcy, have been allowed to keep vast sums of non-performing loans on their books. When the government did act, its actions have been too little and too late. As a consequence, the Japanese banking industry remains saddled with bad loans on which it has yet fully to recognize the losses, the banks remain moribund and reluctant to lend, and the Japanese economy has remained mired in economic stagnation for over a decade.
Serial Bankruptcies? One specter raised by opponents to revived companies is that these companies ability to reduce their costs by renegotiating debt and other contracts will lead to aggressive pricing and then to a cascade of other bankruptcies. But this argument ignores the fact that companies will stay intact only if their creditors believe that the intact entity has more value than the liquidated assets. Also, even if a bankrupt company were liquidated, its equipment would be sold at low levels that then become the basis for low product prices. Finally, it ignores the reality that industries such as telecommunications are characterized by high fixed costs and low marginal costs, which is likely to yield aggressive pricing so long as customers see competitive firms offerings as near-commodities.
Sound Antitrust Principles As they formulate responses to the current telecommunications crisis, policymakers should also continue to follow sound antitrust principles. The resolution of the telecommunications industry's current over-capacity surely warrants some consolidation. But that doesn t mean that exceptions should be made to good antitrust policy. The Horizontal Merger Guidelines of the U.S. Department of Justice and the Federal Trade Commission provide the right antitrust guidance for permitting efficient combinations that will also avoid the creation of market power. They should be followed even in a time of crisis. The excuse of financial difficulties in the telecommunications sector should not be used as a route for allowing firms to exercise market power. After all, the slack antitrust standards that have sometimes been the norm in other regulated industries, such as for railroad and airline mergers, have not had salutary consequences.
Encouraging Innovation
In this regard, spectrum auctions have been and continue to be a good start at improving efficiency. But they are only a start. Auctions would affect far too little of the spectrum. Instead, the effort to propertyze the spectrum to treat it as property in a manner that is analogous to how real estate is treated is the right way to proceed. Only then can markets do their job in increasing the efficiency with which the spectrum is used. Times of financial crises are often watershed epochs. This is likely to be true for telecommunications. Good public policy could steer us through the turmoil and allow us to emerge fairly rapidly with a more efficient telecommunications sector. Poor public policy could leave us in a quagmire of continuing uncertainty and poor performance. Political leadership in Washington will be crucial in determining the path. Lawrence J. White is Arthur E. Imperatore professor of economics at NYU Stern. This article is adapted from an October 7, 2002 presentation at the Federal Communications Commission.
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