Thoughts on Tim Wu’s Master Switch, Part 3 (What is “Laissez-Faire”?)

by on October 27, 2010 · 10 comments

This is the third installment in a series of essays about Tim Wu’s new book, The Master Switch: The Rise and Fall of Information Empires.  As I noted in my first essay, Wu’s book promises to make waves in Internet policy circles, so I’m devoting some space here to debunking what I regard as some of the myths that drive his hyper-pessimistic worldview regarding the supposed death of openness.  In my second essay, I challenged Wu’s view of technological “cycles” and “market failure” and noted that he paints an overly simplistic portrait of both. In a similar vein, in this installment I will address Wu’s mistaken claim that purely free markets and “laissez-faire” have guided America’s communications and media sectors over the past century.

Wu’s narrative in The Master Switch is heavily dependent upon his retelling of the histories of several major sectors: telephony, film, broadcast radio, and cable television.  After surveying the history of those sectors throughout the past century, Wu concludes that “the purely economic laissez-faire approach… is no longer feasible” (p. 303) and that a fairly sweeping new regulatory regime – which I will address in a forthcoming post – is necessary to address the imperfections of the free market.

As any serious historian of the past century of information industries knows, however, we’ve never had anything remotely resembling a “purely economic laissez-faire approach” to communications, media or information policy in this country.  We’ve had a mixed system that allowed a certain degree of market activity accompanied by very heavy doses of “public interest” regulation.  Indeed, the story of 20th century communications and media markets is one of artificial barriers to entry, government (mis-)allocation of key resources (like spectrum), price controls, rate-of-return regulations, speech controls and mandates, regulatory capture, and good ‘ol boy corporatism.

History Grade: Incomplete

Sadly, Wu ignores much of that history in The Master Switch or fails to properly diagnose the root causes of “market failure.”  Consequently, as a work of industrial history, his grade is: Incomplete.

Part of the problem here is that, far too often in the book, Wu dwells on intentions. Like so many other so-called progressive scholars who view most corporate leaders like the satanic spawn of Gordon Gecko or Mr. Burns from “The Simpsons,” Wu often wants to base his indictment of markets on a moralizing view of corporate bad intentions.  He gives us selective juicy bits of boardroom shenanigans and corporate scheming that would make for a good John Grisham novel.  If one’s indictment of free-market capitalism is based on the desires of corporate leaders, however, then it is hardly unsurprising they would conclude that it is a failure.  After all, Adam Smith taught us long ago that every businessman longs for a monopoly over trade in their field.

But intentions are largely meaningless in the larger scheme of things.  It’s the nature of the process and outcomes that give us our real gauge of the worth of a market-based approach. We need answers to questions like:

  • Have markets given us more or less choice, competition, diversity, etc.?
  • To the extent there was an excessive concentration of private “power” in a given sector, was it fleeting or lasting?
  • If it was lasting, were markets to blame, or did government tip the balance in favor or certain actors our outcomes?  In other words, how “free” was this “free market”?
  • Finally, did markets and new technologies evolve to solve whatever “problems” were ailing certain sectors? If not, what held back that progress?

Sadly, Wu often gives us little more than superficial answers to these questions because, again, he’s often too busy attempting to peer inside the minds of corporate leaders to discern what motivated their supposedly wicked ways. In the process, he leaves out plenty of pertinent facts. In particular, despite his insistence to the contrary, he significantly underestimates the importance of regulatory capture or unnatural resource allocation / mismanagement as the key causes of the technological “closings” he cites.  He also downplays or occasionally ignores the trade-offs at work associated with regulatory solutions to the supposed problems he cites.  Finally, he largely fails to appreciate the sweeping nature of technological change that has revolutionized so many of these markets for the better in recent years.

In my post yesterday, I noted how Wu ignored many of these variables when discussing the AOL case study.  Today, I’ll jump back 100 years in history and Wu’s treatment of the early development in America’s communications sector and the rise of the AT&T monopoly.  As we’ll see, he makes some crucial oversights and, ultimately, makes an unconvincing case against “the purely economic laissez-faire approach” since no such thing ever existed in this field or the others he surveys.

Wu’s Incomplete AT&T Case Study

Wu spends a great deal of time in The Master Switch focusing on the old AT&T / Bell System and its leader Theodore Vail as the paradigmatic example of “the Cycle” in action.  To reiterate, “the Cycle” refers to the closing and eventual monopolization of a sector after a period of openness and competition. That Vail and AT&T were hell-bent on monopolizing the American communications systems is beyond question.  What is in question, however, is to what degree any of this process was the result of Wu’s much-lamented “purely economic laissez-faire approach.”  The answer: Not much.

Sixteen years ago I penned a short history of how this sad tale unfolded and called it, “Unnatural Monopoly: Critical Moments in the Development of the Bell System Monopoly.”   What an accurate reading of that history reveals is that this monopolization was anything but the product of “market forces.”  Instead, America’s early communications history – as was the case in so many other countries – was very much shaped by political forces.

During the early years of the past century, when competition among independents was still quite vibrant, AT&T’s extensive campaign for “One Policy, One System, Universal Service” was a thinly veiled front for complete control of the telephone system under one corporate roof.  But was that goal really achievable absent government assistance?  Most industry historians don’t think so.

In his 1994 book, Contrived Competition: Regulation and Deregulation in America, Richard H.K. Vietor of Harvard University noted “Vail chose at this time to put AT&T squarely behind government regulation, as the quid pro quo for avoiding competition. This was the only politically acceptable way for AT&T to monopolize telephony…  It seemed a necessary trade-off for the attainment of universal service.” (p. 167, 172, 185) And AT&T’s own 1917 Annual Report noted, “A combination of like activities under proper control and regulation, the service to the public would be better, more progressive, efficient, and economical than competitive systems.”

Industry historian Robert W. Garnet, author of The Telephone Enterprise: The Evolution of the Bell’s Horizontal Structure, 1876-1909, provides further support for Vietor’s finding that regulation was the crucial driver of monopolization:

Regulation played a crucial role in Vail’s plans. Astute enough to realize that the kind of system he proposed — universal integrated monopoly — would stand little chance of gaining public approval without some form of public control, he embraced state regulation. In doing so, he broke with the company’s long-standing opposition to what [AT&T] management had traditionally regarded as an unwarranted intrusion on its prerogatives. But after years of unfettered competition, during which the firm’s financial strengths had been sapped and its efforts to build an integrated system had been dangerously undermined, regulation became a much-preferred alternative. Thus, Vail obviously saw government regulation as the way to eliminate competitors: the one-way ticket, not only to universal service, but also to monopoly profits. (p. 130, emphasis added)

The Kingsbury Commitment as Classic Corporatism

With the courtship of state regulators and legislators grew more widespread and successful, the stage was then set for the complete monopolization of the industry by AT&T.  Two crucial decisions at the federal level sealed that result.  First came the “Kingsbury Commitment” of 1913. Named after AT&T Vice President Nathan C. Kingsbury, who helped negotiate its terms, the agreement outlined a plan whereby AT&T would sell off its $30 million in Western Union stock, agree not to acquire any other independent companies, and allow other competitors to interconnect with the Bell System.

At the time, the Kingsbury Commitment was thought to be pro-competitive. Yet, this was hardly an altruistic action on AT&T’s part. The agreement was not interpreted by regulators so as to restrict AT&T from acquiring any new telephone systems, but only to require that an equal number be sold to an independent buyer for each system AT&T purchased. Hence, the Kingsbury Commitment contained a built-in incentive for regional monopoly-swapping rather than continued competition. Gerald Brock, author of The Telecommunications Industry: The Dynamics of Market Structure found that, “This provision allowed Bell and the independents to exchange telephones in order to give each other geographical monopolies. So long as only one company served a given geographical area there was little reason to expect price competition to take place.” (1981, p. 156)

In their 1992 treatise on Federal Telecommunications Law, Kellogg, Thorne, and Huber summarized the result of the Kingsbury Commitment as follows:

The government solution, in short, was not the steamy, unsettling cohabitation that marks competition but rather a sort of competitive apartheid, characterized by segregation and quarantine. Markets were carefully carved up: one for the monopoly telegraph company; one for each of the established monopoly local telephone exchanges; one for the Bell’s monopoly long-distance operations. Bell might not own everything, but some monopolist or other would dominate each discrete market. The Kingsbury Commitment could be viewed as a solution only by a government bookkeeper, who counted several separate monopolies as an advance over a single monopoly, even absent any trace of competition among them. (1992, p. 16-17)

The lesson here is clear: the move toward market-carving and mandated interconnection, while appearing in the independents’ favor at first, actually allowed AT&T to gain greater control over the industry. Brock found that “interconnection reduced the Bell’s ability to drive the independents out of business but also eliminated the independents’ incentive to establish a competitive long-distance system.” That is a crucial point, and one that Wu overlooks in his book and that many regulatory activists ignore till this day: Although well-intentioned, interconnection mandates can disincentivize more direct forms of head-to-head competition and disruptive forms of technological innovation.

To his credit, Tim Wu does acknowledge how the Kingsbury Commitment ended up being a disaster in practice. “Superficially a victory for openness and competition, in time the Kingsbury Commitment would prove the insidious death knell of both,” he notes. (p. 56)  But Wu doesn’t dwell on the gravity of this fatal regulatory decision very long.  Instead, he quickly switches gears and suggests that the problem was that regulators just didn’t go far enough. He suggests a preemptive breakup might have been the better way to go and implies that monopolization was inevitable.

Of course, we can never know how differently things might have turned out if that course of action had been pursued. But the problem for Wu is that most of the examples he uses in his book depend on this ‘why-didn’t-the-government-see-it-coming-and-intervene-earlier’ sort of thinking, even though (a) we don’t know how much of a difference it would have made in practice, and (b) such interventions could have backfired and had profoundly deleterious unintended consequences, just as the Kingsbury Commitment did.  Such interventions would have just necessitated additional forms of prophylactic regulation to keep the market as atomistic as Wu preferred.  As the Austrian economist Ludwig von Mises taught us six decades ago:

All varieties of interference with the market phenomena not only fail to achieve the ends aimed at by their authors and supporters, but bring about a state of affairs which—from the point of view of their authors’ and advocates’ valuations—is less desirable than the previous state affairs which they were designed to alter. If one wants to correct their manifest unsuitableness and preposterousness by supplementing the first acts of intervention with more and more of such acts, one must go farther and farther until the market economy has been entirely destroyed and socialism has been substituted for it.  (Human Action, at 858, 3rd ed. 1963, 1949).

(In a moment, we’ll see how the market economy was entirely destroyed and socialism substituted for it in this field.)

Again to his credit, Wu is willing to admit that, “it should also be obvious to anyone – one need by no means to be a raving libertarian – that there are some substantial dangers implicit in aligning the immense power of the state with the greatest of information monopolists.” (p. 59) Well, I am a raving libertarian, so you can imagine how sympathetic I am to this argument!  More impressively, in a footnote to that line, Wu properly labels this system what it is. “The technical term for such a system is ‘corporatism’: in its extreme manifestation it is called ‘fascism,’” he notes. Quite right!  What the Kingsbury Commitment represented was the essence of corporatism or what used to be called fascism before the Nazis essentially made the term impossible to use as a descriptor in economic histories or political philosophy.

A final problem with Wu’s interpretation of the Kingsbury Commitment: He praises Vail and AT&T for at least agreeing to common carriage obligations as part of the deal. “[I]f we regard the Kingsbury Commitment as having sanctioned the most lucrative monopoly in history, it also made good on the essential goals of common carriage,” Wu says. (p. 59) Here he utterly fails to fully appreciate the linkage between common carriage obligations and the corporatist model of industrial organization.  The imposition of common carriage obligations on a particular company or sector is tantamount to a “Game Over” moment for truly free markets.  Once you make that plunge, you’ve essential raised the white flag and surrendered on the notion of facilities-based competition. It is the death knell for laissez-faire.  Yet, Wu never makes that connection clear.

World War I and Communications Nationalization

More surprising, however, is the fact that Wu completely ignores the second major federal intervention that sealed AT&T’s lock on the communications marketplace. It was World War I, the nation’s first major global crisis, that would provide the United States government with a convenient excuse to forcefully gain control over communications and forever change the structure of the telephone industry.  On August 1, 1918, in the midst of World War I, the federal government nationalized the entire telecommunications industry for national security reasons. If, as Wu correctly suggests, the Kingsbury Commitment represented a dose of “fascism,” then this was surely a bit of good ol’ fashion socialism!  How it escaped Wu’s attention is perplexing because its significance cannot be underestimated.

As I noted in my history of the rise of the Bell System monopoly, AT&T executives were initially quite nervous when it was announced that Postmaster General Albert S. Burleson, a long-time advocate of nationalizing the telegraph and telephone industries, would assume control of the telephone system. But, once the benefits of nationalization where made evident to Theodore Vail, his anxieties disappeared. Industry historian George P. Oslin notes when Vail expressed concern over the plan to Western Union President and close personal friend Newcom Carlton, Carlton reassured Vail that the plan was in his interest: “It’s your salvation. The government will be able to raise your rates and get you new money.” As Oslin argues, “That was what happened. Burleson appointed Vail, rated by Carlton as a genius, to manage the telephone, and Carlton to operate the telegraph.”

In his 1939 book AT&T: The Story of Industrial Conquest, Noobar R. Danielian concurred: “There is evidence that Vail appreciated the advantages of Federal control… he was not in much of a hurry in the early part of 1919 to have his System back from nominal government control.” (p. 248) This attitude should not be at all surprising since shortly after the industry was nationalized, AT&T’s proposed contract establishing the terms of government ownership and compensation was accepted by the postmaster general. Danielian summarizes the deal as follows:

The federal government…  agreed to pay to AT&T 4 1/2 percent of the gross operating revenues of the telephone companies as a service fee; to make provisions for depreciation and obsolescence at the high rate of 5.72 percent per plant; to make provision for the amortization of intangible capital; to disburse all interest and dividend requirements; and in addition, to keep the properties in as good a condition as before. Finally, AT&T was given the power to keep a constant watch on the government’s performance, to see that all went well with government operation, by providing that the books of the Postmaster General would be at all times open for inspection. One might well wonder where the real control was lodged. Needless to say, the contract was eminently satisfactory to the Bell System. (p. 252)

In addition, once the nationalized system was in place, AT&T wasted no time applying for immediate and sizable rate increases. High service connection charges were put into place for the first time. AT&T also began to realize it could use the backing of the federal government to coax state commissions into raising rates. Vail personally sent Postmaster General Burleson studies that displayed the need to raise rates. By January 21, 1919, just 5 1/2 months after nationalization, long-distance rates had increased by 20 percent. In addition to being much greater than returns earned during more competitive years, the rates established by the postmaster during the year of nationalization remained in force many years after privatization. Consequently, AT&T’s generous long distance returns continued to average near or above 20 percent during the 1920s.

By the time the industry was returned to private control on August 1, 1919, the regulatory route to competition elimination had paid off handsomely for Vail and AT&T.  Of the estimated $50 million in rate increases approved by the postmaster general during nationalization, approximately $42 million, or 84 percent went to AT&T.  Additionally, the government cut AT&T a $13 million dollar check at the end of the period to cover any losses they may have incurred, despite the fact that none were evident.

You cannot get a better deal than that!  The year of government nationalization was the final nail in the coffin of communications competition, and it was a nail struck with the hammer of Big Government. The lesson: There was absolutely nothing “natural” about this monopoly.   Congress basically blessed the entire farce in 1921 with the passage of the Graham Act, which Wu does cite in his history. As he notes, it “recognized AT&T’s monopoly and remov[ed] any remaining obstacles to integration.” (p. 59)   But, again, this is Wu implying that there had been something natural about that monopoly, which there most certainly wasn’t.

This sad tale of corporatism only grew worse in subsequent years with the initiation of extensive rate regulation and direct barriers to entry and innovation. Rate regulation guaranteed AT&T stable returns and ensured that regulators suddenly had a vested interest in keeping the company healthy and protected from competition so that it could achieve the industrial policy vision of “One Policy, One System, Universal Service.”  AT&T had so utterly captured legislators and regulators that its motto became the prime directive and modus operandi for all communications regulation over the next half century.

And this is a pattern – dare I call it “the real cycle” – that we have seen play out in many other sectors that Wu discusses in the book.  Yet, he doesn’t seem to fully appreciate just how profoundly public policy makers to have distorted markets in the quest to achieve various social policy goals.  In many regulated sectors, history shows that policymakers often ended up depending upon one firm, or a small handful of firms, to provide all industry output/service. Those favored actors, like AT&T and Vail, became partners with the State.  Consequently, competition was made more difficult, if not impossible, by force of law.  As the dean of regulatory economists Alfred E. Kahn noted in his seminal 1971 treatise The Economics of Regulation:

When a commission is responsible for the performance of an industry, it is under never completely escapable pressure to protect the health of the companies it regulates, to assure a desirable performance by relying on those monopolistic chosen instruments and its own controls rather than on the unplanned and unplannable forces of competition. (p. 12)

Conclusion

In sum, Wu serves up an incomplete history of Theodore Vail and the rise of the Bell System by downplaying the role that governments played in spawning, and then sheltering, the resulting monopoly.  In the case of Vail and AT&T, we can definitively conclude that there was no such thing as a “purely economic laissez-faire approach” allowed after World War I.  It basically became a crime to compete against the company or even attempt to innovate around it.

Thus, the lesson we should take from this case study is not, as Wu suggests, that markets failed but that they were never allowed to function naturally. Interventions pursued in the name of protecting consumers and serving “the public interest” often backfire and become the death knell of competition and innovation. Consequently, they undermine consumer welfare — which should be regarded as the ultimate “public interest” — in the process.

A more cautious historian would have acknowledged that and then questioned whether expanded regulatory inventions would — then or now — improve matters, or instead simply lead to even more deleterious forms of regulatory capture and corporatism.

__________

[Jump to Part 4 in the series.]

  • Tim Wu

    Adam,

    With respect, I feel like you are reading about half of the book I wrote. To describe my book as a call for extensive regulation may be what you were hoping to read, but it isn't what I wrote.

    I quote from p. 308 of the book “Again and again in the histories I have recounted, the state has shown itself an inferior arbiter of what is good for the information industries. The federal government's role in radio and television from the 1920s through the 1960s, for instance, was nothing short of a disgrace …. Government's tendency to protect large market players amounts to an illegitimate complicity … [particularly its] sense of obligation to protect big industries irrespective of their having become uncompetitive.”

    Meanwhile, on AT&T: “It should be obvious to anyone that are substantial dangers implicit in aligning the immense power of the state with the greatest of information monopolies. The technical term for such a system is 'corporatism'; in its extreme manifestations it is called 'fascism.'

    “Vail heralded AT&T as the coming of enlightened monopoly, a public utility of the future. He promised to do no evil. And the government bought it.”

    On AT&T, the point here is that, effectively, the State let AT&T have its monopoly, and ultimately became its guarantor. The real difference between us is that you seem stuck on a theory of causation that says it was only the state that created the monopoly, and not the firm itself. Of course, it was both. Vail was a monopolist, and his actions helped create monopoly, but it was a monopoly blessed by the State.

  • http://www.techliberation.com Adam Thierer

    Tim… Thanks for your response. I touch upon some of these points in the next post about your book and do give you more credit for pointing to the dangers of regulatory capture and bureaucratic mismanagement. The problem is, you immediately walk away from this point each time you raise it. There’s seemingly never any lesson drawn from it. Indeed, sometimes within a line or two of raising such concerns, you seem to dismiss them entirely and propose giving the Stare far more power to play games within the information sector. If you really believed in what you said in those couple of lines about the dangers of regulatory capture, you wouldn’t also be so eager to empower the State to do even more meddling in these sectors.

    Moreover, you have not addressed the primary criticism I raised in this piece: Your assertion that a “purely economic laissez-faire approach” must be rejected based upon you’re reading of the history of these sectors. But now you’re stressing the couple of lines in your book pointing to the fact that history is littered with examples of regulatory capture and bureaucratic bungling. Well, which is it?

    You can’t have it both ways, Tim.

  • Tim Wu

    The question isn't whether I'm having it both ways; it is whether there is any middle ground between pure laissez-faire or deregulation and regulatory capture. My view is that government oversight is both necessary and also very dangerous. That's true of the state in so many areas: we have an army, which is necessary for defense, but also extremely dangerous – historically, most countries suffer from their own armies at some point. So the argument is that without any regulation or oversight we get a series of undesirable consequences, illustrated best by Western Union. The argument is also that with too much regulation the industry is either stifled or uses the regulation to maintain a safe monopoly. The question, then, is how you get, essentially, limited, controlled government in regulatory affairs; how you duplicate, in some sense, the limits imposed on other dangerous govn't functions like the army.

    I don't think this is having things both ways; i think this is trying to learn from what has gone wrong in the past.

  • Tim Wu

    To say a few words more. Basically the history of telecom regulation is one of wild swings from total deregulation to intensive regulation bordering on nationalization. Both have proved, in my mind, pretty unfortunate; though defensible, always, on certain grounds.

    The question I'm asking in the end of the book is whether we can do better; try to have rules against the worse forms abuse without a creeping regulation that turns into capture. I suspect you think that's impossible, but I don't.

  • http://www.techliberation.com Adam Thierer

    Thanks for your response, Tim. I have responded in detail to this comment and your other here: http://techliberation.com/2010/10/29/thoughts-on-wu-part-5-what-ultimately-separates-the-cyber-libertarian-cyber-collectivist/

  • http://www.uspassportnow.com Christy

    That's true of the state in so many areas: we have an army, which is necessary for defense, but also extremely dangerous – historically, most countries suffer from their own armies at some point. So the argument is that without any regulation or oversight we get a series of undesirable consequences, illustrated best by Western Union.

  • Mcurtis3

    Adam, Tim:

    The problem here, as it is in most public debates, is that those debating entrench themselves into a belief system no matter what obvious facts are brought to bear. Recently on NPR there was a presentation on just that topic. I read Adam entrenching himself into a position that will remain as it is publically despite the obvious facts tossed his way. When I heard Tim on NPR I thought back to how well the railroads and the oil industry got along with government until they were broken up. Tim brought up the telegraph vs. the telephone on NPR and the history seemed accurate. One has to read the old histories in order to capture the true essence of those events. Even the Pure Food and Drug Act of 1906 was a battle to achieve despite its obvious necessity.

    There are middle paths as Tim points out, but the middle path is not always the answer either.

  • Pingback: Thoughts on Tim Wu’s Master Switch, Part 2 (On “Cycles” & “Market Failure”)

  • Pingback: Tim Wu Redefines “Monopoly”

  • Matthijsvanbergen

    My posts have just been deleted?? Erm, lame???

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