For my latest column in The Hill, I explored the European Union’s (EU) endlessly expanding push to regulate all facets of the modern data economy. That now includes a new effort to regulate artificial intelligence (AI) using the same sort of top-down, heavy-handed, bureaucratic compliance regime that has stifled digital innovation on the continent over the past quarter century.

The European Commission (EC) is advancing a new Artificial Intelligence Act, which proposes banning some AI technologies while classifying many others under a heavily controlled “high-risk” category. A new bureaucracy, the European Artificial Intelligence Board, will be tasked with enforcing a wide variety of new rules, including “prior conformity assessments,” which are like permission slips for algorithmic innovators. Steep fines are also part of the plan. There’s a lengthy list of covered sectors and technologies, with many others that could be added in coming years. It’s no wonder, then, that the measure has been labelled the measure “the mother of all AI laws” and analysts have argued it will further burden innovation and investment in Europe.

As I noted in my new column, the consensus about Europe’s future on the emerging technology front is dismal to put it mildly. The International Economy journal recently asked 11 experts from Europe and the U.S. where the EU currently stood in global tech competition. Responses were nearly unanimous and bluntly summarized by the symposium’s title: “The Biggest Loser.” Respondents said Europe is “lagging behind in the global tech race,” and “unlikely to become a global hub of innovation.” “The future will not be invented in Europe,” another analyst bluntly concluded.

That’s a grim assessment, but there is no doubt that European competitiveness is suffering today and that excessive regulation plays a fairly significant role in causing it. As I noted in my column, “the EU’s risk-averse culture and preference for paperwork compliance over entrepreneurial freedom” had serious consequences for continent-wide innovation.  I note in my recent column how:

After the continent piled on layers of data restrictions beginning in the mid-1990s, innovation and investment suffered. Regulation grew more complex with the 2018 General Data Protection Regulation (GDPR), which further limits data collection and use. As a result of all the red tape, the EU came away from the digital revolution with “the complete absence of superstar companies.” There are no serious European versions of Microsoft, Google, Facebook, Apple or Amazon. Europe’s leading providers of digital technology services today are American-based companies.

Let’s take a look at a few numbers that illustrate what’s happened in Europe’s tech sector over the past quarter century. Here’s an old KPGM breakdown of market caps for public Internet companies over an important 20 year period, from 1995 to 2015, when the digital technology marketplace was taking shape. Besides the remarkable amount of churn over that period (with only Apple appearing on both lists), the other notable thing is the complete absence of any European companies in 2015.

Next, here’s a chart I constructed using CB Insights data for global unicorns ($billion valued companies) from 2010 up through early 2022. It shows how the U.S. dominates fully half the list with China having a 16% share, but all of the European Union’s firms equal just a 9 percent slice of the world’s share.

If you want to see a per capita breakdown of VC investment by country, here’s a handy Crunchbase News chart. While the U.S. is geographically much larger than Europe, a breakdown of VC funding on a per capita basis reveals that only Estonia ($915B) and Sweden ($700B) have startup investment on par with America ($808B). No other European country has even half as much per capita VC investment as the U.S., and most don’t even have a quarter as much.

As we enter the “age of AI,” what will the EU’s same regulatory model for mean for AI, machine learning, and robotics in Europe? We do have some early data on that, too. Here’s a breakdown of AI-related VC activity and AI unicorn in 2021 from the recent State of AI Report 2021, with European countries already trailing far behind:

Also, here’s some data on recent AI investment by region from the latest Stanford “AI Index Report 2022” which again highlights a gap that is only growing larger:

It’s important to listen to what actual AI innovators across the Atlantic have to say about the new EU regulatory efforts. Just last month, the UK-based Coalition for a Digital Economy (Coadec), an advocacy group for Britain’s technology-led startups, published a report entitled, “What do AI Startups Want from Regulation?” Coadec surveyed its members to gauge their feelings about the EU’s proposed approach to AI regulation, as well as the UK’s. 76% of those startups said that their business model would be either negatively affected or become infeasible if the UK were to echo the EU by making AI developers liable, and an equal percentage said they had varying concerns about whether it’s technically even feasible to make their datasets “free of errors,” as the EU looks set to demand. Respondents also said they feared that the new AI Act would be particularly burdensome to small and mid-size entrepreneurs because they cannot afford to deal with the costly compliance hassles like the larger competitors they face. This would end of being a replay of the burdens they faced from GDPR, which decimated small businesses. “The experience of GDPR demonstrated how unclear, complex and expensive regulations drove many startups out of business, and disproportionately impact startups that survived–GDPR compliance cost startups significantly more than it did the Tech Giants,” the Coadec report concluded.

At least those UK-based innovators might be in a slightly better position post-Brexit with the British government now looking to chart a different–and much less burdensome–governance approach for digital technologies. In fact, the UK government recently released a major policy document on “Establishing a Pro-Innovation Approach to Regulating AI,” which makes a concerted effort to distinguish its approach from the EU’s. “We will ask that regulators focus on high risk concerns rather than hypothetical or low risks associated with AI,” the report noted. “We want to encourage innovation and avoid placing unnecessary barriers in its way.” This is consistent with what the UK government has been saying on technology governance more generally. For example, in recent report advocating for Innovation Friendly Regulation, the UK government’s Regulatory Horizons Council argued that, when it comes to the regulation of emerging technologies like AI, “it is also necessary to consider the risk that the intervention itself poses.” “This would include the potential impact on benefits from a particular innovation that might be foregone; it would also include the potential creation of a ‘chilling effect’ on innovation more generally,” the Council concluded. Clearly, this approach to technology policy stands in stark contrast to the EU’s heavy-handed model. So, there is a chance that at least some innovators based in the UK can escape the EU’s regulatory hell.

What about AI innovators stuck on the European continent? What are they saying about the regulations they will soon face? The European DIGITAL SME Alliance, which is the largest network of small and medium sized enterprises (SMEs) in the European ICT sector, represents roughly 45,000 digital SMEs. In comments to the EC about the impact of the law, the Alliance highlighted how costly the AI Act’s conformity assessments and other regulations will be for smaller innovators. “This may put a burden on AI innovation” the Alliance argued, because smaller developers have limited financial and human resources of SMEs.” “[A] regulation that requires SMEs to make these significant investments, will likely push SMEs out of the market,” the group noted. “This is exactly the opposite of the intention to support a thriving and innovative AI ecosystem in Europe.” Moreover, “SMEs will not be able to pass on these costs to their customers in the final customer end pricing,” the Alliance correctly noted because, “[t[he market is global and highly competitive. Therefore, customers will choose cheaper solutions and Europe risks to be left behind in technology development and global competition.”

In March, the Alliance also hosted a forum on “The European AI Act and Digital SMEs,” which featured comments from some operators in this space. Some speakers were quite timid and you could sense that they might have feared pushing back too aggressively against the European Commission so as not to get on the bad side of regulators before the rules go into effect. But Mislav Malenica, Founder & CEO Mindsmiths didn’t pull any punches in his remarks. His company Mindsmiths is trying to build autonomous support systems in many different fields, but their ability to innovate and compete globally will be severely curtailed by the EU AI Act, he argued.

I usually don’t spend time transcribing people’s comments from events, but I went back and watched Malenica’s multiple times because his remarks are so powerful and I wanted to make sure others hear what he was saying. [Malenica’s opening comments during the event run from 42:29 to 49:34 of the video and then he has more to say during Q&A beginning at the 1:27:28 of the video.] Here’s a quick summary of a few of Malenica’s key points (listed chronologically):

• “I’m not sure we are doing everything we can do actually to create an environment that’s innovation friendly.”
• “we see a lot of uncertainty. We see fear.”
• “basically we won’t be able to get funding here.”
• while reading through the AI Act, he notes, “I don’t see start-ups being mentioned anywhere, and startups are the main vehicles of innovation.” […] “I find it very arrogant”
• if AI Act becomes law, “what we’ll do in Europe is we’ll create a new market and that’s the AI markets based on fear,” and in how to just build products that avoid the wrath of government or lawsuits.
• “we are really stifling innovation” and that means Europeans will have to import autonomous products from foreign companies instead of making them there.

Later, during in the Q&A period, Malenica notes how his first virtual currency startup had to use half it’s investment capital just dealing with regulatory compliance issues, and most venture capitalists wouldn’t get behind launching in Europe because of such legal hassles. He reflects upon what this mean for other innovators going forward as the EU prepares to expand their regulatory regime for AI sectors:

• “I don’t think we’re missing talent. That’s just a consequence” of all the regulation. “We are missing a sense that you have opportunities here. If you the opportunities here, then the talent will come, the funding will come, and so on because people see that they’ll be able to make money, they’ll be able to build companies, and so on.”
• “If we now take a look at the 10 biggest companies market capitalizations in the world, we’ll see that none of them comes actually from Europe” with U.S. tech companies dominating the list. “So, we missed that wave completely.” Why? “Because we didn’t inspire anyone to take action,” and that is about to happen for AI.
• “We need to decide if we are going to be a land of opportunities, or will we be just consumers of other people’s tech, the same we are right now” for digital software and services.
• “We’re already finding excuses for the loss” of the AI market, he argues.

Malenica’s comments are extraordinarily demoralizing if you care about innovation. Now, I’m an American and one way to look at this dismal situation is that, by hobbling its own startups and existing AI innovators, Europe is doing the U.S. another favor by essentially taking itself out of the running in next great global tech race. Europe’s actions may also mean that America gains many of their best and brightest if they come to the U.S. when looking to create the next great algorithmic service or application because they can’t do so in the EU. This is exactly what happened over the past few decades for Internet startups, Malenica noted.

But that’s dismal news in another sense. Europe is filled with brilliant innovators, highly-skilled talent, world-class educational institutions, and even many venture capitalists looking to invest in this arena. Unfortunately, the continent’s suffocating regulatory approach makes it nearly impossible for digital technology innovators to have a fighting chance. Through their heavy-handed policies, European officials have essentially declared their innovators “guilty until proven innocent.” And that means that Europeans and the rest of the world are being deprived of many important life-enriching and life-saving AI applications that those innovators could create. Technological innovation is not a zero-sum game that only one country can “win.” Innovation drives growth and prosperity and lifts all boats as its benefits spread throughout the world. When European innovators prosper, people all over the world prosper along with them.

Is there any chance the European Commission softens its stance toward emerging technologies and looks to adopt a more flexible governance approach that instead treats AI innovators as innocent until proven guilty? I think it is extremely unlikely that will happen because, as Malenica noted, European technology policy is too rooted in fear of disruption and extreme risk-aversion. EU officials are forgetting that the most important lesson from the history of technological innovation is there can be no progress without some risk-taking and corresponding disruption. My favorite quote about the relationship between risk-taking and human progress comes from Wilbur Wright who, along with his brother, helped pioneer human flight. “If you are looking for perfect safety,” Wright said, “you would do well to sit on a fence and watch the birds.” European policymakers are essentially forcing their best and brightest innovators to sit on the fence and watch the rest of the world fly right past them on the digital technology and AI front. The ramifications for the continent will be disastrous. Regardless, as I noted in concluding my recent Hill column, Europe’s approach to AI “shouldn’t be the model the U.S. follows if it hopes to maintain its early lead in AI and robotics. America should instead welcome European companies, workers and investors looking for a more hospitable place to launch bold new AI innovations.”

Alas, European officials appear ready to ignore the deleterious impact of their policies on innovation and competition and instead make regulation their leading export to the world. In fact, the European Commission will soon open a San Francisco office to work more closely with Silicon Valley companies affected by EU tech regulation. European leaders have basically surrendered on the idea of home-grown innovation and are now plowing all their energies into regulating the rest of the world’s largest digital technology companies, most of which are headquartered in the United States. It’s no wonder, then, that The Economist magazine concludes that, “Europe is the free-rider continent” that “has piggybacked on innovation from elsewhere, keeping up with rivals, not forging ahead.” Instead, “the cuddly form of capitalism embraced in Europe has markedly failed to create world-beating companies,” the magazine argues.

European officials want us to believe that they are somehow doing the world a favor by being its global tech regulator, when instead the are simply solidifying the power of the largest digital tech companies, who are the only ones with enough resources–mainly in the form of massive legal compliance teams–to live under the EU’s innovation-crushing regulations. Sadly, many US policymakers hate our own home-grown tech companies so much now, that they are willing to let this happen. In a better world, those American lawmakers would stand up to European officials looking to bully tech innovators and we would reject the innovation-killing recipe that the EU is cooking up for AI markets and expects the rest of the world to eat.

Additional Reading on AI & Robotics:

• Adam Thierer, “How Science Fiction Dystopianism Shapes the Debate over AI & Robotics,” Discourse, July 26, 2022.
• Adam Thierer, “Why is the US Following the EU’s Lead on Artificial Intelligence Regulation?” The Hill, July 21, 2022.
• Adam Thierer, “Algorithmic Auditing and AI Impact Assessments: The Need for Balance,” Medium, July 13, 2022.
• Adam Thierer, “What I Learned about the Power of AI at the Cleveland Clinic,” Medium, May 6, 2022.
• Adam Thierer, Governing Emerging Technology in an Age of Policy Fragmentation and Disequilibrium, American Enterprise Institute (April 2022).
• Adam Thierer, “How to Get the Future We Were Promised,” Discourse, January 18, 2022.
• Adam Thierer, “A Global Clash of Visions: The Future of AI Policy,” The Hill, May 4, 2021.
• Adam Thierer, “A Brief History of Soft Law in ICT Sectors: Four Case Studies,” Jurimetrics, Vol. 61 (Fall 2021): 79-119.
• Adam Thierer, “Artificial Intelligence Governance in the Obama–Trump Years,” IEEE Transactions on Technology and Society, Vol, 2, Issue 4 (2021).
• Adam Thierer, “The Worst Regulation Ever Proposed,” The Bridge, September 2019.
• Ryan Hagemann, Jennifer Huddleston Skees & Adam Thierer, “Soft Law for Hard Problems: The Governance of Emerging Technologies in an Uncertain Future,” Colorado Technology Law Journal, Vol. 17 (2018).
• Adam Thierer & Trace Mitchell, “No New Tech Bureaucracy,” Real Clear Policy, September 10, 2020.
• Adam Thierer, “OMB’s AI Guidance Embodies Wise Tech Governance,” Mercatus Center Public Comment, March 13, 2020.
• Adam Thierer, “Europe’s New AI Industrial Policy,” Medium, February 20, 2020.
• Adam Thierer, “Trump’s AI Framework & the Future of Emerging Tech Governance,” Medium, January 8, 2020.
• Adam Thierer, “Soft Law: The Reconciliation of Permissionless & Responsible Innovation,” Chapter 7 in Adam Thierer, Evasive Entrepreneurs & the Future of Governance (Washington, DC: Cato Institute, 2020): 183-240.
• Andrea O’Sullivan & Adam Thierer, “Counterpoint: Regulators Should Allow the Greatest Space for AI Innovation,” Communications of the ACM, Volume 61, Issue 12, (December 2018): 33-35.
• Adam Thierer, Andrea O’Sullivan & Raymond Russell, “Artificial Intelligence and Public Policy,” Mercatus Research (2017).
• Adam Thierer, “Shouldn’t the Robots Have Eaten All the Jobs at Amazon By Now?” Technology Liberation Front, July 26, 2017.
• Adam Thierer, “Are ‘Permissionless Innovation’ and ‘Responsible Innovation’ Compatible?” Technology Liberation Front, July 12, 2017.
• Adam Thierer, “The Growing AI Technopanic,” Medium, April 27, 2017.
• Adam Thierer, “The Day the Machines Took Over,” Medium, May 11, 2017.
• Adam Thierer, “When the Trial Lawyers Come for the Robot Cars,” Slate, June 10, 2016.
• Adam Thierer, “Learning by Doing,” the Process of Innovation & the Future of Employment,” Technology Liberation Front, September 25, 2015.
• Adam Thierer, “Problems with Precautionary Principle-Minded Tech Regulation & a Federal Robotics Commission,” Medium, September 22, 2014.
• Adam Thierer, “On the Line between Technology Ethics vs. Technology Policy,” Technology Liberation Front, August 1, 2013.

In early January, the Trump Administration announced a new light-touch regulatory framework and then followed up with a proposed doubling of federal R&D spending on AI and quantum computing. This week, the European Union Commission issued a major policy framework for AI technologies and billed it as “a European approach to excellence and trust.”

It seems the EU basically wants to have its cake and eat it too by marrying up an ambitious industrial policy with a precautionary regulatory regime. We’ve seen this show before. Europe is doubling down on the same policy regime it used for the internet and digital commerce. It did not work out well for the continent then, and there are reasons to think it will backfire on them again for AI technologies.

An Ambitious Industrial Policy Vision

The new EU framework includes a lot of catchphrases and proposals that are an industrial policy lover’s dream. In an attempt to create “an ecosystem of excellence” and ensure the “human-centric development if AI,” it identifies a variety of existing or new industrial planning efforts, including: Digital Innovation Hubs, Enterprise Resource Planning, the Digital Europe Programme, the Key Digital Technology Joint Undertaking, and broad-based public private partnerships. This is all part of an official “Coordinated Plan” prepared together with the Member States “to foster the development and use of AI in Europe.”

To accomplish that, the Commission says it will “facilitate the creation of excellence and testing centres” that will “concentrate in sectors where Europe has the potential to become a global champion.” The Commission also wants to give special consideration to growing small and mid-size enterprises (SMEs) is establishing these plans.

Again, it’s an ambitious industrial policy vision, and one that will be accompanied by a wide variety of (yet-to-be-determined) regulatory enactments to shape the development and use of AI. But if that approach really works, why aren’t European digital companies global leaders today? Instead, firms based mostly in the US have risen to become household names across the globe. Regulation had an influence on that result because American firms enjoyed a policy regime that was rooted in “permissionless innovation,” which generally allows experimentation by default and addresses concerns by using more flexible, ex post remedies. By contrast, Europe’s internet policy approach was rooted in the precautionary principle, or the notion that innovation is essentially guilty until proven innocent. New technologies are to be subjected to prior constraints—or what the new European Commission white paper calls “prior conformity assessments”—before being allow into the wild.

Precautionary Regulation Dominates

Despite losing that last round of the innovation wars, the new EU white paper makes it clear that Europe will keep using a precautionary approach. What does that mean for AI regulation? The problem here begins with defining what is a “high-risk” AI application requiring prior restraints. The white paper defines it in a somewhat circular fashion, saying that, “an AI application should be considered high-risk where…(it) is employed in a sector where, given the characteristics of the activities typically undertaken, significant risks can be expected to occur” and is “used in such a manner that significant risks are likely to arise.” Instead of providing legal certainty, this definition clarifies almost nothing and will require future regulatory inquires to determine the full scope and nature of AI controls.

There’s also a lot of talk in the proposal about preemptively addressing “risks for fundamental rights,” which is understandable. AI innovations can raise various safety, security, and privacy concerns that deserve to be taken seriously. But what about the risk of not having access to important AI innovations at all? What about the risk of losing out on life-enriching—and in many cases life-saving—innovations because, instead of “building trust,” the regulatory regime builds the exact opposite: fear of innovating.

Entrepreneurs and investors respond to incentives. Before building or investing in a new technology, they want to know how long it will take to get that good or service launched—assuming they can get approval at all. Every innovator and investor factors such political risk into their business plans. When the potential costs of product launch overwhelm the likely benefits, they will abandon innovative efforts or look to engage in them elsewhere.

The EU says “the race for global leadership is ongoing,” and claims that, “Europe offers significant potential, knowledge and expertise” through its efforts to make the continent an AI innovation hub. Indeed, some of the best AI researchers are in Europe, and there are plenty of brilliant people brimming with entrepreneurial enthusiasm about creating world-class AI applications. But all that knowledge and enthusiasm do not matter much if the regulatory deck is stacked against innovation from the start.

And Even More Expansive Regulation Down the Road

Beyond the precautionary approach in that document, the EU’s accompanying white paper on safety and liability implications of AI leaves open the possibility of an expansion in preemptive regulatory requirements. “Additional obligations may be needed for manufacturers to ensure that they provide features to prevent the upload of software having an impact on safety during the lifetime of the AI products,” the document notes. Moreover, if an ongoing AI software update “modifies substantially the product in which it is downloaded, the entire product might be considered as a new product and compliance with the relevant safety product legislation must be reassessed at the time the modification is performed.”

That sort of regulatory regime may sound quite sensible at first blush. In practice, however, it means that every conceivable tweak to an algorithm requires costly and complex regulatory approval. If traditional computer software had required regulatory approval before any new modifications could be made, most consumers would still be stuck with an aol.com email address and Windows 95 as an operating system.

What the European Commission proves with its new AI policy framework is that it is easy to talk a big game about planning for an innovative future, but it is an entirely different thing to actually bring one about. The European approach will have clear competitive effects, or more specifically, anti-competitive effects. As is already the case with the EU’s regulatory approach to the data economy and GDPR in particular, regulatory compliance costs continue to skyrocket and small and mid-size enterprises struggle to cope. This means that only firms operating the largest digital platforms are able to shoulder these burdens, leaving consumers without as many competitive, low-cost choices as they might otherwise enjoy. Not even generous government support for SMEs will be able to counter-balance the costly entry barriers associated with over-regulation.

Solidifying Market Power of Existing Giants?

This is why it is so ironic how worried the EU is about the market power of Google, Facebook and other US-based tech giants: the regulatory burden now helps those firms maintain their market dominance. Over-regulation by the EU undermined both home-grown and international investment and competition that might challenge those existing players. With each addition layer of AI regulation that now gets piled on top of the Europe’s existing regulatory burden, the prospects for creative destruction decrease, as do the chances for life-enriching innovations to ever make it to consumers.

While the European Commission will, no doubt, insist that they are implementing this new AI regime with the very best of intentions in mind, there is no escaping the fact that regulation involves complex trade-offs and unforeseeable consequences. The consequences in this case are likely a bit easier to predict, however: By smothering new AI applications in layers of red tape, we can expect fewer innovations and less competition.

Despite all the talk of boosting SMEs, perhaps the EU will eventually become more like China and unabashedly support larger home-grown firms to make sure they are part of the global AI race. China has already made waves on this front with its 2017 “New Generation Artificial Intelligence Development Plan,” an audacious industrial policy plan which seeks “to build China’s first-mover advantage in the development of AI [and] to accelerate the construction of an innovative nation and global power in science and technology.” The document is as much a manifesto about geopolitical power as it is about technological governance. And it does not try to hide China’s authoritarian impulse to meticulously plan every facet of daily life under the auspices of promoting global technological leadership. China’s AI manifesto even concludes with a section on “public opinion guidance” that creepily insists the country will, “Fully use all kinds of traditional media and new media to quickly propagate new progress and new achievements in AI, to let the healthy development of AI become a consensus in all of society, and muster the vigor of all of society to participate in and support the development of AI.”

The new European AI industrial policy framework does not go as far as China’s, not only because the continent is obviously more open and democratic by nature, but also because the EU is a collection of many countries and cultures that will never be able to speak as coherently and forcefully with one voice on all technological governance matters. In fact, the EU’s new governance framework explicitly leaves room for more tailored AI regulation by individual member states.

Conclusion

This leaves Europe stuck between the polar opposites of China and the US when it comes to AI governance. China’s meticulously detailed, highly centralized, state-driven approach stands in stark contrast to the more bottom-up, adaptive American approach which insists that regulators, “must avoid a precautionary approach that holds AI systems to such an impossibly high standard that society cannot enjoy their benefits.”

The US approach also leans heavily on “soft law,” or informal governance mechanisms that are not as burdensome as precautionary regulatory controls. Soft law can include a wide variety of tools and methods for addressing policy concerns, including multistakeholder initiatives, best practices and standards, agency workshops and guidance documents, educational efforts, and much more. These are the governance tools the dominated for the internet and digital platforms for that past twenty years in the US, and they will likely continue to be the primary governance mechanisms for artificial intelligence, robotics, the internet of things, and other emerging tech sectors.

The EU probably thinks it has found the Goldilocks formula and gotten AI policy just right by falling between China and the US on the governance spectrum. It is more likely, however, that European policymakers will be unable to resist the urge to over-plan and micro-manage AI markets until they are once again left wondering how they got stuck trying to regulate market leaders that are headquartered oceans away from them. With the US once again adopting a more flexible approach, we could see a replay of the Web Wars, with innovators and investors putting their efforts behind AI launches in the US instead of Europe. Meanwhile, China will likely attract far more global venture capital for AI and robotics launches than they did for digital platforms. This could really put the squeeze on Europe.

Only time will tell. But, to paraphrase Yoda, when it comes to global artificial intelligence governance, one thing is clear: Begun the AI war has.

In 2015 after White House pressure, the FCC decided to take the radical step of classifying “broadband Internet access service” as a heavily-regulated Title II service. Title II was created for the AT&T long-distance monopoly and telegraph network and “promoting innovation and competition” is not its purpose. It’s ill-suited for the modern Internet, where hundreds of ISPs and tech companies are experimenting with new technologies and topologies.

Commissioner Brendan Carr was gracious enough to speak with Chris Koopman and me in a Mercatus podcast last week about his decision to vote to reverse the Title II classification. The podcast can be found at the Mercatus website. One highlight from Commissioner Carr:

Congress had a fork in the road. …In 1996, Congress made a decision that we’re going to head down the Title I route [for the Internet]. That decision has been one of the greatest public policy decisions that we’ve ever seen. That’s what led to the massive investment in the Internet. Over a trillion dollars invested. Consumers were protected. Innovators were free to innovate. Unfortunately, two years ago the Commission departed from that framework and moved into a very different heavy-handed regulatory world, the Title II approach.

Along those lines, in my recent ex parte meeting with Chairman Pai’s office, I pointed to an interesting 2002 study in the Review of Economics and Statistics from MIT Press about the stifling effects of Title II regulation:

[E]xisting economics scholarship suggests that a permissioned approach to new services, like that proposed in the [2015] Open Internet Order, inhibits innovation and new services in telecommunications. As a result of an FCC decision and a subsequent court decision in the late 1990s, for 18 to 30 months, depending on the firm, [Title II] carriers were deregulated and did not have to submit new offerings to the FCC for review. After the court decision, the FCC required carriers to file retroactive plans for services introduced after deregulation. This turn of events allowed economist James Preiger to analyze and compare the rate of new services deployment in the regulated period and the brief deregulated period. Preiger found that “some otherwise profitable services are not financially viable under” the permissioned regime. Critically, the number of services carriers deployed “during the [deregulated] interim is 60%-99% larger than the model predicts they would have created” when preapproval was required. Finally, Preiger found that firms would have introduced 62% more services during the entire study period if there was no permissioned regime. This is suggestive evidence that the Order’s “Mother, May I?” approach will significantly harm the Internet services market.

Thankfully, this FCC has incorporated economic scholarship into its Restoring Internet Freedom Order and will undo the costly Title II classification for Internet services.

The Federal Trade Commission (FTC) is taking a more active interest in state and local barriers to entry and innovation that could threaten the continued growth of the digital economy in general and the sharing economy in particular. The agency recently announced it would be hosting a June 9th workshop “to examine competition, consumer protection, and economic issues raised by the proliferation of online and mobile peer-to peer business platforms in certain sectors of the [sharing] economy.” Filings are due to the agency in this matter by May 26th. (Along with my Mercatus Center colleagues, I will be submitting comments and also releasing a big paper on reputational feedback mechanisms that same week. We have already released this paper on the general topic.)

Relatedly, just yesterday, the FTC sent a letter to Michigan policymakers about restricting entry by Tesla and other direct-to-consumer sellers of vehicles. Michigan passed a law in October 2014 prohibiting such direct sales. The FTC’s strongly-worded letter decries the state’s law as “protectionism for independent franchised dealers” noting that “current provisions operate as a special protection for dealers—a protection that is likely harming both competition and consumers.” The agency argues that:

consumers are the ones best situated to choose for themselves both the vehicles they want to buy and how they want to buy them. Automobile manufacturers have an economic incentive to respond to consumer preferences by choosing the most effective distribution method for their vehicle brands. Absent supportable public policy considerations, the law should permit automobile manufacturers to choose their distribution method to be responsive to the desires of motor vehicle buyers.

The agency cites the “well-developed body of research on these issues strongly suggests that government restrictions on distribution are rarely desirable for consumers” and the staff letter continues on to utterly demolish the bogus arguments set forth by defenders of the blatantly self-serving, cronyist law. (For more discussion of just how anti-competitive and anti-consumer these laws are in practice, see this January 2015 Mercatus Center study, “State Franchise Law Carjacks Auto Buyers,” by Jerry Ellig and Jesse Martinez.)

The FTC’s letter is another example of how the agency can take steps using its advocacy tools to explain to state and local policymakers how their laws may be protectionist and anti-consumer in character. Needless to say, this also has ramifications for how the agency approaches parochial restraints on entry and innovation affecting the sharing economy.

In our forthcoming Mercatus Center comments to the FTC for its June 6th sharing economy workshop, Christopher Koopman, Matt Mitchell, and I will address many issues related to the sharing economy and its regulation. Beyond addressing all five of the specific questions asked in the Commission’s workshop notice, we also include a discussion about “Federal Responses to Local Anticompetitive Regulations.” Down below I have reproduced the current rough draft of that section of our filing in the hope of getting input from others. Needless to say, the idea of the FTC aggressively using its advocacy efforts or even federal antitrust laws to address state and local barriers to trade and innovation will make some folks uncomfortable–especially on federalism grounds. But we argue that a good case can be made for the agency using both its advocacy and antitrust tools to address these issues. Let us know what you think.

The Federal Trade Commission possesses two primary tools to address public restraints of trade created by state and local authorities: advocacy and antitrust.[1]

Through its advocacy program, the Commission can provide specific comments to state and local officials regarding the effects of both proposed and existing regulations.[2] Commissioner Joshua Wright has noted that, “For many years, the FTC has used its mantle to comment on legislation and regulation that may restrain competition in a way that harms consumers.”[3] Thus, at a minimum, the Commission can and should shine light on parochial governmental efforts to restrain trade and limit innovation throughout the sharing economy.[4] By shining more light on state or local anti-competitive rules, the Commission will hopefully make governments, or their surrogate bodies (such as licensing boards), more transparent about their practices and more accountable for laws or regulations that could harm consumer welfare. However, to be successful, the Commission’s advocacy efforts depend upon the willingness of state and local legislators and regulators to heed its advice.^[5]

The Commission has already used its advisory role in its recent guidance to state and local policymakers regarding the regulation of ridesharing services. The Commission noted then that “a regulatory framework should be responsive to new methods of competition,” and set forth the following vision regarding what it regards as the proper approach to parochial regulation of passenger transportation services:

Staff recommends that a regulatory framework for passenger vehicle transportation should allow for flexibility and adaptation in response to new and innovative methods of competition, while still maintaining appropriate consumer protections. [Regulators] also should proceed with caution in responding to calls for change that may have the effect of impairing new forms or methods of competition that are desirable to consumers. . . .  In general, competition should only be restricted when necessary to achieve some countervailing procompetitive virtue or other public benefit such as protecting the public from significant harm.[6]

This represents a reasonable framework for addressing concerns about parochial regulation of the sharing economy more generally.

Unfortunately, in areas relevant to the regulation of the sharing economy (e.g., taxicab regulations and rules governing home and apartment rentals) anticompetitive regulations have remained on the books—and in some instances have expanded—in spite of more than 30 years of Commission comment and advocacy.[7]  In fact, as Public Citizen noted in a recent Supreme Court filing:

[M]any more occupations are regulated than ever before, and most boards doing the regulating—in both traditional and new professions—are dominated by industry members who compete in the regulated market. Those board member-competitors, in turn, commonly engage in regulation that can be seen as anticompetitive self-protection. The particular forms anticompetitive regulations take are highly varied, the possibilities seemingly limited only by the imaginations of the board members.[8]

In these instances, the Commission’s antitrust enforcement authority may need to be utilized when its advocacy efforts fall short with regard to regulations that favor incumbents by limiting competition and entry.[9] Many academics have endorsed expanded antitrust oversight of public barriers to trade and innovation.[10] As Commissioner Wright has argued, “the FTC is in a good position to use its full arsenal of tools to ensure that state and local regulators do not thwart new entrants from using technology to disrupt existing marketplace.”[11] He notes specifically that he is “quite confident that a significant shift of agency resources away from enforcement efforts aimed at taming private restraints of trade and instead toward fighting public restraints would improve consumer welfare.”[12] We agree.

The Supreme Court’s recent decision in North Carolina State Board of Dental Examiners v. Federal Trade Commission made it clear that local authorities cannot claim broad immunity from federal antitrust laws.[13] This is particularly true, the Court noted, “where a State delegates control over a market to a nonsovereign actor,” such as a professional licensing board consisting primarily of members of the affected interest being regulated.[14] “Limits on state-action immunity are most essential when a State seeks to delegate its regulatory power to active market participants,” the Court held, “for dual allegiances are not always apparent to an actor and prohibitions against anticompetitive self-regulation by active market participants are an axiom of federal antitrust policy.”[15]

The touchstone of this case and the Court’s related jurisprudence in this area is political accountability.[16] State officials must (1) “clearly articulate” and (2) “actively supervise” licensing arrangements and regulatory bodies if they hope to withstand federal antitrust scrutiny.[17] The Court clarified this test in N.C. Dental holding that “the Sherman Act confers immunity only if the State accepts political accountability for the anticompetitive conduct it permits and controls.”[18] In other words, if state and local officials want to engage in protectionist activities that restrain trade in pursuit of some other countervailing objective, then they need to own up to it by being transparent about their anticompetitive intentions and then actively oversee the process after that to ensure it is not completely captured by affected interests.[19]

Some might argue that this does not go far enough to eradicate anti-competitive barriers to trade at the state or local level that could restrain the innovative potential of the sharing economy. While that may be true, some limits on the Commission’s federal antitrust discretion are necessary to avoid impinging upon legitimate state and local priorities.

Over time, it is our hope that by empowering the public with more options, more information and better ways to shine light on bad actors, the sharing economy will continue to make many of those old regulations unnecessary. Thus, in line with Commissioner Maureen Ohlhausen’s wise advice, the Commission should encourage state and local officials to exercise patience and humility as they confront technological changes that disrupt traditional regulatory systems.[20]

But when parochial regulators engage in blatantly anti-competitive activities that restrain trade, foster cartelization, or harm consumer welfare in other ways, the Commission can act to counter the worst of those tendencies.[21] The Commission’s standard of review going forward was appropriately articulated by Commissioner Wright recently when he noted that, “in the context of potentially disruptive forms of competition through new technologies or new business models, we should generally be skeptical of regulatory efforts that have the effect of favoring incumbent industry participants.”[22]

Such parochial protectionist barriers to trade and innovation will become even more concerning as the potential reach of so many sharing economy businesses grows larger. The boundary between intrastate and interstate commerce is sometimes difficult to determine for many sharing economy platforms. Clearly, much of the commerce in question occurs within the boundaries of a state or municipality, but sharing economy services also rely upon Internet-enabled platforms with a broader reach. To the extent state or local restrictions on sharing economy operations create negative externalities in the form of “interstate spillovers,” the case for federal intervention is strengthened.[23] It would be preferable if Congress chose to deal with such spillovers using its Commerce Clause authority (Art. 1, Sec. 8 of the Constitution),[24] but the presence of such negative externalities might also bolster the case for the Commission’s use of antitrust to address parochial restraints on trade.

[1]     See Maureen K. Ohlhausen, Reflections on the Supreme Court’s North Carolina Dental Decision and the FTC’s Campaign to Rein in State Action Immunity, before the Heritage Foundation, Washington, DC, March 31, 2015, at 19-20.

[2]     Id., at 20. (“The primary goal of such advocacy is to convince policymakers to consider and then minimize any adverse effects on competition that may result from regulations aimed at preventing various consumer harms.”) Also see James C. Cooper and William E. Kovacic, “U.S. Convergence with International Competition Norms: Antitrust Law and Public Restraints on Competition,” Boston University Law Review, Vol. 90, No. 4, (August 2010): 1582, “Competition advocacy helps solve consumers’ collective action problem by acting within the regulatory process to advocate for regulations that do not restrict competition unless there is a compelling consumer protection rationale for imposing such costs on citizens.”).

[3]     Joshua D. Wright, “Regulation in High-Tech Markets:  Public Choice, Regulatory Capture, and the FTC,” Remarks of Joshua D. Wright Commissioner, Federal Trade Commission at the Big Ideas about Information Lecture Clemson University, Clemson, South Carolina, April 2, 2015, at 15, https://www.ftc.gov/public-statements/2015/04/regulation-high-tech-markets-public-choice-regulatory-capture-ftc.

[4]     Cooper and Kovacic, “U.S. Convergence with International Competition Norms,” at 1610, (“Competition agencies could devote greater resources to conduct research to measure the effects of public policies that restrict competition. A research program could accumulate and analyze empirical data that assesses the consumer welfare effects of specific restrictions. Such a program could also assess whether the stated public interest objectives of government restrictions are realized in practice.”)

[5]     Cooper and Kovacic, “U.S. Convergence with International Competition Norms,” at 1582, (“The value of competition advocacy should be measured by (1) the degree to which comments altered regulatory outcomes times (2) the value to consumers of those improved outcomes. For all practical purposes, however, both elements are difficult to measure with any degree of certainty.”).

[6]     Federal Trade Commission, Staff Comments Before the Colorado Public Utilities Commission In The Matter of The Proposed Rules Regulating Transportation By Motor Vehicle, 4 Code of Colorado Regulations, (March 6, 2013), http://ftc.gov/os/2013/03/130703coloradopublicutilities.pdf.

[7]     Marvin Ammori, “Can the FTC Save Uber,” Slate, March 12, 2013, http://www.slate.com/articles/technology/future_tense/2013/03/uber_lyft_sidecar_can_the_ftc_fight_local_taxi_commissions.html (noting that, “not only does the FTC have the authority to take these cities to impartial federal courts and end their anticompetitive actions; it also has deep expertise in taxi markets and antitrust doctrines.”) Also see, Edmund W. Kitch, “Taxi Reform—The FTC Can Hack It,” Regulation, May/June 1984, http://object.cato.org/sites/cato.org/files/serials/files/regulation/1984/5/v8n3-3.pdf.

[8]     Brief of Amici Curiae Public Citizen in Support of Respondent, North Carolina State Bd. of Dental Exam’rs v. FTC, (August 2014): 24.

[9]     Brief of Antitrust Scholars as Amici Curiae in Support of Respondent, North Carolina State Bd. of Dental Exam’rs v. FTC, (August 6, 2014): 24, (“Antitrust review is entirely appropriate for curbing the excesses of occupational licensing because the anticompetitive effect has a similar effect on the market—and in particular consumers—as does traditional cartel activity.”)

[10]   See Mark A. Perry, “Municipal Supervision and State Action Antitrust Immunity,” The University of Chicago Law Review, Vol. 57, (Fall 1990): 1413-1445; William J. Martin, “State Action Antitrust Immunity for Municipally Supervised Parties,” The University of Chicago Law Review, Vol. 72, (Summer, 2005): 1079-1102; Jarod M. Bona, “The Antitrust Implications of Licensed Occupations Choosing Their Own Exclusive Jurisdiction,” University of St. Thomas Journal of Law & Public Policy, Vol 5, (Spring 2011): 28-51; Ingram Weber “The Antitrust State Action Doctrine and State Licensing Boards,” The University of Chicago Law Review, Vol. 79, (2012); Aaron Edlin and Rebecca Haw, “Cartels by Another Name:  Should Licensed Occupations Face Antitrust Scrutiny?,” University of Pennsylvania Law Review, Vol. 162, (2014): 1093-1164.

[11]   Wright, “Regulation in High-Tech Markets,” at 28-9.

[12]   Wright, “Regulation in High-Tech Markets,” at 29.

[13]   North Carolina State Bd. of Dental Exam’rs v. FTC, 135 S. Ct. 1101 (2015).

[14]   Id.

[15]   Id. Also see Edlin & Haw, “Cartels by Another Name,” at 1143, (“Who could seriously argue that an unsupervised group of competitors appointed to regulate their own profession can be counted on to neglect their selfish interests in favor of the state’s?”); Brief Amicus of the Pacific Legal Foundation and Cato Institute, North Carolina State Bd. of Dental Exam’rs v. FTC, (August 2014): 3, (“Antitrust immunity for private parties who act under color of state law is especially problematic, given that anticompetitive conduct is most likely to occur when private parties are in a position to exploit government’s regulatory powers.”)

[16]   See Maureen K. Ohlhausen, Reflections on the Supreme Court’s North Carolina Dental Decision and the FTC’s Campaign to Rein in State Action Immunity, before the Heritage Foundation, Washington, DC, March 31, 2015, at 16, https://www.ftc.gov/public-statements/2015/03/reflections-supreme-courts-north-carolina-dental-decision-ftcs-campaign, (“states need to be politically accountable for whatever market distortions they impose on consumers.”); Edlin & Haw, “Cartels by Another Name,” at 1137, (“political accountability is the price a state must pay for antitrust immunity.)

[17]   See Federal Trade Commission, Office of Policy and Planning, Report of the State Action Task Force (2003): 54, (“clear articulation requires that a state enunciate an affirmative intent to displace competition and to replace it with a stated criterion. Active supervision requires the state to examine individual private conduct, pursuant to that regulatory regime, to ensure that it comports with that stated criterion. Only then can the underlying conduct accurately be deemed that of the state itself, and political responsibility for the conduct fairly placed with the state.”) This test has been developed and refined in a variety of cases over the past 35 years. See: California Retail Liquor Dealers Ass’n v. Midcal Aluminum, Inc., 445 U.S. 97 (1980); Cmty. Comm’ns Co., Inc. v. City of Boulder, 455 U.S. 40, 48-51 (1982); City of Columbia v. Omni Outdoor Advertising, Inc., 499 U.S. 365 (1991); FTC v. Ticor Title Ins. Co., 504 U.S. 621 (1992).

[18]   North Carolina State Bd. of Dental Exam’rs v. FTC, 135 S. Ct. 1101 (2015).

[19]   Edlin & Haw, “Cartels by Another Name,” at 1156. (“Requiring that the state place its imprimatur on regulation is at least better than the status quo, in which states too often delegate self-regulation to professionals and walk away.”) See also North Carolina State Bd. of Dental Exam’rs v. FTC, 135 S. Ct. 1101 (2015) (“[Federal antitrust] immunity requires that the anticompetitive conduct of nonsovereign actors, especially those authorized by the State to regulate their own profession, result from procedures that suffice to make it the State’s own.”).

[20]  Maureen K. Ohlhausen, Commissioner, Fed. Trade Commission, “Regulatory Humility in Practice,” Remarks of the American Enterprise Institute, Washington, D.C. (April 1, 2015).

[21]   Edlin & Haw, “Cartels by Another Name,” at 1094, (“state action doctrine should not prevent antitrust suits against state licensing boards that are comprised of private competitors deputized to regulate and to outright exclude their own competition, often with the threat of criminal sanction.”). See also Brief Amicus of the Pacific Legal Foundation and Cato Institute, North Carolina State Bd. of Dental Exam’rs v. FTC, (August 2014): 2, 21, http://www.americanbar.org/content/dam/aba/publications/supreme_court_preview/BriefsV4/13-534_resp_amcu_plf-cato.authcheckdam.pdf, (noting that courts “should presume strongly against granting state-action immunity in antitrust cases.  It makes little sense to impose powerful civil and criminal punishments on private parties who are deemed to have engaged in anti-competitive conduct, while exempting government entities—or, worse, private parties acting under the government’s aegis—when they engage in the exact same conduct. . . . “Whatever one’s opinion of antitrust law in general, there is no justification for allowing states broad latitude to disregard federal law and erect private cartels with only vague instructions and loose oversight.”)

[22]   Wright, “Regulation in High-Tech Markets,” at 7.

[23]   FTC, Report of the State Action Task Force, 44, (“an unfortunate gap has emerged between scholarship and case law. Although many of the leading commentators have expressed serious concern regarding problems posed by interstate spillovers, their thinking has yet to take root in the law. Such spillovers undermine both economic efficiency and some of the same political representation values thought to be protected by principles of federalism.”); Brief Amicus of the Pacific Legal Foundation and Cato Institute, North Carolina State Bd. of Dental Exam’rs v. FTC, (August 2014): 13, (“Allowing states expansive power to exempt private actors from antitrust laws would also disrupt national economic policy by encouraging a patchwork of state-established entities licensed to engage in cartel behavior. This would disrupt interstate investment and consumer expectations, and would have spillover effects across state lines.”) Cooper and Kovacic, “U.S. Convergence with International Competition Norms,” at 1598, (“When a state exports the costs attendant to its anticompetitive regulatory scheme to those who have not participated in the political process, however, there is no political backstop; arguments for immunity based on federalism concerns are severely weakened, if not wholly eviscerated, in these situations.”

[24]   See Adam Thierer, The Delicate Balance: Federalism, Interstate Commerce, and Economic Freedom in the Technological Age (Washington, DC: The Heritage Foundation, 1998): 81-118.

If there is one thing I have learned in almost 23 years of covering communications and media regulation it is this: No matter how well-intentioned, regulation often has unintended consequences that hurt the very consumers the rules are meant to protect. Case in point: “universal service” mandates that require a company to serve an entire area as a condition of offering service at all. The intention is noble: Get service out to everyone in the community, preferably at a very cheap rate. Alas, the result of mandating that result is clear: You get less competition, less investment, less innovation, and less consumer choice. And often you don’t even get everyone served.

Consider this Wall Street Journal article today, “Google Fiber Is Fast, but Is It Fair? The Company Provides Neighborhoods With Faster and Cheaper Service, but Are Some Being Left Behind?” In the story, Alistair Barr notes that:

U.S. policy long favored extending service to all. AT&T touted its “universal service” in advertisements more than a century ago. The concept was codified in a 1934 law requiring nationwide “wire and radio services” to reach everyone at “reasonable charges.” In exchange for wiring a community, telecommunications providers often gained a monopoly. Cities made similar deals with cable-TV providers beginning in the 1960s.

The problem, of course, is that while this model allowed for the slow spread of service to most communities, it came at a very steep cost: Monopoly and plain vanilla service. I documented this in a 1994 essay entitled, “Unnatural Monopoly: Critical Moments in the Development of the Bell System Monopoly.” As well-intentioned regulatory mandates started piling up, competition slowly disappeared. And a devil’s deal was eventually cut between regulators and AT&T to adopt the company’s advertising motto — “One Policy, One System, Universal Service” — as the de facto law of the land.

It took us almost a century to dig ourselves out of that mess and move towards telecommunications competition. Alas, we’re still living with the vestiges of this old regulatory mentality. Cities and counties across America still impose a wide variety of “universal service” regulatory mandates. Again, their intention is noble: They want everyone in their community served. You can’t blame them for that. But the result is still the same: Limited facilities-based competition and investment.

And so we return to today’s Wall Street Journal story about Google Fiber, which explains how local officials are finally starting to understand these realities. The story notes:

In 2011, Google struck a deal with authorities in both Kansas City, Kan., and Kansas City, Mo., to build the service based on customer demand. City officials say they didn’t push hard for universal coverage because they thought faster Internet service would boost the local economy and they were competing against so many other cities. “The main point was to win and bring that infrastructure to our city,” said Rick Usher, assistant city manager of Kansas City, Mo. As phone and cable companies slowed their own expansion plans, more cities allowed the selective approach.

Google’s ‘build-to-demand’ model is catching on because it produces results: More infrastructure investment, innovation, and competition. Traditional telecom and broadband operators are prepared to step up investment, too, when the incentives are right:

Verizon was required by cities and some state laws to build and offer its FiOS service widely across cities. It stopped expanding to new cities in 2010; to date, it has spent more than $23 billion on the FiOS rollout. Chief Financial Officer Fran Shammo said in March that the company wouldn’t expand to additional markets until FiOS had “finally returned its cost of capital.” If Verizon resumes expansion, the company would consider Google’s build-to-demand model because it has the potential to be more profitable, said Chris Levendos, a Verizon executive overseeing the FiOS build-out in Manhattan. Others are doing just that. AT&T said in April it would offer Internet speeds of up to one gigabit in as many as 100 cities. It is building to demand and working with local authorities to reduce construction costs, the company said. Tuesday, it said it would bring the high-speed service to Cupertino, Calif., close to Google’s headquarters. This approach “starts to make this business model look quite attractive,” John Stankey, AT&T’s chief strategy officer, said at an investor conference on Aug. 13.

Again, when you get the incentives right and give investors and innovators a green light, they will seize the opportunity. And that’s even true — actually, it is especially true — for high fixed-cost investments like fiber networks.

But wait, aren’t there some pockets of the population that will fall through the cracks under this alternative arrangement? In the short-term, potentially yes. But the right answer to that “digital divide” problem is never to restrict short-term investment and innovation opportunities just because you think you have a better, more “well intentioned” plan. That is the crucial mistake policymakers made in the past. Their desire to get everyone served at the exact same time with the exact same plain vanilla service meant we got sub-optimal technologies and stagnant markets with little hope of any new innovation or investment over the long-haul.

This is how “universal service” consistently fails us. Universal service sells us short. It sells human ingenuity short. The logic that motivates universal service regulation is that: ‘Well, this is about the best we can do. Let’s just get everyone some basic level of service and that will be just and good.’  Can you imagine if we would have applied this logic to other major markets and technologies?!

But what about the under-served communities? First, when you allow new innovation in networks, you never know how or where they might spread next. If you have more competitors offering unique networks architectures and services, there is a very good chance that entrepreneurial minds will figure out how to push out the boundaries of what is possible, especially in terms of how the service is delivered.

Consider this: Back in the old days, did it really make sense to try to stretch a thin copper wire way, way out into the middle of every valley, desert, farm field, and mountain? The myopic universal service mindset says: ‘Well, that’s all we had at the time.’ Perhaps for a time it really was. But how much quicker might we have seen some sort of alternative system if we hadn’t locked in those old assumptions as policy requirements? Is it impossible to believe that wireless technologies might have developed much more quickly if the incentives would have been right? Again, there was no reason for any innovators or investors to even consider the idea at a time when policymakers were mandating copper wires be stretched to every corner of the land, and as they were showering favored companies with subsidies to achieve that goal. That’s not something a new innovator could compete with, and so no one did. It would have been like policymakers saying we needed a “universal service” policy for cheap hamburgers for the masses and then showering McDonald’s with subsidies since they were the first one in many local markets who could deliver on that promise. Had we had such a universal cheap hamburger policy, do you think any other fast food places would have ever come to town and tried to compete against those subsidized burgers? Not likely.

The lesson for today’s policymakers is clear: Open up markets, relax regulatory burdens, eliminate discriminatory taxes and subsidies, and clear away other barriers to investment. Then see what happens. As the Google Fiber experience suggests, innovative minds can and will emerge to offer constructive solutions and slowly spread new networks and technologies.

OK, but won’t there still be some communities that are underserved, even with all that new innovation and investment. It’s certainly possible. And where those communities exist, some government action may be necessary to incentivize the spread of some sort of network to them, or even have the government build it for the community. I’m not opposed to that. (Have you ever driven through the hills of West Virginia or the mountains of rural Western states? Hard places to get wired networks out to!) I’m not very optimistic local governments will do a very good job of building sophisticated networks because they already have a horrible track record in this regard. But, again, I don’t oppose local action on this front if no other alternatives appear after a certain period of time.

But, again, the answer here is not crazy national and state-based universal service mandates that regulate everyone in every community as if they had the same problem. Let competition and innovation work its magic where it can and do not mess that up. Where it proves much harder for that network competition and innovation to take root, use smart incentives to get companies to build out their networks further, or offer alternative wireless infrastructure of some sort, or just have the government build the networks themselves. But we should always give competition and innovation the benefit of the doubt and see what happens first.

So, let me perfectly clear what I am saying here: GOOD INTENTIONS ARE NEVER ENOUGH! [And yes, I am using all caps because I am shouting!] The next time somebody starts mouthing something about how they have the moral high ground in these debates because their intentions are supposedly pure as the driven snow, ask them to show you results. Tell them you want evidence that their intentions have actually produced something concrete and positive for society. If their answer is, in essence, ‘Well, with our regulatory mandates we can at least get everybody some basic level of really crappy monopoly service,’ then tell them that they can take their good intentions and shove them. We can do better.

From the time Tom Wheeler was nominated to become the next FCC Chairman, many have wondered, “What would Wheeler do?” Though it is still early in his chairmanship, the only ruling issued in Chairman Wheeler’s first meeting signals a pro-investment approach to communications regulation.

The declaratory ruling clarified that the FCC would evaluate foreign investment in broadcast licensees that exceeds the 25 percent statutory benchmark using its existing analytical framework. It had previously been unclear whether broadcasters were subject to the same standard as other segments of the communications industry. The ruling recognized that providing broadcasters with regulatory certainty in this respect would promote investment and that greater investment yields greater innovation.

The FCC’s decision to apply the same standards for reviewing foreign ownership of broadcasters as it applies to other segments of the communications industry is very encouraging. It affirms the watershed policy decisions in the USF/ICC Transformation Order, in which the FCC concluded that “leveling the playing field” promotes competition whereas implied subsidies deter investment and are “unfair for consumers.”

Chairman Wheeler’s separate statement is also very encouraging. Its first sentence declares that, “Promoting a regulatory framework that does not inhibit the flow of capital to the US communications sector is an important goal of Commission policy.” This Chairman understands that, in a global economy, U.S. companies must compete with innovators around the world to obtain the necessary investment to develop new information technologies and deploy new communications infrastructure. His separate statement indicates the Chairman’s intent to renew the FCC’s commitment to encouraging private investment.

Regrettably, the Chairman’s separate statement is potentially troubling as well. After noting that the broadcast incentive auction is intended to allow the market to assure that the spectrum is put to its highest and best use, Chairman Wheeler says he will “assess foreign ownership petitions and applications by looking at, among other factors, whether they will help to fulfill these goals, including efficient spectrum usage.”

It is not entirely clear what the Chairman meant by this non sequitur (would the FCC impose channel sharing conditions on stations seeking approval for foreign investment exceeding the benchmark?). But it indicates a willingness to use the FCC’s authority over mergers and acquisitions to promote unrelated policy goals through the imposition of unrelated conditions. As I’ve noted previously, using the FCC’s transaction authority in this way silences public debate over critical policy issues and shields the resulting decision from judicial review – due process protections that are essential to ensure that the FCC acts in the public interest. Ironically, the prospect of unpredictable, case-by-case conditions on foreign investment would appear to be at odds with the Chairman’s goal of promoting a regulatory framework that doesn’t inhibit the flow of private capital to the U.S. communications industry.

It is also possible that the Chairman was merely attempting to deter speculative investments in broadcast spectrum that could sabotage the incentive auction. The success of the incentive auction is critical to the future of our mobile broadband ecosystem, and it is appropriate that the FCC be mindful of sudden, significant foreign investments in broadcast spectrum in these circumstances.

It is still early in Wheeler’s chairmanship, and the future is bright in the spring. If the Chairman maintains his focus on pro-investment policies during his term, the future could be brighter in every season.

Why do mobile carriers sell phones with a subscription?  My roommate and I were debating this the other night.  Most other popular electronics devices aren’t sold this way.  Cable and satellite companies don’t sell televisions with their video service.  ISPs don’t sell laptops and desktops with their Internet service.  Bundling phones with mobile service subscriptions is pretty unique.  (The only mass-market analogs I can think of are satellite radio and GPS service.)

Why might this be?  Some might think that US carriers need control over the phones sold to their customers because roughly half of US subscribers use GSM phones (AT&T and T-Mobile) and half use CDMA phones (Verizon and Sprint), but that can’t be the reason because GSM is the standard in Europe yet bundling phones with subscriptions occurs.

Some say it occurs because it benefits carriers at the expense of consumers.  A law review article written a few years ago said bundling profitably exploits the misperceptions of consumers and the value they place on mobile services.  Tim Wu has said that selling phones is an anticompetitive response that allows carriers to control the platform and disable features (WiFi, Bluetooth, VoIP) that might eat into the carriers’ existing revenue streams.  But even if that’s true I don’t think that’s the whole answer.  If network services have that much control over the devices used for their services, why don’t cable, satellite, and Internet service providers sell TVs and computers that only work with their service?  At the very least, if we assume, as Wu does, that carrier control removes features consumers really want, consumers could simply purchase phones directly from phone makers–Apple, Motorola, Samsung, LG–with full functionality intact.

I don’t know the best answer, and maybe commenters can chime in, but I suspect phones and contracts are primarily sold together because of the engineering challenges presented by a device using radio spectrum.   (This would explain why GPS and satellite radio service providers also bundle devices with service.)  Different carriers purchase licenses to use different swaths of spectrum, and these different frequencies require different radio receivers.  Phones, then, need to have radios installed that are tailored for the particular carrier.

In any case, throughout most of the world, phones are sold with subscriptions.  Some on the left, like Wu, say that bundling shouldn’t be permitted because it enables large carriers to exclude competitors and remove functionality consumers want.  To that end, he proposes regulations that require all handsets to work with all carriers.  Despite these objections, I’ll push back on the claim that consumers are being duped or that competition is seriously harmed.  Bundling handsets with subscriptions has several pro-competitive and pro-consumer justifications.

1.  Acts as an installment plan

This may be the most powerful reason selling phones with subscriptions is near-universal:  consumers like it.  Modern smartphones are expensive consumer products costing hundreds of dollars.  Wherever you see expensive consumer products (home appliances, furniture, computers, clothes) you find retailers offering installment plans so that consumers don’t have to pay hundreds or thousands of dollars up-front.  By locking consumers into a two-year contract, carriers can offer heavily subsidized advanced handsets–that they usually sell at an initial loss–and charge more for services over two years.

Consumers seem to prefer bundling since it acts as a de facto financing agreement.  Noncontract prepaid plans are offered by every US carrier, yet the vast majority of Americans still use post-paid plans with contracts in large part because the (subsidized) phones offered are so much cheaper and more attractive deals.  (See my prior post on the subject.)  Further evidence that consumers really value this installment plan option comes from Belgium, where bundling phones with subscriptions was illegal years ago.  That all changed in 2008 when the iPhone 3G came out.  Belgians complained about the fact that their iPhones started at €525 when their neighbors, like those in the Netherlands (who allowed bundling), could get a subsidized phone for as little as €1.  Within a year, with support from a competition minister, the law was changed to allow phones to be sold with subscriptions.  Predictably, the up-front costs of Belgian phones subsequently dropped as carriers subsidized the phones, and broadband penetration increased.

2.  Reduces transactions costs for consumers

Consumers also benefit from having a one-stop shop for their mobile needs.  Instead of needing to go to a phone retailer like Best Buy and then to a carrier’s retail store, consumers can get everything at the carrier’s retail store.  This may sound like a small benefit, but I imagine this especially benefits rural Americans who don’t have the retail options city-dwellers do.

3.  Aids carriers’ marketing and improves competition

It’s probable that bundling phones with subscriptions makes carriers more competitive.  There’s a textbook antitrust justification for why this is true.  Vertical contracts with suppliers aligns the interests of the retailer (carrier) with the supplier (phone maker).  DROID is a good example.  It’s a brand used by Verizon to market higher-end Android smartphones to tech-savvy early adopters.  This is a case of vertical restraints that prevent free-riding on Verizon’s brand promotion since no other carrier can offer DROID phones.  By most accounts, creating the DROID brand was a lucrative marketing move that helped Verizon’s Android phones compete with iPhones.  While DROID is probably the most successful example, all carriers have phones they market and sell exclusively.

4.  Improves carriers’ bargaining power with handset makers (and improves phones)

Selling phones with subscriptions allows carriers to strengthen their position in the value chain.  Carriers don’t want to be passive bit-pipes.  They know crushing price competition between carriers would result.  (Not to mention, being “dumb pipes” would make carriers more susceptible to net neutrality rules.)  Carriers are already being squeezed by handset suppliers, namely Apple, with high prices, so it’s to their benefit to make the handsets complementary to a specific network and not easily interoperable with other carriers.  And by selling differentiated handsets to their customers, the carriers demand innovative handsets from suppliers to differentiate their brand from other carriers and make their network ecosystem attractive to consumers.  If phones worked on all networks, a mandate Wu and others seek, each carrier’s demand for innovative phones from their suppliers would subside.  (Then competition would be driven by consumer demands, but it’s my impression that phone makers prefer to deal with carriers.  Responding directly to consumer demands would tend to fragment the hardware market even more than the existing market, which would add to their costs.)

5.  Smooths revenue streams for carriers (and improves networks)

Finally, locking consumers into a two-year contract, with a subsidized phone as a carrot, gives some predictability to carriers’ revenue streams.  Lumpy revenue streams and high churn is a killer for long-term network investment plans.  Without the ability to sell phones with subscriptions, churn rates would be much higher since few customers would want to be in a long contract.

This is what happened in Finland for years, when regulators banned bundling.  After having one of the best networks when cell phones first became popular in the late 1990s, there was intense price competition for voice and text.  And while Finnish prices were low, the investments in a 3G data network fell far behind other countries.  No bundling led to very high churn rates and made price competition–not advanced services like broadband–the focus of carriers.  Seeing that the lack of network investment was brought on by the ban on bundling, the Finnish equivalent of the FCC repealed the anti-bundling law in 2005.  With the new ability to lock customers into contracts, phone prices fell and network investment into mobile broadband improved.

I expect selling phones with subscriptions will continue for the foreseeable future, absent regulation.  And, for the reasons I’ve outlined, the ability to sell phones with subscriptions is likely a good thing for consumers and the industry.

Finally, though, I’ll note that inexpensive high-end smartphones could upset this entire bundling regime.  Cheap phones would mean carriers are less able to lock consumers into contracts.  We’re not there yet, but phones like the LG Nexus 4–an unlocked high-end Android starting at $300–indicates the day may come when consumers can’t be bribed into contracts by subsidized phones any longer.  Consumers, at that point, will prefer to pay full price up-front and have the ability to switch carriers at any time.  I don’t know how the radio engineering issues would be overcome, but this would be a major disruption of the wireless market and would have some ambiguous effects on competition, network investment, and consumers.  And, it’s important to note that we may enter Wu’s desired world of phone interoperability without regulatory mandates.

I’ve been wading through the FCC’s latest Mobile Wireless Competition Report, and articles about it trying to make sense of what the the agency might be up to on this front.  It’s hard to get a read on where the agency may be going here. As my PFF colleague Mike Wendy suggested in his post on the FCC’s report, “far from press reports which state the FCC clearly determined the market is not ‘effectively competitive,’ well, that’s wrong. In fact, the FCC fails to make any such determination whatsoever.”  Moreover, just flipping through the charts and tables of the 237-page report, one is struck by how dynamic this marketplace is, and how crazy it would be for the FCC to declare it anything other than effectively competitive and highly innovative.

Yet, the FCC and many others seem hung up on industry structure. In particular, there seems to be a lot of hand-wringing about increasing consolidation among the sector’s top players.  But the data the FCC reproduces in the report seem to undermine that concern. For example, here’s a snapshot of the “Mobile Market Structure in Selected Countries,” which appears on pg. 197 of the FCC report.  It shows how much more consolidated foreign mobile markets are relative to the U.S., which is true of wireline markets too.  And you can find much more evidence of how competitive the marketplace is in these two reports.

Nonetheless, it is still they case that the mobile marketplace is experiencing more consolidation these days. It’s nothing to fret about, however. The sky isn’t about to fall on consumers as some seemingly fear. The problem with this “big-is-bad” thinking is that it fails to understand the nature of competition in network industries. The economics of network industries are not those of a corner lemonade stand. We’re never going to have hundreds or even dozens of companies providing the underlying backbone over which bits of information travel. There are significant sunk costs associated with providing network services. Deploying all these network alone is a nightmare. Rolling out a sophisticated and reliable wireless architecture is incredibly costly and labor-intensive. Just siting all the towers, for example, can be cumbersome and get quite expensive.  And then there are the endless “truck rolls” to fix tiny problems and upgrade facilities.

The bottom line is this: The networking business is for big boys, and there are only going to be so many big boys that will ever be able to stick with it and turn a profit to keep those networks functioning properly while also planning for future innovations and upgrades. We learned this lesson the hard way in the late 1990s as we witnessed the FCC conduct a grand experiment with infrastructure sharing in an effort to create more competition in the telecom business. The idea was simple: Let’s provide small telecom resellers every possible incentive to use the networks owned by incumbent telecom companies so we can create a new crop of “competitors.” It was obvious that this scheme was never going to produce any legitimate new network competitors, but what was so interesting about this misguided episode in regulatory planning was that it didn’t even produce any reliable “fake” competitors either. The resellers that were given access to existing networks were never able to concoct a legitimate business model to convince investors (or even that many customers) that they were worthwhile investments. These resellers create networks built of paper instead of serious, facilities-based networks. As a result, almost all of them went under.  Again, the hard lesson here was that the networking business is not a Mom-and-Pop operation.

THIS IS NOT TO SAY THAT THE NETWORKING BUSINESS IS A NATURAL MONOPOLY. Indeed, from everything we know today, we can safely conclude that the wireless world and broadband networking business can be very competitive with even just a couple of major providers in each region. When it comes to wireless, we’re damn lucky to have 4 or more providers in many regions today. I still find it astonishing we have as many wireless providers as we do. Still, many will claim that’s just not enough. We need more networks to have “real” competition, they will say. But, again, the economics of networking will simply not allow it. There is just no way that more than a few providers will be able to remain profitable in direct competition with each other. To amortize the sunk costs of network deployment, maintenance and upgrades, carriers need to have a steady base of customers and fairly reliable rate of return on their investments. Nobody has put it better in recent memory than the current Obama administration Department of Justice when the agency’s leading officials noted in a filing to the FCC:

In markets such as this, with differentiated products subject to large economies of scale (relative to the size of the market), the Department does not expect to see a large number of suppliers. Nor do we expect prices to be equated with incremental costs. If they were, suppliers could not earn a normal, risk-adjusted rate of return on their investments in R&D and infrastructure.

Exactly right. Moreover, almost every mature industry usually shakes out to just a handful of providers. If you don’t believe me, check out The Rule of Three: Surviving and Thriving in Competitive Markets by Jagdish Sheth and Rajendra Sisodia. It’s a few years old now, but it remains the best explanation I’ve seen of how things typically play out in most markets. The following table is a bit dated, but here’s a snapshot of the “big 3” in many other major industry sectors:

If we can live with 3 or 4 players in markets such as these, we’ll be just fine with just 3 or 4 major backbone providers or wireless operators. And if we expect major wireless players to make the investments necessary to support the robust, nationwide, high-speed networks that we will need to have invented and then reinvented every couple of years, then we must allow them to have the assets and scale necessary to thrive going forward. Lemonade stand economics can work for corner coffee shops and shoe shines, not for sophisticated wireless networks.

Yesterday I engaged in a lively luncheon debate about Net neutrality regulation with Ben Scott of Free Press at a Catholic University Law School event on “Implementing the National Broadband Plan.” To open the debate, I made a very quick 5-Part Case against Net Neutrality Regulation. I argued that the the objections to a Net neutrality regulatory regime can be grouped into 5 major categories: (1) Legal; (2) Economic; (3) Engineering; (4) Practical; and (5) Philosophical / Principled. Down below you will find my working notes to see how I then elaborated on each objection in a bit more detail. And then Ben and I engaged in some spirited banter for the next 45 minutes.

Unfortunately, it doesn’t appear that the video of our debate is online just yet, but once it is I will post it here. However, the folks from NextGenWeb asked me to shoot a short 2 1/2 min video clip after the debate summarizing my remarks. If you can stand the sight of my big fat head in your browser for that long, here ya go:

The 5-Part Case against Net Neutrality Regulation

The objections to a Net neutrality regulatory regime can be grouped into 5 major categories: (1) Legal; (2) Economic; (3) Engineering; (4) Practical; and (5) Philosophical / Principled. Each objection will be briefly summarized below:

(1)   The Legal Case

• The FCC utterly lacks the authority to regulate in this way: The Commission’s current effort, which is tantamount to throwing stuff at wall to see what sticks, is troubling. They should go to Congress for authority.
• Importantly, Sec. 230 & 706 of the Telecom Act cannot be the hook: They were deregulatory in nature & aimed at keeping govt’s hands off the Net.
• Litigation nightmare : Regardless of how the FCC or Congress plows forward, we’re going to get tied up in the courts for years if we continue down the regulatory path. It will become “full employment” for telecom lawyers.

(2)    The Economic Case

• NN will likely create substantial disincentives to invest and innovate: At a time when we’re trying to build out broadband infrastructure the last thing we should be doing is disincentivizing network investment.
• NN could regress into old fashion rate or return / price control regime. In the history of network regulation, price and rate controls have always accompanied service regulations.
• Sharing is not competing: If this is all just greasing the skids for a new line-sharing or forced access regime, well, we’ve been there before and it didn’t end well. Creating networks built on paper is a worthless endeavor.
• Facilities-based competition, not infrastructure sharing is the path forward if we want truly robust & competitive networks and markets.
• Contestability counts: This is a contestable market. Threats of new entry at margins keep incumbents on their toes.

(3)   The Engineering Case

• We shouldn’t be freezing networks in stone: (Can you imagine if we would have frozen 1999 walled garden model in place?) The Net was “designed for change” (Richard Bennett) and it should be allowed to adapt to changing circumstances.
• Flexibility is crucial for fast-moving technologies & networks: In particular, we need to grant network managers the flexibility to deal with congestion, latency, malware & other unforeseen problems.
• Innovation at the core of networks is every bit as important as innovation at the edge: We don’t want stagnation at the core or networks, and the applications that ride on them, will suffer.

(4)   The Practical Case

• The FCC just isn’t very good at regulating fast-moving industries & technologies: And its track record is poor when it comes to incentivizing new things (remember Video Dialtone? Open Video System rules?)
• No such thing as a “simple rule” when it comes to Net neutrality or network regulation in general: Consider the paperwork burden generated by just three major “competition” rules the FCC issued in an attempt to implement the Telecom Act and define the “cost” of unbundled network elements (“UNEs”):

o   Local Competition Order (1996): 737 pages, 3,283 footnotes o   UNE Remand Order (1999): 262 pages, 1,040 footnotes o   UNE Triennial Review (2003): 576 pages; 2,447 footnotes o   That’s 1,575 pages and 6,770 footnotes worth of regulation in just three orders! o   This was all implemented following the passage of a bill (The Telecom Act) that was supposed to be deregulatory in character! And this doesn’t even begin to cover the tens of thousands of pages of legal filings, economic studies, consultant reports and other filings submitted to the FCC and state agencies by groups and individuals looking to have a say in the matter. That’s an enormous deadweight loss.

• The potential for industry capture grows in proportion to size of the regulatory regime: Alfred Kahn, author of the seminal Economics of Regulation said it best long ago: “Responsible for the continued provision and improvement of service, [the regulatory commission] comes increasingly and understandably to identify the interest of the public with that of the existing companies on whom it must rely to deliver goods.”
• Markets need not be perfect to be preferable to government regulation: That’s especially true in light of the inefficiencies associated with bureaucratic regulation.
• Community policing can help: Any deviations from “neutrality” will be policed by the watchful eyes of the digital world (and the press) and the white hot spotlight of public attention will scrutinize every carrier move (and already is). Plus, experts and technical bodies (ex: Net Neutrality squad) will be watching.

(5)   The Philosophical/Principled Case

• Whatever happened to “Hands Off the Net”? Do we believe in markets or not? And are we willing to let the experiment we started with the Telecom Act continue or not?
• NN is a declaration of surrender and a call to return to the era of public utility-style regulation. We should not give up so easily on the idea of facilities-based competition. Even just two major rivals per region is better than one regulated monopoly.
• The slippery slope of regulation is real: Neutrality mandates will gradually spread to other layers of the Net and cover content and applications. (FCC is already hinting at interest in regulating in the cloud and other Net services and content). Google and Apple’s necks will be on the neutrality chopping block next.
• There are some First Amendment concerns in play here, but not those raised by regulatory advocates (Net Neutrality is not the Internet’s First Amendment as the regulatory advocates claim; the First Amendment is the Internet First’s Amendment).

This morning, the Technology Committee of the New York City Council convened a large hearing on a resolution urging Congress to pass a robust Net Neutrality law. I was supposed to testify, but our narrowband transportation system prevented me from getting to New York. Here, however, is the testimony I prepared. It focuses on investment, innovation, and the impact Net Neutrality would have on both.

“Net Neutrality’s Impact on Internet Innovation” – by Bret Swanson – 11.20.09

Last night here on the TLF, Bret Swanson raised a number of objections with this FCC-commissioned report about international broadband comparisons, which was conducted by some folks at Harvard University’s Berkman Center. Meanwhile, over at the Digital Society blog, George Ou also offers a hard-nosed look at the Berkman broadband report and concludes “The underlying data cited by Berkman study is simply too flawed to be of any use.”  I recommend everyone check out both essays.  It will be interesting to hear how the Berkman folks respond.  Some of these international broadband comparisons are really fishy.  [Here’s a podcast we did on that issue two years ago.]

One quick point… Like Bret, I also found it shocking that–even though the report reads like an ode to forced access regulation–the Berkman folks didn’t spend much time discussing the result of America’s previous open-access regime. “The gaping, jaw-dropping irony of the report,” Bret argues, “was its failure even to mention the chief outcome of America’s previous open-access regime: the telecom/tech crash of 2000-02. We tried this before. And it didn’t work!”  Indeed, America’s regulatory experiment with forced access regulation involved a lot of well intentioned laws and regulation, and too many acronyms to count–CLECs, TELRIC, UNE-P, etc– but it did not result in serious, facilities-based competition.  Instead it offered us the fiction of competition through network-sharing, or what Peter Huber once referred to as building “networks out of paper.” The results were disastrous for investment during that period since regulatory uncertainly led to a lot of stunted innovation.

In sum, sharing is not competing.  You can socialize and commoditize old pipes for awhile and get decent results in the short-term, but you’ll sacrifice long-run investment and innovation if you do.  [For more background, see my recent essay on “The Fiction of Forced Access ‘Competition’ Revisited” and this old Cato piece on “UNE-P and the Future of Telecom “Competition” as well as Jeff Eisenach’s PFF white paper, “Broadband Policy: Does the U.S. Have It Right After All?”]

Whatever you think about this messy dispute between AT&T and Google about how to classify web-based telephony apps for regulatory purposes — in this case, Google Voice — the key issue not to lose site of here is that we are inching ever closer to FCC regulation of web-based apps!  Again, this is the point we have stressed here again and again and again and again when opposing Net neutrality mandates: If you open the door to regulation of one layer of the Net, you open up the door to the eventual regulation of all layers of the Net.

You might not buy that story initially but if you doubt it then I invite you to read just about any history of American broadcast media regulation over the course of the past seven decades. (You might want to start with Krattenmaker & Powe’s Regulating Broadcast Programming or Jonathan Emord’s Freedom, Technology, and the First Amendment). In such histories you will find a common theme: Once regulation of media and communications platforms gets underway, the natural progression of things is uni-directional — Up!  That is, when new questions arise about how to “deal with” a new service, network, platform, or technology, the general tendency is the “regulate up” instead of “deregulating down.”  When regulators are given a greater say about the contours of markets as technologies evolve and/or converge, we shouldn’t be surprised that their first instinct is to “bring them into the fold.”

And, sadly, that is exactly what is likely to occur eventually with Google Voice. The only really interesting question is what else regulators start mucking with in the search and applications layer once they get their hands on it.  And if you still insist that I am being overly paranoid about “regulatory creep” and the prospect of the FCC gradually transforming into the Federal Information Commission, then consider what the agency had to say about cloud computing in paragraph 60 (pg. 21) of the FCC’s recent Wireless Innovation and Investment Notice of Inquiry, which was launched on August 27th:

As other approaches, such as cloud computing, evolve, will established standards or de facto standards become more important to the applications development process? For example, can a dominant cloud computing position raise the same competitive issues that are now being discussed in the context of network neutrality? Will it be necessary to modify the existing balance between regulatory and market forces to promote further innovation in the development and deployment of new applications and services?

Wow, who knew that the FCC even had the authority to oversee or regulate the cloud, right?  Well, they don’t. But, again, this is exactly how things have unfolded before: Throw statutory authority to the wind and slowly start extending the agency’s regulatory tentacles into new areas, services, technologies, platforms, and networks.  In this case, you can just imagine how some folks will use that FCC language to accuse Google of being in “a dominant cloud computing position” such that “the context of network neutrality” will be applied to cloud service (like Google Voice!) to “modify the existing balance between regulatory and market forces.”  Indeed, that’s pretty much what AT&T is suggesting in their letter to the FCC this week.

In a post yesterday over at the Google Public Policy Blog, my old friend Rick Whitt of Google insists that Google Voice is different than a traditional common carrier telecom service and that it doesn’t belong in the same regulatory bucket as those older voice services.  To Rick and my other friends at Google, I have only one thing to say about that argument: Good luck with that!  My prediction: Within two to three years you’ll be under the FCC’s thumb.

Again, I very much hope I am proven wrong. But I know that I won’t be wrong because neither side is going to back down in the escalating net neutrality war of mutually assured destruction.  “Regulating up” will carry the day and become, once again, our new telecom M.A.D. policy.

Despite my frequent disagreements with his policy conclusions, Farhad Manjooo of Slate is one of the most gifted tech policy pundits around today and everything he writes is worth reading (and I whole-heartedly agreed with his recent article on the high-tech and antitrust).  Alas, I find myself again disagreeing with him again today.

In his latest column, “The Great iPhone Lockdown: Should the FCC force Apple to sell Google’s apps?” Manjoo responds to a recent essay by TLF contributor Ryan Radia (“Newsflash to FCC: The iPhone is a Closed Platform, and Consumers Love It“). In that essay, Ryan generally argued that: (a) a lot of people own and love the iPhone despite some silly restrictions on certain apps; and (b) if they don’t like that, there are plenty of other options from which they can choose. Consequently, regulation seems unwarranted and likely highly misguided in light of the potential unitended consequences in might yield.  It’s an argument I very much agree with, of course.  Anyway, Manjoo responds:

Radia’s argument isn’t crazy. Just the other day, I argued that the government shouldn’t go after Google for antitrust violations because the tech industry is fluid; companies that are on top today can fall tomorrow. So what if Apple rejects apps capriciously? If its actions are so terrible, consumers will eventually abandon it.

But then Manjoo counters that argument and goes completely off-the-rails with several assertions that I find quite perplexing:

Yet [Radia’s] analysis misses a key point: The iPhone runs on public networks and therefore falls under government jurisdiction. At the very least, the regulators have a duty to ensure fair competition on wireless networks—and by arbitrarily blocking rivals from its device, the iPhone’s software platform simply isn’t fair. We would never accept its rules in other contexts: Imagine if Apple were building cars instead of phones and one day decided that everyone who’d bought an iCar would be banned from listening to any music not purchased from iTunes. Or say that Apple banned all Mac users from downloading Firefox because the browser duplicated the functionality of Safari. Such restrictions sound ridiculous; they wouldn’t pass the barest scrutiny of regulators or consumers. So why should we allow Apple to do the same thing with the iPhone?

Well, let’s begin with a few things he gets wrong here.  First, ” The iPhone runs on public networks and therefore falls under government jurisdiction.”  Uh, no. Last time I checked, AT&T was not running a “public network” owned by the government.  It’s true that AT&T is subjected to some FCC and state rules governing the provision of service, but it isn’t a “public network” like our highway system or inter-coastal waterways.  Thus, AT&T has the right to set terms of service (along with partners like Apple) to achieve both profitability and continue to invest in innovative new networks and services.

Manjoo then asserts that: ” At the very least, the regulators have a duty to ensure fair competition on wireless networks—and by arbitrarily blocking rivals from its device, the iPhone’s software platform simply isn’t fair.” It’s true that there are consumer protection laws on the books, but it’s unclear to me how the FCC has any jurisdictional authority to be regulating Apple or the iPhone.  There simply is none as I noted here in my essay, “Where is FCC Authority to Regulate in Apple-Google Spat?”

Manjoo’s next argument that “We would never accept its rules in other contexts,” uses some very rather strange examples. He asks us to consider what we (or the government, I suppose) might do “if Apple were building cars instead of phones and one day decided that everyone who’d bought an iCar would be banned from listening to any music not purchased from iTunes. Or say that Apple banned all Mac users from downloading Firefox because the browser duplicated the functionality of Safari.”

Well, I think it’s quite clear what we would do: WE WOULD STOP USING APPLE PRODUCTS!  Or at least we could if we didn’t like the terms of the deals they offered.  So, even if it is true that many of us would find such restrictions “ridiculous,” as Manjoo suggests, it certainly does not follow that ” they wouldn’t pass the barest scrutiny of regulators...”  Rubbish. I’m not even sure which agency it is that Manjoo think would be in the business of regulating “iCars” or, for that matter, Firefox and Safari web browsers. (A “Federal Computer Commission?”)

Regardless, it’s a bad idea.  These are activities that are better settled by consumer responses and market backlashes. If you want more innovation and competition in response to bone-headed moves by Apple (or anyone else for that matter), the solution is most definitely NOT the sort of common carriage regulatory regime that Manjoo seems to be suggesting.  That will just lock us into plain vanilla technologies, networks, and services.  Real tech innovation happens when people and competitors get pissed and get off their duffs to do something about it, not when government attempts to micro-manage results by tinkering with yesterday’s platforms.

Again, I want to make it very clear that I am not saying there is no such thing as “market failure” or “code failure.” To the contrary, as I argued in my recent exchange with Lawrence Lessig, I see mini-market failures happening all the time in the technology world.  But:

here’s the amazing thing: I usually wake up the next day, fire up my RSS reader again, and find a world almost literally transformed overnight. I see the power of public pressure, press scrutiny, social norms, and innovation by competitors combining to correct the “bad code” or “code failures” of the previous day. OK, so sometimes it takes longer that a day, a week, or a month. And occasionally legal sanctions must enter the picture if the companies or coders did something particularly egregious. But, more often than not, markets evolve and bad code eventually gives way to better code; short-term “market failures” give rise to a world of innovative alternatives.

Thus, I went on to argue that:

“code failures” are ultimately better addressed by voluntary, spontaneous, bottom-up, marketplace responses than by coerced, top-down, governmental solutions. Moreover, the decisive advantage of the market-driven approach to correcting code failure comes down to the rapidity and nimbleness of those response(s). Of course, this assumes we can agree on a definition of “bad code” and “code failures.” What concerns me about the way Prof. Lessig approaches these issues in Code and in his subsequent work is that he is far too quick to declare the debate over by labeling short-term code hiccups as sky-is-falling market failures. The end result of such myopic techno-pessimism is the inevitable call for governments to intervene and “do something” to correct supposed code failures. The cyber-libertarian instead counsels patience. Let’s give those other forces — alternative platforms, new innovators, social norms, public pressure, etc. — a chance to work some magic. Evolution happens, if you let it.

But, again, such evolution and innovation will most decidedly not happen if you people are always running around crying “market failure!” and calling in the code cops at every juncture, as Manjoo seems to be doing in the Apple-Google spat.  The problem with that think, as I noted in my debate with Lessig, is that it:

creates perverse marketplace incentives by discouraging efforts to innovate or “route around” bad code or code failure. We don’t want the whole world sitting around waiting for government to regulate the mousetrap to improve it or even give everyone better access to it; we should want the world to be innovating to create better mousetraps!

No one is going to build a better mousetrap to compete with Apple if regulators make it too easy for Apple to become the one preferred platform for all mobile apps developers. If Google is pissed about Apple screwing them over on their Google Voice app, that is a great thing: It will give them all the better reason to plow even more resources into Android and other platforms to compete against Apple!  And that’s exactly the sort of serious competition and innovation we should all be rooting for.

How is it that smart people like Manjoo fail to grasp this crucial point?

Our readers may be interested in this excellent WSJ article, Too Risky for Venture Capitalists: Why proposals for a government bailout were roundly rejected.  We should all take heart in the the fact that the venture capital community itself resoundingly opposed the notion of accepting a massive infusion of taxpayer money, especially Tom Friedman’s suggestion:

“You want to spend $20 billion of taxpayer money creating jobs?” Mr. Friedman wrote. “Fine. Call up the top 20 venture capital firms in America” and invest the money with them.

But I see three more reasons why those interested in technology policy should pay attention to this encouraging episode.

First, the groundswell of opposition seems to have been driven largely by the Internet, both as a vehicle for disseminating the bailout proposals and for voicing opposition to them:

Venture capitalists certainly agree that innovators and start-up companies, not bailed-out GMs or Chryslers, will create the new jobs. They rightly brag that almost 20% of U.S. gross domestic product is generated by companies built by venture capital, such as Intel, Apple and Google. Still, they almost universally panned the notion of taxpayer support. Their real-time rejection is an excellent example of how social media — here, the venture community dissecting a proposal online — can now quickly take down bad ideas.

Second, it should almost go without saying that venture capital is the fountainhead of innovation, especially the disruptive innovation that is constantly pushing the envelope of technology policy.  A healthy VC sector is the bedrock of a dynamic, free and innovative economy.  The VCs realize that this requires, more than anything else, avoiding the market distortions caused by government funding:

“The top venture firms don’t want, don’t need and are never going to take government money. The same is true of the top entrepreneurs,” Fred Wilson of New York’s Union Square Ventures wrote on his blog. “The worst firms, on the other hand, will gladly accept government money,” which would go to investors who can’t raise funds privately and to entrepreneurs whose ideas shouldn’t be funded. “It’s a problem of adverse selection….” The idea of direct government funding is also anathema because it would undermine market discipline. Pension funds, endowments and other institutional investors keep a close eye on how their invested money is doing. Venture firms can raise new funds only if their previous performance was good. Several venture capitalists pointed out the irony that government-funded venture capital could mean trading a credit bubble for another technology bubble. Artificially inflating the venture coffers through a government fund could risk repeating the debacle of 1999-2000, when too much money chased too few good ideas, resulting in the sharp deflation of the Internet bubble. 

Third, the VC community’s response should serve as a lesson for other industries, but particularly high-tech industries, about how the government subsidies they find attractive today in a time of intense pressure on their bottom lines could ultimately harm them.  Instead of jumping on bailout bandwagon, perhaps these industries ought to focus their lobbying efforts on some of the eminently sensible suggestions coming from the VC community, such as the following:

If policy makers want to help entrepreneurs and their investors, there’s no mystery about what’s needed. Immigration needs to be reopened. Venture capital is still available, but the U.S. is now a laggard in the other half of the equation, which is making sure the entrepreneur’s sweat, energy and risk-taking can ultimately pay off. Sarbanes-Oxley helped kill the market for public offerings, which had been a lucrative step for successful start-ups. Income taxes are going up, not down. And the U.S. capital gains tax rate of 15% contrasts with the 0% rate in Hong Kong, Singapore and even Germany, where there’s an understanding that these investments are made with income that’s already been taxed once.

I’ve warned about the dangers of subsidies to the high-tech industry, but I do recognize that the unintended consequences of  subsidizing technological innovation may far outstrip those of subsidizing technological infrastructure, which is what the Obama administration seems to be focused on.  Indeed, if one is going to spend taxpayer money on any subsidies in the name of “stimulus,” it’s difficult to think of a better way to spend that money than on promoting broadband deployment and adoption (however much of a myth it is that we are lagging behind the rest of the world in these areas).  

Still, no matter how worthy the objective, all subsidies distort markets. Few do as much damage as those showered on industries particularly based on risk—e.g., venture capital and financial markets.  But whatever these distortions, the Golden Rule still applies: he who has the gold, makes the rules!  With government subsidies, come government controls.

MIT’s Technology Review has a great review of a new biography of Georges Doriot (Wikipedia) by Businessweek Editor Spencer E. Ante entitled, Creative Capital: Georges Doriot and the Birth of Venture Capital.  Born in France, Doriot fought in World War I, then studied at Harvard Business School, served as director of the U.S. military’s Military Planning Division during World War II as a brigadier general, and in 1946 launched American Research and Development Corporation (ARD) as the first publicly owned venture capital firm.

Doriot’s legacy looms large today, even if his name is new to most:

Contemporaneously with ARD’s watershed investment in [Digital Equipment Corporation], others began walking the trails Doriot had blazed: Arthur Rock (a student of Doriot’s in the Harvard class of 1951) backed the departure of the “Traitorous Eight” from Shockley Semiconductor to form ­Fairchild Semiconductor in 1957, then funded ­Robert Noyce and ­Gordon Moore when they left ­Fairchild to found Intel; ­Laurance ­Rockefeller formed ­Venrock, which has since backed more than 400 companies, including Intel and Apple; Don ­Valentine formed Sequoia Capital, which would invest in Atari, Apple, Oracle, Cisco, Google, and YouTube.

Doriot himself would likely have felt at home among today’s embattled and outnumbered regulation-skeptics in the technology policy community:

he opposed both the dirigiste political economy of his native France and the tax hikes and anticompetitive laws enacted in the United States under the New Deal. Such regulations, he maintained, arrogated to bureaucrats the function of the markets; their worst feature was that they let government lend money to failing businesses. Ante notes that a former colleague of Doriot’s, James F. Morgan, recalled him as “the most schizophrenic Frenchman I’ve ever met”–devoted to his original land’s wine, cuisine, and language even as “the French capacity to make very simple things complicated drove him nuts.”

Even more intriguing is what Doriot’s experience has to say about the vital role that corporations and securities laws plays in facilitating–or hindering–innovation by constraining the structures of the investment vehicles that fund the commercialization of new technologies:

Doriot endured bureaucratic regulators who did not understand or care how a venture capital firm differed from other investment companies. ARD suffered because, since it was incorporated as a publicly traded investment company, its employees could not generally receive stock options in its portfolio companies, despite Doriot’s ceaseless pleas to the U.S. Securities and Exchange Commission. The reality that Doriot’s company faced from 1959 onward was that a new organizational form–the limited partnership, born in Texas’s oil-wildcatting industry–was being adopted by newer VC firms. Ante quotes a former ARD executive who recalled that after he supervised the IPO of one portfolio company, the net worth of that company’s CEO “went from 0 to $10 million and I got a $2,000 raise.” A VC limited partnership, by contrast, gave its general partners not just management fees but also portions of its capital gains; additionally, it permitted profits to be passed on to its investors without incurring corporate taxes, and it mandated that limited partners stand clear of management. Small wonder that when Perkins helped found Kleiner Perkins Caufield and Byers in 1972, it was as a limited partnership. When Doriot finally accepted the SEC’s intransigence, he deemed ARD “not competitive anymore” and sought the merger with Textron. Similar disagreements continue between government and industry. After the dot-com and telecom crashes, Washington passed the Sarbanes-Oxley Act and new accounting rules for expensing stock options, despite the predictions of many tech­nology executives and VCs that regulation would undermine innovation. John Doerr at Kleiner ­Perkins, for one, believes that that happened: ­”Sarbanes-Oxley did have some chilling effects on technology startups in terms of the cost of being able to go public.”

R.I.P., Monsieur Dorian.  I look forward to reading Ante’s biography.

Note that an audio version of the Technology Review article is available in audio form (Flash, MP3) as part of TR’s podcast of all their stories.  Once you get used to the Audiodizer computer voices that read the story–whose unintentionally hilarious mispronunciations and mis-emphases I have grown to love–the podcast becomes a valuable source of high-quality tech news and commentary.