In this new Money Morning article, “The Antitrust Curse: What Apple Can Learn From Microsoft, IBM,”  David Zeiler wonders whether the antitrust lawsuit filed against Apple and several book publishers by the U.S. Department of Justice last week could open the door to a broader case against Apple or, at a minimum, simply become a major distraction to the firm and it’s ability to innovate going forward. He uses IBM and Microsoft as case studies in this regard and notes that, “the problem with being in the DOJ’s gunsight is that it distracts management, makes the company hesitant to innovate, and blemishes the company’s public image.  While antitrust woes may not have been entirely responsible for Microsoft and IBM ceding their dominant positions in tech, they were clearly a major factor,” he says. “And worse for Apple, the e-book case could be just the beginning.”

Quite right. I raised the same concern in my recent Forbes column,”Regulatory, Antitrust and Disruptive Risks Threaten Apple’s Empire,” which Zeiler was kind enough to quote in his essay. In that piece, I argued:

Even if Apple beats back [the eBooks] investigation, broader questions are being raised about the company’s power that could invite a much broader investigation. The danger for Apple is that antitrust becomes an omnipresent threat that must be factored into all ongoing business decisions. Antitrust is a particular danger to Apple because the firm is highly vertically integrated and that integration is the source of many of their innovations.  As earlier tech titans like IBM and Microsoft learned, when antitrust hangs like the Sword of Damocles, every decision about how to evolve and innovate becomes a calculated gamble.

Regarding the earlier impact that antitrust Sword of Damocles had on Microsoft, Zeiler unearthed this terrific 2005 quote from Mark Kroese, a general manager of information services at the Microsoft Network, who described the impact of the MS antitrust case on innovation at the firm as follows: “Working at Microsoft today vs. five years ago is different,” Kroese said. “If anyone thinks the antitrust case hasn’t slowed us down, you’re wrong. If I want to meet with a products manager for Windows, there needs to be three lawyers in the room. We have to be so careful, we err on the side of caution. We are on such a fine line of conduct.” Regarding how antitrust chilled IBM, Zeiler cites veteran tech journalist Steve Wildstrom of Tech.pinions who noted,  “Twelve years of litigation were an enormous distraction in a time of rapid technological and business change. IBM management became cautious and over-lawyered, constantly looking over its shoulder-a condition that persisted for years after the case ended. The antitrust case was almost certainly a major cause of the serious decline of IBM in the late 1980s and early 90s,” Wildstrom said.

Of course, it is impossible to scientifically determine to what degree antitrust harassment contributed to either IBM or Microsoft’s inability to innovate and adapt to the rapidly changing market conditions. And let’s be clear: both IBM and MS have found ways to rebound and innovate in other ways. But one wonders what was lost in the process as the threat of antitrust constantly loomed and potentially chilled innovative efforts that could have kept both firms on the cutting-edge.

It’s not just Apple that faces similar threats today. Google is obviously another company increasingly mentioned as an antitrust target. Commenting of the dangers of a potential case against Google, Bernstein Research senior analyst Carlos Kirjner argues that “even if regulatory proceedings come to naught, the process has the potential, in the most extreme circumstances, to consume so much of the company’s energy that it can lead to important strategic missteps: many believe that Microsoft missed the boat on the Internet, and IBM on the importance of the personal computer, in large part because their management teams were focused on defending against the DoJ’s antitrust efforts.”

The better approach to disciplining tech firms and markets is to rely less on intervention and more on Schumpeter’s “perennial gales of creative destruction,” which are blowing harder than ever in our modern high-tech economy. In markets built largely upon binary code and governed by Moore’s Law, the pace and nature of change has become hyper-Schumpeterian: unrelenting and utterly unpredictable. Innovative risk-takers are constantly shaking things up and displacing yesterday’s lumbering, lethargic giants. Just ask some of the players that have been largely left in the dust, including AOL, AltaVista, MySpace, Palm, and others. Of course, there’s my favorite recent case study: Research In Motion’s BlackBerry smartphone.  As I noted in my recent column, “Bye Bye BlackBerry. How Long Will Apple Last?” BlackBerry was virtually synonymous with “smartphones” and was considered one of the tech titans that seemed destined to dominate for many years to come. But now the BlackBerry’s days appear numbered and its parent company Research In Motion Ltd. is struggling for its very survival.

Too many tech industry pundits today ignore these dynamic realities and instead rely a myopic analytical approach to the information economy that is fundamentally static in character. Many static equilibrium scholars in both the legal and economic profession tend to adopt a snapshot view of markets and innovation. Such critics often express an overly nostalgic view of the technological past while adopting an excessively gloomy view of the present and the chances for future progress.

But, a la Schumpeter, modern tech markets are highly dynamic. There is no static end-state, “perfect competition,” or “market equilibrium” in today’s information technology marketplace. Change and innovation are chaotic, non-linear, and paradigm-shattering. Schumpeter said it best long ago when he noted how, “in capitalist reality as distinguished from its textbook picture, it is not [perfect] competition which counts but the competition from the new commodity, the new technology, the new source of supply, the new type of organization… competition which commands a decisive cost or quality advantage and which strikes not at the margins of the profits and the outputs of the existing firms but at their foundations and their very lives. This kind of competition is as much more effective than the other,” he argued, because the “ever-present threat” of dynamic, disruptive change “disciplines before it attacks.”

By contrast, the static equilibrium mindset is myopically fixated on short-term market share and price competition while ignoring “competition for innovation,” which is what matters most in the more dynamic Schumpeterian model. “Schumpeterian competition is primarily about active, risk-taking decision makers who seek to change their parameters,” note economists Jerry Ellig and Daniel Lin. “It is about continually destroying the old economic structure from within and replacing it with a new one.” Thus, while static or “perfect competition” models assume away innovation and are preoccupied with equilibrium, dynamic models revolve around disequilibrium and assume that the only constant is change. What is most important to economic progress, therefore, is the ongoing process of constant experimentation and spontaneous discovery that allows new business models and organizational structures to emerge in response to market signals.

The other danger of the static equilibrium mindset is that the same new innovators and innovations that obtain success and scale quite rapidly as a result of this process are sometimes thought to possess problematic market power. Accusations of “monopoly” quickly follow. As Nobel Laureate Ronald Coase noted, “if an economist finds something—a business practice of one sort or another—that he does not understand, he looks for a monopoly explanation. And as in this field we are very ignorant, the number of understandable practices tends to be very large, and the reliance on a monopoly explanation, frequent,” he argued.  Of course, non-economists are just as likely—perhaps more likely—to make that same error. This is why a short-term fixation on market share and market power is so problematic.

Moreover, as Schumpeter also taught us, it is essential that uneven entrepreneurial gains be tolerated so that innovation can occur and be continuously incentivized. Economies need innovators to take risks because progress is born from it. Penalizing the risk-takers by trying to “level the playing field” through rash regulation or antitrust interventions will simply sap the entrepreneurial spirit from the marketplace, limit technological innovation, and diminish the possibility of progress and prosperity over the long-haul.

If you’d like a better understanding of this dynamic conception of competition and an explanation of why the static equilibrium mindset — especially in the antitrust field — is so horribly misguided, then I strongly recommend you begin your investigation with the following readings:

The FCC’s universal service tax is officially out of control. The agency announced yesterday that the “universal service contribution factor” for the 1st quarter of 2012 will go up to 17.9%.  This “contribution factor” is a tax imposed on telecom companies that is adjusted on a quarterly basis to accommodate universal service programs. The FCC doesn’t like people calling it a tax, but that’s exactly what it is. And it just keeps growing and growing. In fact, as the chart below reveals, it has been exploding in recent years. It was in single digits just a few years ago but is now heading toward 20%. And not only is this tax growing more burdensome, but it is completely unsustainable. As the taxable base (traditional interstate telephony) is eroded by new means of communicating, the tax rate will have to grow exponentially or the base will have to be broadened to cover new technologies and services. We should have junked the current carrier-delivered universal service subsidy system years ago and gone with a straight-forward voucher system. A means-tested voucher could have targeted assistance to those who needed it without creating an inefficient, unsustainable hidden tax like we have now. For all the ugly details, I recommend reading all of Jerry Ellig’s research on the issue.

One of the reasons that so many of us here take issue with proposals to expand regulation of communications, broadband, and media markets is because we have studied the horrendous inefficiencies of economic regulation in practice. We oppose regulatory proposals not because of a “blind faith” in free markets, but because we understand that even when markets stumble they correct themselves quicker and more efficiently than regulatory systems do. One can profess the supposed theoretical benefits of enlightened “public interest” regulation all they want, but the facts are the facts. And the facts do not support the proposition that government regulation generally enhances consumer welfare.

In that regard, Tim Lee’s new Net neutrality report for Cato does a nice job of surveying some of the past unintended consequences of regulation. Also, even though it is now 10 years old, I highly recommend “Economic Deregulation and Customer Choice” by Jerry Ellig and Robert Crandall. It’s an outstanding overview of why economic regulation of various industries failed consumers so miserably in the past.

But if you want even more shocking proof of how horrendously inefficient communications regulation can be in practice, then you must read my PFF colleague Barbara Esbin’s two essays this week on the Universal Service Fund (USF): “The High Cost of USF Support,” and “More FCC Support Fund Follies.” In these two essays, Esbin walks the reader through various grim reports and statistics that have been released recently documenting the failures of the USF.

Her first essay notes how a recent FCC Inspector General report found that the USF “High Cost” fund is spiraling out of control. According to a FCC press release, that report found that “a program is at risk if the erroneous payment rate exceeds 2.5% and the amount of erroneous payments is greater than $10 million. The estimated erroneous payment rate for the High Cost Program (“HCP”) was 23.3%. The previous estimate was 16.6%. Total estimated erroneous payments were $ 971.2 million as compared with the previous estimate of erroneous payments of $617.8 million. Accordingly, the FCC-OIG concluded that the High Cost Fund program is “at risk” under applicable [..] criteria.”

Esbin puts these shocking results in perspective:

“At risk” is a surely a euphemism for a program that loses in “erroneous payments” nearly one out of every four dollars collected from telephone subscribers. In 2007, pursuant to FCC rules, telephone consumers were effectively taxed over $4 billion for the high-cost portion of the USF. Thus, nearly $1 billion dollars of subscriber money went out the door in “erroneous payments.” As the report makes clear, erroneous payments include both over- and underpayments, and also instances where the agency is unable to discern whether a payment was proper as a result of “lack of documentation.” The report’s conclusions state that the “rate of improper overpayments is 22.8%, and the proportion of improper overpayments out of total improper payments is 98.2%.” To be considered “erroneous,” an payment “need not be the result of fraudulent misrepresentation, or a corrupt administrative process.” “Nor does it necessarily exclude those factors as potential causes of erroneous payments.” Significantly, nor are “the erroneous payments . . . necessarily recoverable from recipients by process of law.” Fabulous. Not only has nearly $1 billion in erroneous overpayments gone missing, but even if final audits indicate where it has gone, it may not be recoverable! Among the interesting results of this preliminary report are the identified causes of erroneous payments. According to Table 2 of the report, 50% of the causes of erroneous payments can be attributed nearly equally to two factors: either “Inadequate Documentation” (25.3%) or “Inadequate Auditee Processes and/or Policies and Procedures” (24.6%). Another 10% “Disregarded FCC Rules” and 12% had “Applicant/Auditee Weak Internal Controls.” That is, roughly 75% of the erroneous overpayments can be attributed to poor bookkeeping, inadequate internal controls and “disregard” of FCC rules. This is stunning information. No wonder it made its appearance the day before Thanksgiving.

But wait, things get worse. So much worse. In Esbin’s second essay, she notes that:

On Monday, the OIG released its Semi-Annual Report to Congress, discussing the full range of audit activities conducted from April 1, 2008 to September 30, 2008. Thus we learn that in addition to the loss of nearly $1 billion in erroneous overpayments to the High Cost program, another fund the FCC is ultimately responsible for, the “Telecommunications Relay Service” (TRS) Fund, which provides funds for a variety of telephone transmission services for those with hearing and speech disabilities, also appears to be at risk for substantial overpayments due to the lack of adequate controls. Since 1993, according to the FCC’s website, the Commission’s rules have required that each common carrier providing voice transmission services provide TRS throughout its service area. All providers of interstate telecommunications services contribute to the TRS Fund, and TRS providers recover the costs of providing interstate services from the Fund on a minutes-of-use basis. Intrastate TRS funding is generally administered by the states, although some intrastate TRS offerings are supported by the interstate TRS Fund. The current TRS Fund Administrator is the National Exchange Carrier Association (NECA). Although NECA directly manages the Fund, the FCC sets the Fund size and carrier contribution factor annually and is ultimately responsible for Fund oversight. When the TRS Fund started, it disbursed about $31 million, growing to over $38 million by 1999. Since 1999, the OIG report states that the TRS Fund has increased approximately 50-80% each year, to reach $637 million for the Fund’s fiscal year from July, 2007 to June, 2008. The size of the fund for the current fiscal year is $850 million, a 26% increase over the previous fiscal year. That is, in roughly ten years the TRS Fund has ballooned from $38 million to $850 million! What, if any, other communications service has seen 50-80% growth in costs per year?

Indeed, that is a shocking degree of waste and inefficiency by just about any standard. And Esbin goes on to document specific examples of this waste and inefficiency in action within the TRS Fund. It’s shocking stuff and doesn’t make for pleasant reading if you care about good government.

Barbara is actually much more tempered and tolerant than me when it comes to what to do about all this. She recommends a lot more reform and oversight. If you ask me, however, then entire USF program should be dismantled immediately and any future support deemed necessary should be distributed directly to consumers at the state level in the form of a welfare payment. After all, at root, that’s what universal service is: a communications industry welfare program, but one in which most of the support flows to companies instead of individuals. And that makes it one of the most insanely misguided and inefficient regulatory / subsidization systems known to man. 13 years ago, in one of the very first things that PFF ever published ( The Telecom Revolution: An American Opportunity) I was advocating exactly this sort of a plan along with a dozen other think tank colleagues. (And we also set forth another, less radical reform plan than the “voucher-ize & devolve” plan I favored).

But no one listened. Business as usual continued. And so the endless waste and inefficiencies continue. Somebody will have to remind me how any of this benefits consumer welfare. I can’t see how anyone could make such a case, and I would hope the USF follies serve as a cautionary tale for how the best of intentions are meaningless when it comes to what regulation actually means in practice. Because it sure ain’t pretty.

But hey, it’ll all be different going forward right? We just need to have faith in the media reformistas and the Net neutralitistas.  If we click our heels together enough time and just wish hard enough, all our dreams can come true.

Sure.