Will the Virtuous Circle be Unbroken?

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Regardless of whether the Federal Communications Commission ultimately reclassifies broadband termination as a Title II telecommunications service or not, the agency will likely justify its efforts to regulate broadband service based on its mandate in Section 706 to “encourage the deployment on a reasonable and timely basis of advanced telecommunications capability to all Americans” using “measures that promote competition [and] remove barriers to infrastructure investment.”  Indeed, at the center of the agency’s net neutrality argument is the theory of a “virtuous circle,” whereby innovation and investment at the edge of the network increases the demand for advanced telecommunications capability” and thus, in turn, drives investment back into the network. This “virtuous circle” or “virtuous cycle” theory is entirely unspecified, lacking any formal theoretical basis.  Not to say there may be some theoretical model to support it, but for now it’s pure fluff.  Nevertheless, given the D.C. Circuit’s embrace of the Commission’s “virtuous circle” idea in Verizon v. FCC, we are pretty much stuck with this vague network investment theory as settled gospel.

Let’s go with it for the moment.

These days, it appears things aren’t so virtuous in the virtuous circle.  Following President Obama’s strange endorsement this week of utility-style regulation for broadband services, AT&T announced that it was suspending its investment in fiber optic deployment.  As AT&T’s CEO Randall Stephenson bluntly stated, “We can’t go out and invest that kind of money deploying fiber to 100 cities not knowing under what rules those investments will be governed.”

So much for Title II increasing investment in advanced communications services.

While Mr. Stephenson’s response to the President’s announcement was an important reality check for those wanting to radically expand Internet regulation, it wasn’t half as interesting, at least to me, as AT&T’s earlier announcements that it was cutting its capital expenditures by 14% in 2015, a sizeable slash in spending.  It’s still spending billions, mind you, but the company indicated it plans to focus its capital on “transformative investments” in “international and video” markets.  It is, for example, spending $2.5 billion to acquire assets in Mexico.  That’s right: Mexico. That’s called capital flight people, and it’s almost inevitable now given the Obama Administration’s unprecedented expansion of regulation in the communications sector.  Somehow I don’t think the purpose of Section 706 is to increase investment in Mexico or other international markets.

It doesn’t stop at AT&T.  Cable stocks took a wallop after the President’s announcement.  Cable broadband connections have never been regulated under Title II, so the change to utility-style regulation would represent a radical change in regulatory status for the industry.  An event study on cable prices shows substantial declines across the cable industry.  In the two days after the President’s announcement, the stock prices of Comcast and Cablevision were down about 5%, and Time Warner Cable and Charter Cable were down nearly 7%. DirecTV and Dish stocks didn’t budge, confirming these abnormal negative returns were not video-industry related.  Stock prices for Google and Netflix, the purported beneficiaries of net neutrality, exhibited typical price movements. Thus, it’s all bad news.


I suspect there will be those who will argue that the goal of regulatory policy is not high stock prices.  That’s true.  But the alleged goal of net neutrality regulation via the “virtuous cycle” is increased network investment, and stock prices influence investment incentives.  The most popular model of investment studies in the q-theory of investment.  The “q” is a financial statistic computed as the ratio of market value to replacement value. The higher is q, the greater is investment.  The q-theory is relevant here because market capitalization—that is, the value of common stock—is a significant element of the numerator of the q-ratio.  Changes in stock returns imply changes in the q-ratio, and by the q-theory of investment, changes in the rate of investment.  As stock prices fall, the q-ratio falls (other things constant).  From the stock market evidence last week, we can presume that investment incentives in the cable industry were reduced by the increased probability of Title II regulation resulting from the President’s support of the scheme.  As observed by Comcast’s EVP David Cohen, “This would be a radical reversal that would harm investment and innovation, as today’s immediate stock market reaction demonstrates.”

Still skeptical?  Equipment vendors are also worried. Cisco’s CEO John Chambers recently stated that its slowdown in sales was directly related to net neutrality.  And Simona Jankowski at Goldman Sachs just observed, “We believe bringing broadband services under Title II could dampen service providers’ capex, as they would have less incentive to invest in their networks.”

Funny thing is, we know all this already.  In 2010, FCC Chairman Julius Genachowski proposed Title II regulation for net neutrality.  I co-authored a paper at the time entitled The Broadband Credibility Gap which found comparable negative stock returns for cable companies upon that announcement.  So if history teaches us anything, investors don’t like Title II regulation for the Internet.  (They also don’t like it for the mobile broadband industry, but that’s another blog.) It’s a pity that the Commission seems exclusively focused on the politics and unconcerned about the facts.

While the FCC’s “virtuous circle” theory may give you the warm and fuzzies, the fact of the matter is that net neutrality regulation is not a policy, it’s an idea.  Investment incentives are not based on regulatory ideas, not matter how sweet. Rather, investment incentives flow from the specific form the regulations take.  There are many legal (and illegal) approaches to implementing net neutrality.  The trick is to find the one that does the job as best as possible but does so with least damage.  Reclassification is not in that class of options.  It’s not even clear reclassification helps at all.  The evidence suggests—indeed, all the evidence suggests—that applying Title II regulation to broadband will reduce investment in broadband networks.

And according to the nation’s most prolific capex spender (that is, AT&T), it already has.