SMART Letter #64
Avoiding Permacession
December 16, 2001

!@#$%^&*()!@#$%^&*()!@#$%^&*()!@#$%^&*()!@#$%^&*()!@#$%^&*() ------------------------------------------------------------ SMART Letter #64 -- December 16, 2001 Copyright 2001 by David S. Isenberg -- "where economic growth goes in a recession" -- -- 1-888-isen-com ------------------------------------------------------------ !@#$%^&*()!@#$%^&*()!@#$%^&*()!@#$%^&*()!@#$%^&*()!@#$%^&*() CONTENTS > How Networking Advances Screwed Up the Economy by Roxane Googin > Two Scenarios for the Future of Telecommunications by David S. Isenberg > Copyright Notice, Administrivia ------- How Networking Advances Screwed Up the Economy by Roxane Googin [For the last two years Roxane Googin and I have participated in a small early-September telecom conference. In 2000 I wish I had listened to her with my wallet (in addition to my ears). In 2001, her warnings extended to the larger economy. I convinced publicity-shy Googin that her message needed to reach beyond her community of portfolio managers, that it needed to reach policy makers, corporate strategists and other decision makers if we're to avoid a Japan-style permacession and get the communications revolution -- and economic growth -- back on track. Below is what Googin said early last September -- David I] "I run a strategy advisory service for portfolio managers. I listen carefully when people talk about the Internet because it is the leading edge of the new telecommunications paradigm, and telecom is one of the world's largest businesses along with oil and automobiles. The telecom business has been rendered economically dead because of a real important piece of progress that has come out that acted differently than anyone planned. "I spoke earlier about how the best network is one that is totally generic so that you can't tell one bit from the next. That is the beauty of how the Internet works. You can project on to it what you need to do. Also the network is infinitely extensible, [because] we have ongoing continuous improvement in the underlying technology. Two examples are Moore's Law and DWDM. "I walked out of this conference last year [in September 2000] and told all of my clients to sell every stock that they owned as fast as they could. And raise cash. The reason for that is . . . a system that behaves like that is an economic horror show. It is going to repel capital because any system that is totally generic has no barrier to competitive entry. You can't differentiate yourself. One that is infinitively extensible means that you are going to be stuck in a Malthusian swamp, where your cost of selling will be one inch above the marginal cost of production. "The goodness of the new network on one hand is a nightmare economically on the other. It is a paradox. And just like oil, society is going to benefit the most if bandwidth is the cheapest. But if bandwidth is so cheap, no one is going to be there to build the bandwidth. So what I saw happening is that the cat had been let out of the bag, the genie was out of the bottle, and people were building these networks and we were headed for this huge train wreck whereby capital would start pulling away from this industry once they realized that this was going to happen. "So the attackers with the new technology were going to starve to death because they have to build this huge network. As prices come down, the network has to be bigger before you are profitable so the new technology they were building would be working against them. "On the other side, the incumbents are slowly going bankrupt, some quicker than others. I'm talking not only the BTs and the DTs and the FTs and the NTTs and the ATTs and the Worldcoms and the Global Crossings but the Incumbent Local Exchange Companies (ILECs) too because their SONET-based networks have a very high cost of provisioning. "But even though the attackers are starving, they are forcing marginal bandwidth prices below the ILEC's cost of provisioning -- not only replacement but also provisioning. So the ILECs are going to get squeezed because they have this complex labor intensive infrastructure that is no longer supported by the economic base. "In this kind of nightmare scenario, nobody wins. It is just a big mess because the attackers are going under. Meanwhile, they have crippled the incumbents. We are witnessing the perfectly predictable outcome of this process: no equipment sales, and no more progress. No one planned this, but it is too late to turn back. "The other problem is the phone companies don't own their gear -- it is leveraged. That is, they bought it forward in time. These guys have 20/30 years bonds outstanding against their SONET gear, because this was never supposed to happen. "Those 30-year bonds that were funded on the assumption of continued SONET operations will never be paid back. The insurance companies, those widows and orphans owning those bonds, the asset that they were buying against will not be economically viable in two years, much less twenty. "So not only is the ILEC capital base being rendered useless, but now the ILECs are supposed to reinvest in a bunch of new gear. They are not doing it because they can't. "This is what I envisioned when I walked out of here last year. And now it is happening. DT just fell below its offering price in 1996 for the first time. NTT continues to slide, France Telecom, British Telecom, they're at multi year lows. And it continues to get worse. "We live in interesting times. "So what happens next? One thing that I do for my clients is I predict trends. I never predict the future. There is a difference. "We need to restructure the entire industry, but how? We want it dirt cheap because then it can be as good as it can be for all the other economic things that it is supposed to do. But it can't be so cheap that it repels capital. "This need to restructure telecom is dragging the rest of the economy down. The economy isn't weak because of high interest rates, but everyone is watching as Greenspan cuts rates. If interest rates had been 22% and he took them down to 3, then you could say interest rates caused this. But interest rates have nothing to do with it. This is technology problem, so interest rates aren't going to impact it one way or another. "You can go to Japan and see 11 years of decline with zero-percent interest rates. So we have to fix the problem. This means restructuring the debt and owning up to what the real issues are. This owning-up hasn't been done yet. "Then we have to reallocate the assets to the right parties. Unfortunately some markets don't behave in a traditional market way. Typically common-good markets, like transportation systems, tend to be regulated markets, because the capital outlay upfront is associated with an unknown return in the future. This regulation is rather contentious, whether it is the old telecom, the airlines, or even trucking. There are just some markets that don't behave well, and I'm afraid that this is one of them. So we have a lot to think about. "Time is of the essence. The reason that we are in this downward spiral is because telecom is draining the vitality of the entire economy. On the margin, this is where our last decade of growth came from, and now it has stopped. It would be helpful if policy-makers knew the problem from this perspective. "I can explain the problem, but I don't think I'm qualified to solve it. I hope it doesn't take 3 to 5 year to fix, because we are all going to be living on our cash balances in the meantime. "I am convinced that our capital markets aren't going to recover until we figure out what to do. Optimistically enough, I think as soon as we do figure out what to do, they will jump up a lot, because they are a discounting mechanism. But their immunity to recent tax cuts and interest rate cuts tells me, on the down side, that this is something that everyone might benefit from putting their heads together to figure out. "I think that our government is going to have a very hard time. I think that they will get involved, and I am afraid that they might side with the wrong people. It is up to all of us to try to think about how we can pull together to make some sub-optimal solution come out of this, since there is no optimal solution. "Finally, I observe that this move toward unlimited supply extends beyond bandwidth. Think about the symbiotic relationship between open source software and the Internet, and how they work together, and how the Internet helps foster the open source movement, and what economics this [synergy] starts to impact. The incumbent software business is a very large business, and it could be negatively impacted by open source software. I'm not passing a judgment on open source software. I happen to like some of it. But it is a fact that it will be impacting our markets. Not as big as the telecom issue because the business is smaller, and it is not leveraged. But it will redefine economics well beyond the bandwidth sector." [Roxane Googin edits the High Tech Observer, a pricy little sheet published by Global Investment Research. You can learn more about it by calling GIR at 203-791-3830.] ------- Two Scenarios for the Future of Telecommunications: Re-verticalization vs. Economic Reset by David S. Isenberg Roxane Googin's thinking suggests two scenarios. Let us call the first scenario RE-VERTICALIZATION. It is heir-apparent to the "official future". The alternative future called Re-verticalization is a big-telco-controlled future, in which the incumbent telcos (and their henchmen, the content industry) continue to thwart the deployment of new technology and the advent of new competition. To do this, the open, end-to-end Internet is gradually whittled away by a multi-front campaign employing massive lobbying, scare tactics, endless litigation and other techniques available to the big telcos. The idea that telecom facilities are Common Carriers" (i.e., open to all comers under public and equitable terms) is replaced by a regime of Private Commercial Arrangements in which big players are selectively advantaged and small, innovative players are squeezed out. With no competition and weakened demands for new services, the big telcos are no longer reminded that their networks are completely obsolete twenty years before they're depreciated. The Re-verticalization scenario can play out in two main ways. The first is stable and ugly -- the telcos and their allies in government and industry use the new technology to keep the lid on potentially disruptive communications technology, to ensure that innovation within and around the communications network is predictable and approved. This would create a chilly environment for potentially threatening innovation and keep the world safe for incumbent businesses. The result would be permacession, or, perhaps verrrrry slow growth, depending on where you think economic growth comes from. The second play-out is unstable, but a bit more heartening. In this alternative future, advanced technology, such as that which already exists, will be suppresses, but it will be impossible to suppress it all. Forward-looking countries, such as Canada, Sweden, and a handful of others will deploy new communications technology and will reap its benefits in compounded rates of economic growth. Furthermore, in incumbent-telco-dominated countries like the United States the behemoth telcos will move too slowly to dominate the entire value space. Pockets of new telecommunications will form (e.g., municipal fiber builds, wireless community networks) and grow faster than they can be surrounded, usurped and shut down. The news of advanced telecommunications and economic growth from other countries -- and from within -- will travel. This could resolve peacefully (e.g., via policy shift) or cataclysmically, because not only is economic growth at stake, but fundamental human rights are too. But Googin suggests a second scenario. Let's call it ECONOMIC RESET. In this alternative future, the United States, indeed the countries of the developed world, belly up to the fact that the telecom plant became worthless before it was fully depreciated, that advances in communications technology have rendered existing telecom infrastructure obsolete. This requires either (a) decades fighting to stay out of bankruptcy court and decades in it, or (b) a collective act of will to put the debacle behind us. The latter collective act of will is to reset the value of the worthless assets to near-zero, where they belong. Googin finds an analogy in the Savings and Loan Crisis of the late 1980s. The causes of the S&L debacle were different, but there was a big similarity -- the changes in the economic underpinnings of the S&Ls were too fast for the S&Ls to react to within the context of their established business model. The massive institutional insolvency that resulted, Googin says, will be seen again in the demise of the world's established telcos. The S&L bailout of 1989, piloted by President George Bush Senior, effectively excised the infected parts of the economy. The solution was not any prettier (or any fairer or more just) than the problem, but it let the United States get on with business; it let the wounds heal. Could it happen again? The U.S. might once again have the right president for the job. But the telcos, the government and incumbent network-based businesses are living in the re-verticalization scenario. They do not yet apprehend the economic devaluation of what just yesterday was the most advanced network that money could buy. Further, they might not be able to see the imperative for change until their business model is in cardiac arrest. The play is in motion but the score is not tallied -- the telcos' accountants have not been called. If the telcos succeed in the courts, in government and in the court of public opinion, they may never be. It could take a decade of permacession before we know the source of our pain. Meanwhile, humanity stands on the threshold of building an omni-functional network that embodies the highest principles of democracy, expression and entrepreneurialism. Freedom-loving people should hold it dear. Should we delay its construction to preserve yesterday's moribund businesses? Must we endure permacession until the incumbent telcos have played their last card? ------- COPYRIGHT NOTICE: Redistribution of this document, or any part of it, is permitted for non-commercial purposes, provided that the two lines below are reproduced with it: Copyright 2001 by David S. Isenberg -- -- 1-888-isen-com ------- [There are two ways to join the SMART List, which gets you the SMART Letter by email, weeks before it goes up on the web site. The PREFERRED METHOD is to click on and supply the info as indicated. 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