Bill Frezza’s History of Telecom Innovation (and Not)
2015-11-18 · Guest: Bill Frezza (Tech entrepreneur and radio host) · 52:24
History of AT&T monopoly and innovation vs regulation
Bob Zadek interviews Bill Frezza about the history of the telecommunications industry, focusing on how government-sanctioned monopolies like AT&T stifled innovation for decades. They discuss the transition from a highly regulated utility model to the explosion of technology following deregulation and draw parallels to modern issues in banking and healthcare.
Topics: Telecommunications, Innovation, Monopoly, Regulation, AT&T, Bell Labs, Crony Corporatism, Internet History, Banking, Healthcare
Speakers: Bob Zadek, Bill Frezza
Introduction to Bill Frezza [00:00]
Bob Zadek: Hello everyone, and welcome to the Bob Zadek Show. We are the only live libertarian talk radio show on the air all weekend. Thank you so much for listening. We are proudly the show of ideas, not attitude. 800-345-5639. As they say in radio, have we got a show for you today.
This morning, I’m delighted to welcome my good friend, fellow radio host, tech entrepreneur, and witness to the whole span of telecom regulation—from free market to stifling regulation devoid of innovation, and then the promised land of innovation and economic freedom once again. He has a wonderful story to tell. Please welcome my guest, Bill Frezza. Bill, thanks so much for joining us this morning.
Bill Frezza: Oh, Bob, how could I turn you down after coming on my show and telling so many delightful stories about Greek diners? I don’t think I’ve ever laughed so much with a guest.
Bob Zadek: Well, thank you so much. And now’s your chance to return the favor. Of course, when I was a guest on your show, we talked about Greek diners. This morning, we’re going to talk about something with far greater impact and infinitely more interest, which is the parallel history of the interaction of innovation and regulation at a company that was and still is called—although it doesn’t resemble itself anymore—AT&T. Of course, you and I know that AT&T stands quaintly for American Telephone and Telegraph Company, “telegraph” being the interesting word.
We are going to discuss what the history of AT&T and its subsidiary Bell Labs teach us about innovation, crony capitalism—or as you like to say, Bill, crony corporatism, and I agree with that—and what it teaches us about how innovation is stifled by regulation and is set free once again once the yoke of regulation is dismissed. Now, tell us about your relationship to AT&T, just so the audience can appreciate with what authority you speak.
Bill Frezza: Well, I don’t know so much about authority, except for the fact that I was there for about half the history. I was blessed to graduate MIT in 1978 and join Bell Labs at the final days of its glory years. It had been in control of a monopoly business.
Bob Zadek: Now Bill, let’s just mention—you say Bell Labs as if everybody on the planet knows exactly what Bell Labs is. I do, but that doesn’t help. So put Bell Labs in the perspective of what we used to call the telephone company.
Bill Frezza: Long ago and far away, there was this research organization called Bell Laboratories, which was considered a national gem. It was the one place that could legally do research and develop products in the telecom industry because until 1982, it was illegal to compete with Ma Bell and the Bell System. It collected pretty much every engineer and scientist who was interested in communications, and actually a wider number of scientists—people who went on to do things like develop the laser, develop the transistor. It has a glorious reputation that’s lionized in many history books, but we never look at the flip side of the story, which is what would have happened had they not had monopoly control over the business.
Bob Zadek: Now Bill, isn’t it fair to say that Bell Labs was one company, but it was—if you want to draw a reasonable parallel—it was the equivalent of the amalgam which is called Silicon Valley today? It was the Mecca. It was the place to go if you wanted to work in that industry.
Bill Frezza: Well, you didn’t have much of a choice. In fact, when I bailed out of my PhD program, my advisor said, “Bill, you’ve got to go to Bell Labs. It’s the only place to go.” It was the only place I interviewed, and I ended up there in ‘78. The year I joined Bell Labs, the Bell System—which included AT&T Long Lines, all the operating companies, Western Electric (which manufactured all the equipment), and Bell Laboratories—had one million employees. It was the largest private employer in America.
Bob Zadek: And as you said, the one company manufactured all the phones, they designed all the phones, they did all the research, and they controlled the entire electronic communication from one human to another in the United States. One company.
Bill Frezza: It was considered normal. Actually, we were quite proud of it. Other countries followed the same model. In most other countries, believe it or not, it was run by the post office, if you can imagine such a thing. So in the UK, and in France, and in Canada, all of the telecom systems until the early ’80s were run by government-sanctioned monopolies, which were an odd conglomeration, at least in the US, of private shareholders but under public strategic control.
The Era of the Telephone Monopoly [02:59]
Bob Zadek: How did we get there? We started with an invention, or a series of inventions, by human beings who invent things in their proverbial garages and laboratories. How did we get from a very, very clever and important invention to one company controlling everything?
Bill Frezza: Well, let me tell the story, if I may, the way I tell it when I get in front of college audiences. Since retiring from the VC business and starting my radio show, I’m out on college campuses about a dozen times a year talking to young kids, mostly with Young Americans for Liberty and Students for Liberty, which believe it or not are among the fastest-growing groups on campus. They’re both libertarian organizations.
I love to start the kids off by asking them, “Raise your hand if you own a phone.” And of course, everyone in the audience raises their hand. They look at me like I have two heads. And then I say, “Raise your hand if you know when I was your age, it was illegal to own your own telephone.” And no one under 30 ever raises their hand. It’s as if the history I’m about to describe disappeared from the face of the earth. Because of course, when you and I were young, you had to lease your phone from the phone company. On the back, it actually said “Property of Western Electric” or “Property of New York Telephone,” depending on how it was done. And we thought that was normal.
The other thing you and I remember—in fact, anyone our age will remember—long distance was so expensive that when you hitchhiked back to college and you wanted to let Mom know you got there safe, typically you would dial home, you’d ring the phone three times, and you’d hang up. And then she would know that you got home safely. The college kids look at me: “Why would you do that?” I mean, these are kids who are used to making Skype calls to China for free. And I explain to them that when we were in college, a three-minute phone call home to Mom cost exactly the same as two pitchers of beer and three bags of beer nuts. Now, because of inflation, the dollar figures don’t mean anything. A pitcher of beer was a buck fifty, beer nuts were fifteen cents a bag, and long-distance telephone was one dollar a minute, and had been for years and years and years because it was used to cross-subsidize the rest of the industry.
The Kingsbury Commitment and Cross-Subsidization [05:51]
Bill Frezza: So let’s take it on back. If you go back to the turn of the century—the last century—so we’re talking about the late 1800s going into the pre-World War I era, the telecom industry was a tremendously competitive business. There were dozens and dozens of companies beating each other’s brains out to wire up the country. And there was invention coming from all over the place.
People don’t remember that the very first electromechanical switch was developed by an undertaker. You can go Google it up; it’s called the Strowger switch. It was an undertaker who was burned because his competitor’s wife—the other undertaker in town—was the phone operator. And when people used to call up to say, “I want to talk to the undertaker,” she would switch all the business to her husband. So he got mad, and he sat down—people used to tinker in those days—and he built the first and patented the first electromechanical switch, went on to form a company.
All of this was vibrant and innovative and creative until about 1913. That’s when the story starts to change. If you remember, that was the era of the trustbusters.
Bob Zadek: It was also the year of the income tax.
Bill Frezza: Yeah, that’s right. All these things are related. So AT&T had a somewhat different strategy in that while dozens and dozens of companies were competing to wire up a city—so you might have ten phone companies in New York City—they were beginning to run long-distance lines and hooking cities up to each other. So you could actually—someone in New York could call someone in Chicago, which was a big innovation in those days.
And they had a very smart strategy. They would come into a city and they would say, “Hmm, Mr. Phone Company, we think we want to hook you up to our long-distance network.” And of course, we’re not going to hook up any of your competitors to our long-distance network, in which case they would die on the vine. And then they’d turn around and they’d say, “And we’d like to make you an offer you can’t refuse to buy your business.”
So they started rolling up the phone business. They got sued by the government for antitrust, and they made a deal. It’s called the Kingsbury Commitment, and it’s the foundation of what really became the public utility model in the telecom industry, and then the electrical industry, and then the gas industry across the country for basically a hundred years. And the promise they made—which over time, between 1913 and 1934 when the FCC was formed, over time this got codified—but here’s the deal they made. They said, “You know what? Give us a monopoly. Make us the only legal phone company in the country. And in return, we promise to wire up the whole country. Everybody’s going to get a phone. And even better, we promise we’re going to charge the stockbroker downtown the same price as we’re going to charge the farmer out in Iowa, even though it costs ten times as much to provide service to the farmer in Iowa by cross-subsidizing the system. We’re going to take money out of the systems and we’re going to create telephone equality across the land.” And of course, this was something that was very desirable, especially if you were a farm state Congressman, to bring phones out there. And they began, under this Kingsbury Commitment, to start rolling up the business. It was all codified in ‘34 when the FCC was formed. The Interstate Commerce Commission got involved.
Bob Zadek: And of course, that’s a major—just so our friends out there can appreciate that—that is a huge cross-subsidy, which means you’re telling the urban dweller or urban business person, “We are going to give you a hidden tax, and we are going to transfer your money.” It’s a wealth transfer. “We will transfer some of your wealth to the farmer in Iowa, and you can’t do anything about it if you want to have a phone.” That’s the deal. And that trick—we will come back to this later on—but isn’t that the structure of Obamacare? Isn’t that the structure of banking in America? And so governments have learned a long time ago, and our government has learned a long time ago, that you can have private business do your bidding by having them be the tax collectors. And that’s exactly what this cross-subsidy was.
Stifled Innovation and the “Seven Apps” [08:33]
Bill Frezza: It was an incredible engine. And one of the things they were concerned about, of course, whenever there’s a monopoly, you’re concerned about predatory pricing. And so again, the Bell System was smart enough and said, “We’ll make you a deal. We’ll open our books to you. We’ll show you all our investment. We will let you set our prices. And in return, all we ask is a 12% guaranteed rate of return in perpetuity.”
Bob Zadek: 12%! Just so we can pay our bills.
Bill Frezza: Forever. Riskless. So they used to call it a widows and orphans stock. So for a hundred years—well, not quite a hundred, because it was probably in the 1920s they started that—but they got a riskless 12% rate of return, which was fantastic for the shareholders.
And the consequence of that is that all the innovation went into the network side and not into the consumer side. So this is the unseen—this is Bastiat’s unseen—in that for 50 years, there was no progress on the consumer side. In 1923, my dad’s father, my grandfather, had a phone, which was unusual. He was the superintendent of the building. They actually had to cut a hole in the wall—they couldn’t afford a phone all their own—so they cut a hole in the wall to the tenement. They had a little box there. So when the phone rang, and if it was for the neighbor, you’d knock on the box and he’d pick up the phone. But you could have taken that phone in 1923 when my dad was born, brought it with me to Bell Labs in 1978, plugged it into the Bell System, and it would have worked just fine.
And I ask the kids in the college audience, “Take out your iPhone. You think that’s still going to be working on the network 50 years from now? Do you want that working on the network 50 years from now?” So what we saw was a system that was completely run for the benefit of the shareholders. The consumers were trained to think that nothing ever changed. And in fact, some wag wrote an article recently that said in 70 years, the Bell System only came up with seven apps. I mean, think about it. No new features. And I can—you and I remember what those apps were, right? When we grew up, you had to dial the phone with your finger, and they introduced Touch-Tone. Ooh, that was a big deal, right? You got to push the buttons. They went away from operator assistance to direct distance dialing, right? So you could actually—instead of dialing seven digits—you know, when you and I grew up, you actually had an exchange with a name. I was Pioneer 7-30…
Bob Zadek: I was Hollis 5.
Bill Frezza: Yeah, because people couldn’t be expected to remember seven digits, much less ten. So every exchange actually had a name. They went to direct distance dialing, they offered directory assistance. So if you happened to know the name of a person you wanted and where they lived, you might have a shot at getting their phone number. Of course, if their name was John Smith, forget it, you’d never find out.
Bob Zadek: And with directory assistance, if you paid extra, you had to pay extra to have your name not included, to have a quote “unlisted” number. But you had to pay extra. So the default rules were: no privacy unless you bought the privacy by paying the phone company like a dollar a month extra, and they would give you the privilege of not being included in the phone book.
Bill Frezza: It was really amazing, the system they ran. And you know, it actually wasn’t until the late ’70s, after the development of electronic switching—there was a system element called the No. 5 ESS that came in—it wasn’t until the late ’70s that we got things like Caller ID, Call Waiting, Call Forwarding, and voicemail. For all those years, the phone hardly changed. Everyone thought this was normal. No one looked the other way. There weren’t competitors beating each other’s brains out to introduce new features.
The advent of cellular telephony was long delayed. Even cordless phones—Bob, you remember when you and I grew up, Mom would have a curly phone wire between the handset and the phone was on the wall. It was usually avocado because avocado was the right color in the ’60s. And she would have this phone cord that she’d stretch, you know, 15 feet…
Bob Zadek: Along from the wall phone to the stove so she could cook. And if you were walking into the room, you got your neck strangled.
Bill Frezza: Right, you’d get clotheslined because they didn’t have cordless phones. Now, the radio technology existed to do cordless phones. I mean, I had walkie-talkies when I was a kid. But we didn’t have the competitive consumer products press to bring cordless phones. And it really wasn’t until the ’80s that we first started—I remember the first time I saw a cordless phone was on Dallas. Remember the prime-time soap opera Dallas? J.R. had a cordless phone. This was like a big deal.
So what people don’t see is that this promise for universal service, this promise for neutrality, this promise for equality—to AT&T’s credit, they delivered. They did wire up the whole country. They did provide everybody service at the same price. They made a boatload of money doing it, and we sacrificed innovation.
Deregulation and the Digital Explosion [10:52]
Bob Zadek: And what’s important—and so what we had was there was this pact. And our audience, as you have instructed your college student audiences, there is this terrible tradeoff where you get—you can’t have the monopolist gouge you because the government is given control over the pricing. But in reality, you are being gouged. You’re paying well over what a competitive price would be. But you don’t think you are because the price is set by the government. But you give up the benefits of innovation, which means you are denied the benefits of the human imagination in this essential product. You just denied it. And no one would think that tradeoff is worth it. So the consumer took it in the shorts for 70 years so that the capitalist—although they are not capitalists at all—could earn a guaranteed 12% return for life. And if you think that Bill is telling us this quaint little corner of American business, as I hope we will get to today, this model and this exploitation of the consumer is happening today. And we may get to be able to make a comparison with Obamacare and with my favorite, banking in America, where the same scenario is going on this minute.
Bill Frezza: Well, you know, we’re only halfway through the process with healthcare because they don’t have price control yet. It’s just a matter of time. We’re beginning to see it already. We’re seeing the political agitation to control prices because pharmaceuticals are too expensive. So it’s just a matter of time before somebody in the pharmaceutical industry makes a Kingsbury Commitment and says, “I’ll tell you what, federal government, you make me the monopoly provider of pharmaceuticals and I’ll let you set my prices.”
Bob Zadek: By the way, you say “too expensive.” “Too expensive” is defined as “more expensive than I feel like paying.”
Bill Frezza: Well, you know, there are some egregious examples that people use. Certainly $100,000 a year for maintenance drugs is not something that’s rational by any stretch of the imagination. If we run the clock forward, unless we make changes, I think it’s pretty clear we’re going to end up with a public utility model in pharmaceuticals. And if that happens, we’re going to end up with public utility innovation like we had with the Bell System for so many years.
So now we have the Bell System with a monopoly, no innovation except in the back office, where the Bell System gets to be more efficient and makes products that have its system work better, but to no benefit to consumers in terms of their experience. Then what happens?
Bill Frezza: Well, you know, what was real interesting is—and it’s not entirely fair to say there was no innovation at all, because there were pockets inside of Bell Labs that did tremendous things. A guy named Shockley did invent the transistor. This was a very big deal. They did invent the first carbon laser. The problem was that under the agreements they had made over time, they were not allowed to go into other businesses. So for example, they invented this transistor, which of course you and I know revolutionized the world. They didn’t know what to do with it. They couldn’t do anything with it. And so Shockley decamped for Silicon Valley, right? He started Shockley Semiconductor. And of course, you know the history of Shockley Semiconductor begat Fairchild Semiconductor, begat Intel. And because there were no regulations in the semiconductor or the PC business, Silicon Valley grew up outside the purview of the federal government, and we had total innovation in that field. And all of these fruits were born forward by that outside the Bell System. In fact, the Bell System was looking jealously at, “Hey, what happened over there? We invented this transistor and we got nothing out of it.” And that’s when people started scratching their heads, you know, later on in the ’70s, wondering whether this deal was worth going forward with.
Bob Zadek: So how did it come to pass that the Bell System—the nationwide monopoly over telephone service where you go to jail if you owned a phone, you couldn’t shop at all, you paid the price the government tells you to pay—how did we get out from under that system?
Bill Frezza: Well, you know, the crony corporatists eventually got a little restless. They were looking at the explosive growth of the semiconductor industry, they were looking at the explosive growth of the computer industry, and they said, “Geez, we’ve got the smartest scientists and engineers in the world. We could build computers. Why can’t we—we have software.” They invented Unix, which was one of the—and they used it to run their own switches, right? “We invented Unix, why can’t we get into those businesses?” They were prevented from it by these agreements. And they actually went to the government—they were in the midst of yet another antitrust suit—and said, “You know what? Let’s call it a day. Let’s turn back the hands of time. Let’s go back to 1913. Let my people go. Let us get into any business we want.”
And they had to divest the Bell operating companies, what they called the Baby Bells then. So there was this period during which all the local operating companies—because they were—that’s a tougher monopoly to break, right? They have the wire to your house—were broken up. AT&T became competitive. Companies like MCI, which had been chomping at the bit for some time, entered the long-distance service. And in 1982, that was the end. There was an agreement made to demonopolize the phone industry. And at that point, we went on a rocket ride for the next 30 years of all this pent-up innovation.
And I was blessed to be a young engineer at the time. I had jumped ship to General Instrument. We were building the first generation cable modems back in the early ’80s. And I don’t think since the late Industrial Revolution America has ever seen such a burst of innovation as we saw once we got freedom. And in the aftermath, we built the entire digital world, the universe that these college kids take for granted in their everyday lives.
Bob Zadek: And all it took was the demonopolization and the permission of the telephone monopoly to divest its monopolistic practices and in exchange they were allowed to become innovators themselves and go into other businesses. And all of a sudden innovation happened, prices go down, new products up the wazoo, with nobody being harmed. So we had a system of 70 years when there was profound harm in the sense of no innovation, high prices, and a moribund industry. And all it took—all it took—was deregulation and demonopolization. Gee, you think there’s a lesson there?
Parallels to Banking and Healthcare [13:34]
Bill Frezza: Well, you know, the problem is that the harm is unseen, right? The phone system was tremendously reliable. Everybody thought it was just fine. It was very controversial when they broke up the phone system. In the early days, things got a little ragged. The quality dropped a little bit, it wasn’t quite as reliable. People used to pine for the old days, “Oh, can’t we go back to when we had a monopoly?” because it took a while for the industry to sort itself out. Interestingly enough, when AT&T was allowed to compete, they became Lucent. They failed. It took them 20 years, but little by little by little, because of the culture, because of the changes, they couldn’t keep up. They ended up getting bought by the French, of all people. It became a part of Alcatel, and it’s pretty much disappeared under the waves.
Bob Zadek: Bill, you are active and affiliated with the Competitive Enterprise Institute. And the story of AT&T, Bell Labs, Western Electric, et al. can be looked at incorrectly as sort of—it points out some of the evils of business. Business became monopolistic, and isn’t that an argument that capitalism is a bad model and capitalism needs to be controlled? But in point of fact, isn’t it true that it is proof that capitalism needs to be encouraged, and the history of AT&T has a lot to do with business but very little to do with capitalism?
Bill Frezza: Well, you know, let’s be careful. People confuse capitalism and crony corporatism. And in fact, I don’t like the word “crony capitalism” because it’s a contradiction in terms. Capitalists go to the verdict of the market; crony corporatists go to the verdict of the politician. And the whole history of the Bell System until its deregulation is actually the most successful crony corporatist history that we can find anywhere. And again, it wasn’t universally bad. It delivered many, many goods. The problem is it didn’t deliver goods that we never got to see. Again, that’s the unseen that was missed by the monopoly. It wasn’t even a predatory monopoly. It was a very well-run, successful monopoly. It got bloated at the end, but it delivered to the people what was promised. What we missed out on was everything that happened afterwards. In 1982, when they fired the starting gun for the digital revolution, it was really the most exciting period of time that I’ll ever see in my life when it comes to technology. Perhaps we’ll see something similar in biotech in the future, but it was an era of just completely unrestrained innovation.
The Universal Service Constraint [18:38]
Bill Frezza: And if I may, Bob, I’d like to tell a little story that people might relate to now that they’re getting ever faster and faster speeds. I remember back in Bell Labs, there was a hierarchy of publications, and the holy of holies was called the Bell System Technical Journal. This was a publication inside the Bell System of the highest caliber. And I wish it was online because there’s an article I remember reading which I can’t find that stated that for the Bell System to introduce a data service to people’s homes, it could never run faster than 9600 bits per second—9,600 bits per second.
Now, you think about that today, right? We’re routinely getting 10 megabits, I’m getting 100 megabits. How could they have believed you can only get 9600 bits per second down a phone line? Because we all know that that’s not true. And whenever you see something like that, you have to check your premises. Remember, the premises of the Bell System was universal service. So to have fairness, any service they introduced anywhere had to be available everywhere. So it was anathema to say, “I’m going to introduce a high-speed service, but it’s only going to be available in these areas.” That would create a digital divide. And so at the time, they believed that the fastest you can go down a phone line was 9600 bits per second because out in Iowa, if you had a five-mile phone line, five miles of twisted-pair copper with load coils, you’d be lucky to get 9600 bits per second down that. And so that colored everything we did inside the Bell System.
Think about how different that was than the PC industry, right? The PC industry was not looking at universal service. It’s like, “Who could we get to buy our stuff?” And in the early days, it was underpowered and overpriced, and a small sampling of people bought it. And they took the profits from that and they built higher-power machines at lower prices, and they followed this virtuous cycle down until the point where everybody could afford one. Not because of universal service, but because of free-market capitalism.
Bob Zadek: You look at movies from the ’90s and they want to show some important business figure or celebrity, they were holding the cell phone the size of a shoebox.
Bill Frezza: Oh yeah, that’s a good one. The cell phones especially—the cycle that the cell phones have gone on, which took a little bit more maturity in the semiconductor industry before they can make it that small, has been the perfect testament to free-market capitalism. And in fact, you know, competitors got their brains out. Everybody remembers Research In Motion developing the BlackBerry. They really created the smartphone category. My friend Mike Lazaridis became a billionaire. Where are they now? Right? I mean, no one owns their position in a competitive market. Even the iPhone today—sure, iPhone’s the king of the hill right now. We’ll see how long they last with Steve Jobs gone. It’s an area of constant ferment.
The Birth of the Commercial Internet [22:12]
Bill Frezza: And what was most interesting about all this is, unbeknownst to anybody, unbeknownst to Bell Labs, gestating in the background was this thing called the internet. And you know, everybody’s got their own version of the story of the development and the invention of the internet. There are people that believe Al Gore invented it. There are people believe that it couldn’t have been invented without government research dollars. My take on it is that you can absolutely credit government research dollars for the following: they gave money to a bunch of scientists. These scientists wanted to hook their computers up to talk to each other over usually leased lines from third parties—at the time it was the Bell System—and they needed a protocol, a language to exchange files, to say whose turn is it to talk, “Did you get that message?”, “No, I didn’t get that message.” And they developed this protocol called TCP/IP. You can credit the government with funding that. You can’t credit the government with anything beyond that.
The rest was a Donnybrook of competition, which started slowly. In the early days, in fact, under the acceptable use doctrine, it was illegal to put commercial traffic on the internet. You had to be associated with a university in order to get an email account. You had to lie, “Oh yeah, I’m affiliated with MIT,” right? So you’d lie to get your account. And all that changed—and I’ll give Bill Clinton credit for that—all that changed in 1992 when it came to a head: should we allow commercial traffic on the internet?
And I remember going to hearings in Washington. I remember sitting next to Bill Shrader, who was the founder of PSINet. Some of you might remember PSINet was the first consumer internet service provider. Bill Shrader was the only other person I knew who became a billionaire—actually, Bill went from zero to a billion and back to zero again, which is another story. And we were fighting hammer and tong against none other than Ralph Nader and his minions, who were furiously trying to block the internet from ever allowing commercial traffic.
Bob Zadek: Why?
Bill Frezza: Because there was this thing called the Taxpayer Assets Project. You can Google it up. There was a guy named Jamie Love—I mean, Ralph Nader operates through this octopus set of organizations that promote his ideas. And their view was that the internet should really be like the public library. We should not allow people to profit from the internet. We should not allow people to shop on the internet. We should not allow people to advertise on the internet. This would be a horrible misuse of the taxpayer’s assets because, you know, they developed TCP/IP.
And thankfully, thankfully, Congress was looking the other way, Bill Clinton had bigger fish to fry, and in ‘92 or ‘93 they allowed commercial traffic on the internet for the first time. This was what, a year or two before the first browser was invented. No one knew what the business model was going to look like. No one had any idea what the future was going to bring. All of the innovation happened around the edges. Companies sprang up out of nowhere developing new products. People began developing applications. What no one expected was that people began—particularly once the browser was made commercial—people began putting up websites with their stuff on it. What was their business model? They didn’t even know. They just wanted to put their stuff up.
And so this wonderful self-organizing, self-evolving, unregulated, undirected, unplanned, unpriced—and almost free—took off. And you know, for a bunch of free services, it’s amazing how many multi-billion dollar companies were created. All these companies providing jobs, all these companies providing global leadership for American technology. All of this resulting in the digital world we know and love. We can’t even imagine living without the internet. You can’t go half an hour without the internet nowadays. None of it was centrally planned.
Top-Down vs. Bottom-Up Innovation [25:31]
Bill Frezza: You know, Bell Labs had this thing called X.25. I remember. They were planning the future of the digital network too. It was a top-down, centrally controlled system of protocols. This is what X.25 was. And I remember the first time—this was probably back in ‘79 or ‘80—I went into an auditorium. This guy named Bob Metcalfe was coming to give a talk about something called Ethernet. “What is this Ethernet thing?” right? And I remember absolutely having my mind blown when he came and he described a set of protocols that were totally alien to anything in Bell Labs or the Bell System’s DNA. It was not centrally controlled. It was chaotic. It was amazingly chaotic. And I walked out of there saying, “Oh my God, this is going to change the world.”
Bell Labs paid no attention to it. It became the foundation of Ethernet, which is the company 3Com, which became the foundation of all our local area networks to this day. When you hook your computer up to your cable modem or your DSL modem, you use Ethernet to talk to it. That became the first two layers of this multi-layered system that we all have come to know and love, built on almost anarchic principles.
And there’s a downside to this anarchy, right? We all see what this downside to this anarchy looks like. We’ve got viruses, we’ve got spoofing, we’ve got spam. You know, there’s a lot of unpleasant things that come along with freedom. And little by little, market providers are fighting back. You’re getting spam filters, you’re getting virus protection companies. Had the Bell System been left in control, you bet none of that would have happened. And nothing else would have happened either.
We had a project—my last project at Bell Labs was Knight Ridder newspapers. We were going to bring in home shopping and home banking and electronic newspapers to the world. It was a pre-web, pre-internet view of how things were done. But all of it was top-down. All of it was organized under principles of the phone system. Thank God it never happened.
The Value of Failure [27:56]
Bob Zadek: And whether we have a top-down system with government running it or a top-down system with one corporation running it, it’s the top-down nature that is inherently fatal to any innovation. And innovation is what today’s show is all about. You have to sort of throw open the world and say, “Okay, all you smart people, have at it. There are no rules, just make consumers happy.” And there’ll be—the ground will be littered with failure, but also will be flourishing with successes. And the failures are somebody else’s problem; the successes are to our collective benefit. And that’s what innovation means.
Bill Frezza: And it’s not fair to say there are no rules. There are no rules imposed from the top. The internet’s full of rules, but they came up from the bottom. Internet service providers began cooperating with each other. They said, “You know, let’s create these peering points. Let’s figure out how to exchange traffic. Let’s figure out how to make—yes, we’re competing with each other.” I think they coined the word “coopetition,” right? “We’re cooperating, we’re competing with each other. Let’s make the pie bigger than gouge each other’s eyes out trying to get a bigger piece.” And when you have that mentality of “let’s make the pie bigger first before we fight over our share,” it’s very, very different than saying “let’s freeze the size of the pie and then fight to death over our piece.”
Bob Zadek: Growing up on the streets of New York, we were sent out into the streets in an unstructured way, and we got together, we invented games, we invented rules, we had—if you broke the rules, there were penalties in the game. And we adjusted the rules as necessary. There was no playtime supervisor telling us how to do it. And we somehow—we got hurt and then we got better, and we hurt somebody’s feelings but we apologized. And that was how it was, and we all were better for it.
And now the culture has changed. And now everything requires a monitor and somebody to protect us from any of the bad things in life that might happen. And so innovation is throwing it open. People will lose buckets and buckets of money, but they did so voluntarily. And the most amazing thing is the innovators who lose, they lost their money trying to do one thing: “Give me something that’s at the right price and it’s something that I really want.” And for somebody to lose all their money trying to make me happier, it gives me goosebumps.
Bill Frezza: You know, and what people also miss—I like to describe my technology career and frankly my venture capital investment career as follows: everything that I’ve ever done has been a success for someone else 15 years later. One of the things you forget about innovation is that the successful entrepreneur, just like the army ant, climbs over the dead bodies of the prior failures. Every failure is a lesson to the guy who comes next. We were building cable modems in ‘81. It was way too soon. We failed. We were doing multi-user games in ‘85. It was way too soon. We were doing Wi-Fi in ‘87. It was way too soon. We launched our first wireless email in ‘92. We just barely caught a taste of that one. That was when Mike Lazaridis and Research In Motion started.
So what people don’t see—they see the successes. They don’t understand the many, many failures that came before, all of which provided an education. Because let’s not forget another important thing about America: failure is not fatal. All of the employees and the founders and the customers of the failed companies got an education, and they put that education to work in the next company. And that’s how we evolve. Matt Ridley has a fantastic book out now called The Evolution of Everything. In fact, I just had him on my show yesterday. And he goes through almost every aspect of our lives, from language to law to technology, to talk about the importance of evolution through voluntary exchange, through people getting together trying to make the world better, trading with each other, getting their crap beat out of them, right? Failure is such an important part of the process. And this is how we move ahead as a species. When you try to prevent failure—like in the banking business, “We can’t have any more bank failures”—that’s a disaster. That’s an absolute disaster. Banks are supposed to fail. They need to fail. Then you look at their dried bones and you say, “What killed this thing? How can we build a smarter bank in the future?” We’ve stopped doing that.
Cartels and the Taxi Industry [32:27]
Bob Zadek: You know, it’s interesting. There was a study that I remember learning about of the business culture in parts of Western Europe—France, if I remember correctly, was the specific basis of the study. And in France, if you fail at something, at business, it is a disgrace. You’re done. You don’t get a second chance. You are tainted, as if you have to go to a failure registry like a sex offender, and nobody will touch you. And so entrepreneurs in France have to go to other countries to try, fail, and then try and succeed, because failure is a huge black mark. In the US, failure makes you stronger, and it is tuition you pay to get good.
Bill Frezza: You know, I’ve probably hired and fired two dozen CEOs in my career as a venture capitalist. And whenever I’m interviewing a prospective CEO, I always try to get them to tell a failure story. Their success stories I can Google up, right? And I don’t need them bragging. Tell me a failure story. Tell me when you tried to accomplish something and it just didn’t work. And you listen very carefully to two things: one, to see what lessons they learned, and two, to see what kind of pronouns they used. Is it “I failed because my CFO was an embezzler” or was it “I failed because I hired the wrong CFO”? Is it “I failed because my investors didn’t stand behind me” or “I failed because I took money from the wrong people”? If you listen carefully to their failure stories, you can see who actually learned from them and is going to be better at it the second time around. And you know, we’re nothing but a collection of our scar tissue. We get better and better and better. That’s part of the American system that it would be such a shame for us to lose by having everybody run around with helmets and pillows and trying to keep us from falling down.
Bob Zadek: And look at how the American educational system has legislated, if you will, failure out. The losing teams get trophies for trying. I mean, imagine if we had a system where we wrote checks to everybody who failed just so they wouldn’t feel bad.
Bill Frezza: Well, we have a president now who’s at war with ISIS who says he doesn’t care if we win. How could the Commander-in-Chief get up and say “I don’t care if we win”? I don’t get it.
Bob Zadek: And there’s a lesson in your story about Bell Labs, the story about what’s called regulatory capture, where crony corporatists capture the governmental system and legislate them protection against any kind of failure. That is happening today in two areas, as you point out, Bill: in banking, which I know quite well and have spoken about on this show, and in healthcare.
Now, banking is I think the best example because in banking, just like in the Bell Labs story or the AT&T story you told us, bankers have made an alliance with government. Government says, “You do our bidding for us. You carry out our policies. You make loans to our constituents who don’t deserve loans, but make them anyway so we can curry favor with them. In exchange, we will give you free money and protection against failure.” And that is the same deal that AT&T made with the government 80 years ago. And AT&T became in many ways an arm of the government carrying out wealth transfers from urban areas to rural areas, as you have pointed out. And banks do the same wealth transfers. So it’s not as if Bill tells us a story which is interesting and has no lesson. The lesson is right in today’s news. It still is existing.
Bill Frezza: Alas, it’s a lesson we never learn. And we keep falling for the same stories over and over again. “This legislation will make sure this problem never happens again.” Whether it’s Sarbanes-Oxley, whether it’s Dodd-Frank, they claim they’re going to keep the financial system from collapsing. They’ve got all the safety valves tied down. No one knows what’s going to happen next. It’ll be a miracle if we get through the next five years without another debacle like 2008.
And meanwhile, where’s the innovation happening? You know, I think since Dodd-Frank was passed, I think there’ve been a total of maybe three bank charters let in the entire United States, and I think they were on Indian reservations. There is fintech evolution going on, innovation. It’s all happening in the edges. It’s happening in the shadow banking business. It’s happening in startups that are trying to develop new consumer lending models. And we’ll see how far they get before they get crushed by the regulators.
Luckily, we have positive models like Uber to look for. You know, the taxi cartels were just like the Bell System. They regulated rates, they controlled entry, they really took it out of the hides of consumers to the benefit of the medallion holders. And luckily an Uber comes along, upsets the whole thing. Will we see an Uber of banking? Will we see an Uber of healthcare? I hope so.
Closing and Real Clear Radio Hour [34:40]
Bob Zadek: And you know, the taxi cartels are a very interesting substory, which of course they’ve been—they’ve had the heck beat out of them by Institute for Justice and other organizations who are breaking down the cartels. Talk about stifling innovation. There’s one very interesting story that I like to share about government control of an industry. In New York City, which has terrible, terrible traffic problems, always has and always will—and Bill, you may not know this story—but in when you and I were growing up, there were these Checker cabs, which were big, boxy, and really comfortable taxi cabs. The doors opened the other way, you got in easier, they were wonderful. And a mayor who nobody will remember named Vincent Impellitteri, a one-term New York City mayor, he got this idea: the way to alleviate New York City’s traffic problem is to make the cabs smaller. They’ll take up less space in the street. So he banned Checkers and you had to have these compact cars as taxi cabs. It was the only one. And that was going to solve our problem. Well, Checker goes out of business because they have no customers anymore, and the traffic isn’t any better because the taxi cabs are smaller. I don’t remember that story, but I remember the Checkers going away. It was an end of an era.
Now Bill, tell our friends out there how they can follow your radio show, which I do every weekend. I love it when my little red one pops up that tells me another podcast of your show has hit my cell phone. Tell our friends out there how they can follow your writings and your speaking.
Bill Frezza: Well, Bob, unlike you, I don’t have the courage to do a live show. So I do two interviews, an hour show every week. It’s called Real Clear Radio Hour. You can go to realclearradio.org and get all the information. Or since you’re listening on AM radio, if you just go a little bit up the dial to 960 AM KNEW every Saturday at 10:00 AM and 4:00 PM—I repeat it at 4:00 PM—you can hear my program. And we have a long list of interesting doers and shakers and writers and thinkers. I tell my sponsor, the Competitive Enterprise Institute, I will do all subjects except two: I don’t do sports and I don’t do the arts. Those are two areas I don’t do. But we talk politics, we talk economics, we talk technology. And in fact, next Saturday I’ve got Chuck Leavell from the Rolling Stones on, who actually happens to be an award-winning tree farmer, and we talk about sensible environmentalism. So I’m having a ball doing this. I’m coming up on my 100th show. Love to have your audience on Saturdays tune in at 10:00 AM or 4:00 PM to listen, or you can get it on iTunes, YouTube, or SoundCloud if you want to catch the old ones.
Bob Zadek: Which is what I do, and I loved your show when you did in one hour Winston Churchill and FDR. That was a great show.
Bill Frezza: I had a good time with that one. It was a writer in England who dug into Winston Churchill’s finances. Talk about a gambler. This was a guy who lived on the edge of bankruptcy his whole life, and not only did he defeat the Nazis, he defeated the tax collector, which is an interesting story. And then taking another look at the New Deal and particularly some of the stories that have been forgotten by history, like the dry cleaner who got arrested and put in jail because he charged 35 cents instead of 45 cents to press a pair of pants, and the famous story of the kosher chickens, which finally the Supreme Court used to get rid of the National Recovery Administration. Fascinating stories.
Bob Zadek: Bill, you’re on your way to becoming our next national treasure. Thank you so much for giving us an hour of your time this morning. It’s a great tale you tell for all of us. To my friends out there, thanks so much for listening. I’ll be back next Sunday for another hour of libertarian thought and opinion. Thanks so much for listening and have a nice Sunday.