The Unraveling, Part 1

For some seventy years, AT&T, parent company of the Bell System, was all but unrivaled in domestic American telecommunications. For most of that time, General Telephone, later known as GT&E and then simply GTE, was AT&T’s only rival of any significance. Yet it accounted for a mere two million telephone lines at mid-century, less than five percent of the total market. AT&T’s period of dominance – from the gentleman’s agreement with the government in 1913 until that same government dismembered it in 1982 – roughly marked the beginning and end of a peculiar political era in the United States; a time when the citizenry was capable of believing in the benevolence and effectiveness of a large, bureaucratic system.

It is difficult to impugn AT&T on its outward performance during this time. Between 1955 and 1980, AT&T added nearly a billion new miles of voice telephone circuit, most of it in microwave radio. Its cost per circuit mile dropped by an order of magnitude over the same period. These cost reductions were passed onto the consumer, who saw continuously decreasing real prices (i.e., adjusted for inflation) on their telephone bills. Whether measured in percentage of households with telephone service (90% by the 1970s), signal-to-noise ratio, or reliability, the United States could consistently boast the best telephone service in the world. At no time did AT&T show any sign of resting on the laurels of its existing technical infrastructure. Its research arm, Bell Labs, made fundamental contributions to the development of computers, solid state electronics, lasers, fiber optics, satellite communications, and more. Only by comparison with a rate of change exceptional in all of human experience – i.e. that of the computer industry – could they be made to seem a foot-dragging laggard.¹ Nonetheless, by the 1970s, the idea that AT&T was holding back innovation gained sufficient political momentum to bring about its (temporary) dissolution.

The unraveling of the system of cooperation between AT&T and the U.S. federal government came about slowly, and took decades to play out. It began when the Federal Communications Commission (FCC) decided to make some little tweaks to the system – they only wanted to tug away one little loose thread over here, then another over there. But their attempts to tidy up around the edges loosened more and more of the fabric. By the mid-1970s they looked on in confusion at the mess they had made. Then the Justice Department and the federal courts stepped in with a pair of scissors and had done with it.

The single most important agent driving these changes, outside of the government itself, was a little upstart called Microwave Communications, Incorporated. But before we get to all that, let us see how the federal government and AT&T interacted in the happier times of the 1950s.

Status Quo

As we saw last time, there were two distinct areas of law that checked the power of industrial giants like AT&T in the twentieth century. On the one hand, there was regulatory law. In AT&T’s case regulatory oversight took the form of the Federal Communications Commission, created by the 1934 Telecommunications Act. On the other hand stood antitrust law, whose enforcement was the purview of the Justice Department. These two branches of law were of a very different character. If the FCC was a lathe, convening regularly to make small decisions that gradually shaped AT&T’s behavior, antitrust law was a fire axe: usually stowed away in a cabinet, but not at all subtle in its effects when deployed.²

In the 1950s AT&T received threats from both directions, but both were settled fairly amicably, with little imposition on AT&T’s core business. Neither FCC nor Justice Department challenged the assumption that AT&T would remain the dominant supplier of telephone equipment and services in the United States.

Hush-a-Phone

Let’s first consider AT&T’s relationship with the FCC, by way of an unusual little case regarding foreign attachments.  Since the 1920s, a tiny company in Manhattan called the Hush-a-Phone Corporation had made its living by selling a cup that attached to the speaking end of the telephone. By speaking directly into the device, a telephone user could avoid being easily overheard by those nearby, and also block out some of the background noise in his or her environment (in a busy sales office, for example). In the 1940s, however, AT&T, began to crack down on such foreign attachments – that is to say, any equipment connected to the Bell System that was not provided by the Bell System.

According to AT&T, the humble Hush-a-Phone was such a foreign attachment, and thus any subscriber using such a device on their phone was subject to disconnection for being in violation of their terms of service. As far as is known, such a threat was never carried out, but the possibility probably did cost Hush-a-Phone some business, especially from retailers who refused to stock it. Harry Tuttle, inventor of the Hush-a-Phone and “president”³ of the business, chose to challenge this policy, and filed a complaint to the FCC in December 1948.

The FCC had the power to promulgate new rules, like a legislature, but also to resolve disputes, like a court. It was in this latter capacity that the commission acted in 1950, when Tuttle came before it. Tuttle came not alone, but armed with expert witnesses from Cambridge, Massachusetts, prepared to testify that the Hush-a-Phone’s acoustic qualities were superior to the alternative – a cupped hand.⁴ The Hush-a-Phone position rested on these facts – that the Hush-a-Phone silencer was better than the only available alternative, that as a mere physical attachment it could not in any way harm the telephone network, and that private users should have the right to make their own decisions about equipment they found beneficial.

From a contemporary point-of-view, these arguments seem indisputable, and one may find AT&T’s position absurd on its face – what right could they have to forbid private individuals from attaching something to a phone in their own home or office? Should Apple have the right to forbid you from putting your iPhone in a case? AT&T’s main agenda however, was not to attack the Hush-a-Phone specifically, but to defend the general principle of the ban on foreign attachments. There were several cogent economic and public interest arguments in favor of that principle. To begin with, the disposition of an individual AT&T telephone set was not a private matter, insofar as it could connect to millions of other subscribers sets, and anything that impaired quality on the call could potentially affect any of those other users. Also, one must remember that at this time telephone companies such as AT&T owned the entirety of the physical telephone network. Their ownership extended from the central switching stations down the wires and on into the telephones themselves, which were leased to customers. Thus from a simple private property point of view, it seemed sensible that the phone company should be able to control what was done with its equipment. AT&T had invested many millions of capital over many decades developing the most complex machine known to man. Why should every two-bit entepreneur with a wild idea assume the right to leech off of this accomplishment? Finally, it bears considering that AT&T also offered a variety of first-party attachments, from signaling lights to shoulder rests, all of which were leased (typically by businesses), and all of which put money into the coffers of AT&T that helped subsidize the low-cost bare bones local service to ordinary subscribers. Transferring that revenue into the pockets of private entrepreneurs would impair this system of redistribution.

Whatever merit you may find in these arguments, they convinced the commission – the FCC unanimously confirmed that AT&T’s right to end-to-end control of their network extended as far as a simple cup attached to the rim of a telephone handset. In 1956, however, a federal appeals court overturned the FCC decision. The Hush-a-Phone may have degraded voice quality, the judges ruled, but only for subscribers who chose to use it, and AT&T had no grounds for overruling this private decision. Moreover, AT&T had neither the ability nor the intent to prevent users from muffling their voices in other ways. “To say that a telephone subscriber may produce the result in question by cupping his hand and speaking into it,” the judges wrote, ” but may not do so by using a device which leaves his hand free to write or do whatever else he wishes, is neither just nor reasonable.” Though the judges seemed disgusted by AT&T’s audacity in this case, their ruling was narrow – they did not throw out the ban on foreign attachments altogether, only the specific right for telephone subscribers to use a Hush-a-Phone, should they so desire.⁵ AT&T amended its tariffs to indicate that foreign attachments that were electrically or inductively connected to the phone system remained forbidden. Nonetheless, it served as a first warning that other parts of the federal government might not treat AT&T as gently as their regulators at the FCC.

Consent Decree

Meanwhile, in the very same year as the appeals court decision on Hush-a-Phone, the U.S. Justice Department closed an antitrust investigation against AT&T. The origins of that suit went all the way back to the origins of the FCC itself. There were two salient facts of the matter: 1) Western Electric, by itself an industrial giant, controlled 90% of the telephone equipment market and served as sole supplier of all such equipment for the Bell System, from the telephone stations leased to end users to the coaxial cables and microwave towers used to transmit calls cross-country. And 2), the entire regulatory apparatus that restrained the AT&T monopoly relied on capping its profits as a percentage of its capital investments.

Here was the rub. One with a suspicious mind might easily imagine a conspiracy within Bell to take advantage of these two facts. Western Electric could inflate its prices to the rest of the Bell System (for example, charging $5 for a length of wire when the fair price would be $4), artificially increasing the dollar amount of its capital investments, and thus the absolute profits of the company. Say, for example, that the Indiana regulatory commission set the maximum return on capital for Indiana Bell at 7%. Assume that Western Electric charged it $10,000,000 for new equipment in 1934. The company would be allowed to earn $700,000 in additional profits – but if the fair price for that equipment were only $8,000,000, it should have been allowed only $560,000.

Congress, concerned that shenanigans of this very sort might be in progress, made a study of the relationship between Western Electric and the operating companies part of the FCC’s initial mandate. The study took five years to complete and ran to 700 pages – thoroughly documenting the history of the Bell System, its corporate, technological, and financial structure, and all of its many operations, foreign and domestic. On the matter of the original question, the authors found it basically impossible to determine if Western Electric’s prices were fair or not – no comparable entity existed to compare them to.  Nonetheless, they recommended that competition be forced into the telephone equipment market, in order to ensure fair practices and stimulate greater efficiency.

By the time the report came to fruition, however, in 1939, war loomed on the horizon. No one wanted to interfere with the communications backbone of the nation at such a time. A decade later, however, the Truman Justice Department revived the suspicions about the relationship between Western Electric and the rest of the Bell system. Rather than a bulky and somewhat noncommittal report, those suspicions now took the rather more pithy form of an antitrust suit. It requested that the court not only require AT&T to divest Western Electric, but also carve up the latter into three constituent companies, willing a competitive market for telephone equipment into existence through judicial decree.

AT&T had at least two reasons to be nervous. First, the Truman administration had proven itself extremely aggressive in the enforcement of antitrust law. In 1949 alone, in addition to the AT&T action, the Justice Department and the Federal Trade Commission brought suit against Eastman Kodak, grocery giant A&P, Bausch and Lomb, the American Can Company, the Yellow Cab Company, and many others. Second was the precedent of United States v. Pullman Company. Much like AT&T, Pullman had a service arm, which operated railroad sleeping cars, and a manufacturing arm, that built them. Also much like AT&T, the ubiquity of Pullman’s service, and the fact that they would only serve Pullman-built cars, meant that no one could compete on the manufacturing side. Despite the suspicious relationship, as with AT&T, no evidence arose of abusive pricing by Pullman, or even of unhappy customers. Nonetheless, in 1943, a federal court ruled that the Pullman company was in violation of anti-trust law and should have its service and manufacturing businesses separated.

Ultimately, however, AT&T escaped dismemberment, and indeed never faced a day in court. Instead, after years of limbo, it agreed to a consent decree with the new Eisenhower administration in 1956 to resolve the suit. The change in attitude of the government was partly due to a change in administration. The Republicans were significantly less hostile to big business than the New Deal Democrats.  But a change in economic conditions also deserves some of the credit – the continued growth of the economy from strength to strength after the war undermined the argument, popular with the New Dealers, that the prevalence of big business inevitably caused recessions, by inhibiting competition and putting a floor under prices. Finally, the growing scope and scale of the Cold War with the Soviet Union also played a role. AT&T served the War and Navy Departments ably during the Second World War and continued to do the same for its successor, the Department of Defense. In particular, in the very year of the antitrust suit, Western Electric had begun operating the Sandia nuclear weapons lab in Albuquerque, New Mexico. Without that lab, the United States could not develop and build new nuclear weapons, and without nuclear weapons it could not maintain a credible threat to the Soviet forces in Eastern Europe. The Defense Department therefore had no desire to see a weakened AT&T, and lobbied the rest of the administration on behalf of its contractor.

The terms of the decree required AT&T to restrict its operations to the regulated telecommunications business. The Justice Department allowed a few exceptions, most notably government contract work – it wouldn’t do to outlaw Sandia Labs, after all. The government also required AT&T to license and provide technical advice on all its present and future patents at reasonable rates to any domestic entities. Given the panoply of innovations that continued to be forged at Bell Labs, these easy licensing terms would help propel the development of American high-tech companies for decades to come. Both of these requirements would have a major effect on the how computer networks took shape in the United States, but they did not affect AT&T’s role as the de facto monopoly provider of domestic telecommunications services. The fire axe had been restored to its cabinet, for now.  But very soon, a new threat came from the unexpected quarter of the FCC.  The lathe, always so smooth and gradual in its operation, suddenly began to bite deeper.

The First Thread

AT&T had long offered private line service, which allowed a customer (typically a large  company or government department) to lease one or more telephone lines for its exclusive use. Many organizations with intensive internal communication needs – such as the television networks, large oil companies, railroads, and the U.S. Department of Defense – found this more convenient, economical and secure than relying on the public telephone network.

The advent of microwave relay towers in the 1950s, however, reduced the entry costs for long-distance service to the point where it it became attractive to many of these organizations to simply build their own private network, rather than lease one from AT&T. The political philosophy of the FCC at this point, well-established in many rulings, held that rival telecommunications services should only be allowed where the incumbent could not or would not provide an equivalent service. To do otherwise would be to encourage wasteful inefficiencies, and to disrupt the carefully balanced system of regulation and rate-averaging that held AT&T’s monopoly in check while maximizing the services it offered to the public. The established precedent thus left no room for a general opening of private microwave service. As long as AT&T was willing and able to offer a private line service, other unregulated carriers had no right to enter that business.

And so an alliance of interested parties set out to challenge that precedent. They were almost all large corporations with the wherewithal to build and operate their own private networks. Among the most prominent in this coalition was petroleum extraction industry (represented by the American Petroleum Institute (API)). With pipelines snaking across whole continents, wells spread across vast, remote oilfields; and exploratory ships and drill sites scattered across the globe, they wanted communication systems that would precisely serve their own needs. Companies like Sinclair and Humble Oil envisioned using microwave networks to monitor the status of pipelines, control derrick motors remotely, and communicate with offshore rigs, and they didn’t want to wait for AT&T’s say-so. But the petroleum industry was not alone. Virtually every form of large business from railroads and trucking companies, to retailers and automakers, petitioned the FCC in favor of private microwave systems.

In the face of this pressure, the FCC opened hearings in November of 1956 to decide whether a new frequency band (above 890 megahertz) should be opened to such networks. Given that virtually the only parties to speak against private microwave were the common carriers themselves, the conclusion seemed nearly forgone. Even the Justice Department, feeling that AT&T had somehow bamboozled them in the recent consent decree, put in a word in favor of private microwave. This became a habit – for the next twenty years, Justice would consistently put its nose in the FCC’s business, opposing AT&T and favoring new market entrants in proceeding after proceeding.

AT&T’s strongest counter-argument, one to which they would also return to again and again, was that the new entrants would damage the delicate balance of the regulatory system by cream-skimming. That is to say, large businesses could and would choose to build out their networks along low-cost, high-traffic routes (which were most profitable to AT&T), and then lease AT&T private lines where it was more expensive to build. The costs would ultimately by borne by ordinary telephone subscribers, whose low rates were subsidized by the highly profitable long-distance services which large companies would no longer pay for.

Nonetheless, the FCC ruled in 1959, in the so-called “Above 890” decision, that any entrant could build its own private long-distance network.  This marked a break in federal regulatory policy. It called into question the fundamental assumption that AT&T should act as an engine of redistribution, charging higher rates to deep-pocketed customers in order to offer inexpensive telephone service to local users in small towns, rural areas, and poor neighborhoods. But the FCC still believed it could have its cake and eat it too. It told itself that the change was minor. It only affected at tiny percentage of AT&T traffic, and did not affect the core of the public service philosophy which had guided telephone regulation for decades. The FCC had, after all, only tugged at one loose thread. And indeed, by itself, the Above 890 decision was of modest consequence. But it set in motion a chain of events that caused a complete revolution in the structure of American telecommunications.

Further Reading

Fred W. Henck and Bernard Strassburg, A Slippery Slope (1988)

Alan Stone, Wrong Number (1989)

Peter Temin with Louis Galambos, The Fall of the Bell System (1987)

Tim Wu, The Master Switch (2010)