Of all the distortionary federal regulations in existence, few are more patently inefficient and convoluted than those governing the television airwaves. Aereo, a new startup backed by media mogul Barry Diller, is looking to blow it all up.

Aereo offers a subscription service that for about $10 a month lets you watch your local broadcast television channels over the Internet. That deal is attractive to the increasing number of persons who are dropping their cable subscriptions in favor of cheaper online alternatives. Netflix, iTunes, and Hulu offer a great assortment of on-demand shows and movies, but until Aereo there was no way for "cord-cutters" to watch live sports, news, and awards shows over the Internet.

To say broadcasters are not happy about the new service would be an understatement. They accuse Aereo of pirating their signals, and all the major networks have filed suit against the company.

If you attach rabbit ears to your TV set or install a big aerial on your roof, you can watch all the over-the-air broadcasts you want without paying anyone a thing. However, when a cable company retransmits those same broadcasts, it usually pays the broadcasters for the right to do so. Aereo, on the other hand, isn't paying broadcasters anything to transmit the signals over the Internet. They don't have to, they argue, because they're not offering a cable service. Instead, they are renting antennas.

Each and every Aereo customer is assigned a dime-sized antenna that picks up over-the-air signals just for that one customer. As a result, the claim is that Aereo is not in fact retransmitting the broadcasters' signals the way cable companies do; instead it is customers who are using an antenna (albeit with an extremely long cord to their house) to tune in over-the-air channels that they have a right to watch.

It's an ingenious way to comply with the letter, if not the spirit, of the law. In fact, it's a technology that exists solely to exploit a loophole, yet the courts have so far approved. The district court hearing the case denied the broadcasters' request for a preliminary injunction against Aereo, and this month the United States Court of Appeals for the 2nd Circuit upheld that decision, stating that the networks' lawsuits "are not likely to prevail on the merits."

At this point you may be feeling sympathetic to the networks who are seemingly getting a raw deal. They spend billions of dollars on rights for NFL games and other programming, and then Aereo comes along and builds a business on top of that investment without contributing a cent. That sympathy might wear off, though, when you remember that broadcasters get the airwaves they use for free.

In an ideal world there would be property rights in, and markets for, spectrum. Unfortunately, the federal government nationalized the airwaves in 1927 and since then only licenses their use. Today, wireless broadband providers like Verizon and AT&T must bid at auction for the spectrum licenses they use, and this bidding helps ensure that the valuable airwaves are allocated efficiently to their best uses. Television broadcasters, on the other hand, have never had to bid for airwaves. The Federal Communications Commission licenses spectrum to station owners in exchange for a promise that they will operate in the public interest—and that includes making their programming available for free over-the-air and supported by commercial advertising.

Given that television broadcasters have accepted this deal, and have promised to make their signals free, why should they be paid anything for retransmission? If what the public gets for giving broadcasters free spectrum is the right to put up an antenna and grab the signals without charge, why does it matter how they grab the signals? As long as Aereo—or even cable or satellite TV providers—retransmit a station's broadcast unedited, with commercials and all, they are not taking anything away from the broadcasters.

In fact, that's how it used to be until Congress created and gave broadcasters a new property right in retransmission in the 1992 Cable Act. The act prohibits cable operators from retransmitting broadcast signals without first obtaining the broadcaster's consent, usually with a payment. And if a cable system is not interested in carrying a channel, then the act gives that channel the right to force the cable company to carry it at no charge. Either way, broadcasters get something from the local cable system—payment for retransmission or free access to a wider audience.

It's a sweet deal considering that fewer than 15 percent of households still watch local broadcasts over-the-air. In a world without federal regulation one can imagine that the broadcast networks would have become cable channels long ago, and local broadcasters would have put their airwaves to higher valued uses, such as wireless broadband. Instead, television—the killer technology of the 1920s—continues to occupy vast swaths of the most valuable spectrum even though a big chunk of their revenue comes from retransmission fees.

Aereo is threatening to slice up this layer cake of federal regulation by undermining the broadcasters' "retransmission consent" rights. If Aereo wins in court, then cable and satellite providers are going to start wondering if they might not be able to give each of their customers tiny antennas of their own and avoid the retransmission fees. So it's not surprising that after the latest court defeat, some networks, like Fox and Univision, have warned that they might go off the air and switch to being subscription services if Aereo wins. If this unlikely scenario comes to pass, one hopes that the spectrum broadcasters now occupy will be made available for other uses.

More likely, Congress will ultimately take up this regulatory mess, at which point it will have a choice. It could simply add one more layer to the cake, making internet services like Aereo illegal or folding them into the existing retransmission consent scheme, or it could opt to allow markets to work by making spectrum tradable and deregulating the market for video distribution. Here's hoping it makes the right choice.