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What This Country Needs Is A . . . Good Recession
(January 10, 2005)
(commentaries added March 12 and June 3, 2005)
The Four Horsesmen of the Financial Apocalypse are galloping toward us, and yet the nation is basking in a profound and worrisome complacency. Warning signs are visible everywhere--a negligible savings rate, tepid income growth for all but the wealthiest slice of society, and the hollowing out of the chief middle-class asset, home equity-- but the nation's leadership, punditry and citizenry are blissfully tuned into sideshows: corporate profit growth, so-called "reality shows," and a four-fold sales increase of luxury goods.
Times, it seems, can't get any better: unemployment is low, corporate profits are rising double-digits year after year, the cost of borrowing money is incredibly cheap, housing just keeps going up 10% a year, confounding the glum predictors of an asset bubble, and there's so much surplus money floating around that luxury items are more the rage now than they were in the heady bubble days of 1999.
Party like 1999? Not at all--now it's even better. We have $600,000 recreational vehicles, million-dollar starter homes, zero-percent auto loans, and best of all, terrorism has been completely vanquished. At least, that's the conclusion you have to draw from the media coverage and tenor of the times. No one's worried about oil tankers being hijacked or blown apart in the Straits of Molucca, for instance, except some old fuddy-duds in the pages of Foreign Affairs; and who reads that kind of serious magazine now, anyway? Why scare people with stories about the many vulnerabilities of a world economy entirely dependent on the free and cheap flow of petroleum? They might not go out and charge another few thousand bucks on their credit cards or home equity line. What would happen, God forbid, if Wal-Mart didn't increase its sales by 3% per quarter? What if sales actually dropped? It's too horrible to even imagine.
Sure, there are the doomsdayers, muttering about bubbles in all three asset classes: stocks, bonds and real estate; but they are obviously wrong, because the markets have just roared ahead for over two years running. Stocks are up 60%, bonds are up 8% just over the last year, and housing is up 40-60% over the past few years, with no end in sight. Of course there could be a modest flattening of yields, and a slowdown in the rise of real estate--but these would be temporary phenomenon, just the markets taking a healthy breather.
The Four Horsemen are visible on the ridge, just about to begin their descent into the Valley of Happy Excess, and those few with keen eyesight are frightened. But not many dare to speak out now--you have cried "wolf" too often, you Cassandras--and so the masses of happy consumers and hedge fund clients are partying away the waning days of excess.
The bumper sticker summarizes the nation's values rather well: "What's our oil doing under their land?" Indeed. The nation's value system is largely a collection of shortsightedness, corruption, greed, smug complacency, apathy and a supremely self-absorbed sense of superiority. Issues which should cause at least widespread skepticism are ignored or dismissed with a complacent yawn: the erosion of individual rights, highlighted by the legal limbo of the detainees in Guantanamo; the "hollowing out" of the National Guard by the nation's political leadership, to avoid the financial and public relations costs of enlarging the regular Army; and the continuing corruption within corporate America, where the vaunted high-tech industries of Silicon Valley fight tooth and nail to avoid having to expense an expense, i.e. employee stock options. What would Intel's actual profits have been all these years if they'd actually had to report the expenses they incurred as a business? Perish the thought, for they have to beat "estimates" by at least a penny every quarter, year after year, or their stock value will reflect reality and plummet like a stone.
What this country needs is a good recession--for instance, the one we should have had in 2001, a regular, healthy, business-cycle recession in which excess capacity and debt are wrung out of the system, and replaced with pent-up demand and savings. But no, our leadership decided to skip a messy, unpopular recession, and so the floodgates of cheap money were cranked open, and remain open. It is unprecedented that the Fed Funds rate is below inflation, and yet even with the recent 1.25% rise in that rate, it's still below inflation.
This uncontrolled rise in money supply is precisely what's led to bubbles--most recently, in Japan during the late 80s. The excesses of that asset bubble in stocks and real estate are still plaguing Japan, for that nation's leadership has yet to grapple directly with the bad debt and chronic fiscal deficits created by the bubble.
The pernicious effects of the Fed's "free money" (that is, money that's cheaper than the rate of inflation) and enormous M2 money supply expansion are numerous.
The most important is the hollowing out of the primary middle-class asset, a home. This flood of cheap money has predictably driven up the price of housing--huge demand, driven by cheap money and a rush to hard assets, chasing a limited supply, in this case, real estate. On paper it looks like a positive development for the middle-class; their losses in the dot-com stock market meltdown of 2000-2002 have been more than offset by a spectacular rise in the value of their home.
But as the Japanese found out the hard way, asset bubbles never end happily. The value of real estate in the U.S. has fallen twice in recent memory, in direct linkage to recessions and the rising cost of money. Once mortgages rise from 5% to 7% (a number which would simply reflect historical averages, i.e. Fed Funds rate plus 2.5% plus 2% for the cost of the money), that translates into a 40% rise in the cost of that mortgage. Yes, 40%, because 2% is 40% of 5%. That means that to be affordable, i.e. for the mortgage to remain affordable, the value of the house being purchased would have to drop by 40% as well. But let's be cautious, and suggest a 30% drop will be required to keep that house affordable at the higher interest rate.
To those who say "impossible," I refer you to New York real estate in the last severe recession, or California in the period 1991-1996, or indeed, any location which experienced a bubble created by cheap, easy money and the euphoria of rapidly rising values.
What really makes this real estate bubble dangerous, however, is the draw-down the average American homeowner has made on home equity via refinancing and equity lines of credit. It has been well-established that people's sense of wealth is directly tied to their house value; now what happens when that value actually declines (again)? And what about the absolute decline of their real wealth? Let's say the average American house gained 30% in the past few years. Let's also posit that the average homeowner has taken out much or all of that rise. If the value of the home drops back, as it surely will once interest rates rise, then how much equity will be left? Enough to borrow against in the near future? That is very unlikely.
It's impossible not to conclude that this current "economic expansion" has been funded by a one-time, self-fulfilling event: cheap money begets rising home values which beget huge equity draw-downs which begets vast consumer spending (the share of consumer spending having risen from 67% to 71% of GDP in just a few years). And so now that the cost of money has to rise--and perhaps a lot more than the complacent policymakers expect--what happens to the bloated consumer spending based on a draw-down of the average American's only real wealth, his/her home?
It goes away, of course, and for a long time: until a real honest-to-goodness recession wrings all the excess out of real estate values, and deflates the bubbles in bonds and stocks as well. And that will take a while.
The era of cheap money financed by foreigners is ending. It's well-known that this explosion of cheap money has been financed by foreigners: some $1.6 trillion in U.S. government debt is held by foreign central banks, and the amount held by foreign individuals and entities such as pension funds and insurance companies is unknown (though no doubt it is also significant).
It is also well-known that cheap money in the U.S. has exported the same low interest rates to overseas markets as well. Coupled with the enormous flow of dollars out the U.S. and into China, the Eurozone and Japan (otherwise known as the current account deficit) the net result is a worldwide asset bubble in real estate and stocks.
The imbalance between the domestic savings rate (currently less than 1%) and the current account deficit (5% of GDP and rising) has understandably put downward pressure on the dollar. Not only are we exporting cheap money, but we're exporting debt as well via a cheapening dollar. The more dollars you hold, the more money you lose. The foreign holders of our debt must be truly desperate, for now their capital is being significantly reduced by a sinking dollar. So far, the story is that the Chinese and Japanese central banks will continue to give us free money (by buying low-interest bonds), and then suck up the annual decline in their capital caused by the dropping dollar. They will continue to do so, indefinitely, the story goes, to keep their currencies cheap so foolish Americans will continue to buy their manufactured goods (with borrowed money, of course).
But who wants to be a bagholder as the dollar decline continues? Foreign central banks will eventually catch on that there is no political will in the U.S. for curbing either government debt or the current account deficit. Once they understand this, it will be a question of who's dumb enough to be left holding $2 trillion in rapidly depreciating assets. Buying more when everyone else is selling won't prop up anyone's currency; it will simply be good money after bad.
The story is that an "orderly decline" in the dollar is "healthy"--but for whom? The U.S. of course, debt-bloated and self-absorbed, our primary interest is keeping our own borrowing costs cheap. But suppose foreign holders of debt have tired of the charade, and see that a day of reckoning is at hand; isn't the natural impulse to rush to the exit to avoid being the last one out the door? The current policy of supreme confidence in the stupidity of the Chinese and Japanese central banks is truly bankrupt, and every day brings the possibility of a meltdown in the dollar closer.
The sidebar to the story says that a declining dollar is good for the U.S., as it will make our goods cheaper in the rest of the world and boost exports. This, we're told, will erase the $600 billion current account deficit. Excuse me, but has anyone spouting this nonsense noted that manufacturing is now only 16% of the U.S. economy? Sure, we can export services--Starbucks and your friendly Citicorp banker, for instance--and agricultural products, such as soy beans-- but does anyone actually believe we can sell $600 billion more of these goods and services? That's the size of the current account deficit, by the way, and if you consider it a form of borrowing, which it is, then add it to the Federal deficit of $430 billion to get a sense of the true dimensions of American borrowing: $1 trillion a year. By most accounts, this enormous appetite sucks up fully 80% of all available capital in the entire world economy.
Does this strike you as a sustainable system? If so, I have a bridge I want to sell you.
As for the low savings rate in the U.S.--it's only rational. Why save money and earn a pathetic 3% on your money, when you can borrow as much as you want for 4 or 5%? If you're sharp--and American corporate types are nothing if not smart-- then the obvious play is this: borrow cheap money to the hilt, and then re-invest it in assets with a higher return. Borrow at 4.5%, reap 8%--not a bad deal at all. And so the net result is an asset bubble in stocks (that average annual return of 9% looks awfully inviting if you've got billions in free money to play with) and junk bonds (ditto for those fat junk bond returns). In other words, the riskiest asset classes are precisely the ones which have ballooned up --and as a result, they are the ones most prone to a correspondingly catastrophic decline in value.
Is it rational to think this charade of "prosperity" based on borrowing $1 trillion every year can continue indefinitely? No--but that's not stopping anyone from believing the fairy tale.
Inflation is rising, and far faster than the phony government statistics suggest. If you go shopping-- and I presume you do because you're a red-blooded American, aren't you, and it's been your sacred duty since 9/11 to go out and spend money like crazy to prop up a sick economy--do you really believe the bogus Fed statistics that inflation is 1.5%? Huh? While there are academic debates about various deflators and such--that Dell PC has more goodies for the same money as last year's model, so let's throw in a nice big deflator--it's obvious to Joe and Suzie Consumer (if they pay attention) that inflation is already way ahead of the official manipulated rates. Examples abound: the cost of coffee, two rooms worth of carpet from Home Depot, the cost of a year in a state college, you name it: 1.5% a year, ha! If you know anyone in small business, then you'll know that shipping rates alone are through the roof, and the cost of getting anything from 10 pounds of frozen chicken to auto parts has risen 10%-20% or even more.
Bottom line: inflation only appears tame, due to a quirk in the calculation of the CPI. The "real" rate of inflation is undoubtedly higher than the "official" rate of 3%. Consider the labor component of the economy, which Labor Department data reveals has started heating up:
"The new data show that hourly compensation in businesses outside farming rose 6.3% in the first quarter and 10.2% in the fourth quarter, both estimates substantially higher than previously reported 4.8% and 3.8% increases." (Wall Street Journal, 6/3/05)So far, businesses are sucking up these higher expenses without passing them on, but the breaking point is nearer than official stats can measure. At some in the very near future, these rising costs will be passed on at the wholesale level, and then at the retail. Then you'll finally see the "official" rates edging up.
The asset bubbles in stocks, bonds and real estate will pop, possibly sooner than pundits expect. Cheap money has driven asset bubbles in real estate, bonds and stocks, and while pundits are working overtime with justifications for how stocks can keep rising in an environment of rising energy costs, rising inflation and rising interest rates-- all conditions which make stocks the asset class you least want to own--reality has a nasty way of intruding on such self-serving fantasies.
I know, I know; 89% of the smart money managers and pundits are predicting corporate profits rising "only" 15.6% this year (compared to last years' 16.6%), and an "average" 9% return for stocks this year. But if corporations and the stock market are doing so great, why are insiders selling their holdings at a furious pace? And if business is so good, why are companies spending their huge cash hordes not on new investment or R&D, but on stock buybacks? Could it be so their stock price is pumped artificially higher while they're unloading all their options to the poor dumb suckers who bought the fairy tale hook, line and sinker?
And take a closer look at those "average" returns of 9% per year in the market. Guess how many years since 1920 the market has actually returned this average: exactly three. The other 81 years it swung wildly higher and lower. What are the odds that after 60% gains in the Nasdaq, the market is going to rise another 10%? If that's a good bet, why aren't corporate insiders buying instead of selling the stock of their own companies at the unprecedented rate of $28 sold for every $1 purchased. It doesn't look like prosperity ahead--it looks more like rats leaving a sinking ship.
Before you get completely bamboozled by those amazing corporate profits--20% rise per year forever!--take a look at corporate sales. They're not rising anywhere as fast as profits. So what does this mean? Simply that the economy isn't as strong as those giddy profits would suggest. Companies are booking profits either through slight-of-hand (not expensing stock options, for instance) or through relentless attrition of headcount and expenses. For many firms, this has meant opening shop in China to reduce manufacturing expenses to the bone, and getting rid of support staff.
So sales are mediocre and expenses are cut to the bone; now what happens when interest rates rise? Corporate debt service gets more expensive, so that comes off the bottom line, and sales drop as consumers get pinched, reducing the top line. It's the classic recession crunch.
It's simple: rising interest rates make both stocks and bonds a lousy investment. Rising inflation makes real estate and commodities valued assets, but then we already have an asset bubble in real estate, so that's on the way down, too. That leaves gold, silver and commodities, but they've had pretty substantial runs as well.
So what's left? How about wealth destruction on a vast scale?
It's not a popular fact at this point in time, but recall that rising interest rates make stocks look risky. Why gamble on an iffy 9% return when you can earn a guaranteed 7%? (or 10%, if inflation really gets clipping along.) Ditto for all existing bonds, which will drop by the same percentage as interest rates rise: a 40% rise in interest rates (from 5% to 7%) means all existing bondholders will instantly lose 40% of their capital. Ouch.
And let's not forget that the housing bubble's rise is approaching its inevitable end--with global losses for all involved.
There are derivatives, of course, and it's possible that every mutual fund and hedge fund has fully protected their long assets with a trillion or two in put options, short-selling, currency straddles and the like--but let's suppose for a moment that all these money managers have been lulled into expecting low volatility, low interest rates, declining energy costs and a benign slide in the dollar--the entire fairy tale which dominates the leadership and media of the nation at the moment--then what?
It's called wealth destruction on a vast scale.
There are two other "surprises" in store for the flailing U.S. economy: local government defaults and skyrocketing petroleum prices. Oil is "supposed" to go down. Why? Well, because it should. The price has risen so people will use less, and demand will fall appropriately. Say what? What country have you visited where the cost of oil has slackened demand? Nobody in the U.S. or Euroland is using less; people here simply don't care, or they grin and bear it because their pickup, Volvo or SUV is more important than saving money or being thrifty. (For proof, see the 1% savings rate and the booming vehicle sales, 60% of which are trucks and SUVs.) In Euroland, petrol is already so expensive, you think anyone's going to drive less because gasoline goes from 1 euro a liter to 1.20 a liter? Dream on.
As for Asia: spend some time in Bangkok, Tokyo or Shanghai, and then tell me demand will slaken. A motorbike needs so little petrol, and is so essential to the livelihood of the driver, even a 50% rise isn't going to affect demand. Ditto for taxis, trucks, government buses, etc. The tolls in Japan are so expensive (over $100 just to drive a 100 kilometers or less) that what's another 1000 yen for gasoline?
Belief that oil will drop to $35 or less a barrel is a misguided fantasy, unhinged from reality. For the first time in history, the demand for oil exceeds supply--and that imbalance is now permanent. As you will have noted elsewhere in my website, I strongly recommend "Hubberts' Peak: The Impending World Oil Shortage" by Kenneth Deffeyes. This geophysicist explains in great detail why the world's great oil fields have already been discovered and tapped; there won't be anymore 10 billion barrel fields discovered, and the costs of extracting oil from leftover fields or shale oil will be very high. In other words, there may well be enough oil to last 100 years, but it's going to cost $100 or more per barrel to extract.
Meanwhile, back at the Fed, soothing words about the minimal impact of rising energy costs are papering over the reality, which is simple: energy costs are rising, and that always triggers a recession. The question isn't if, but when, and when you consider the heightened risks created by cheap money, dependence on foreign capital, an unsustainable Federal and current account (foreign trade) deficit, the decline in the dollar (maybe not as "orderly" as pundits hope), then it's difficult not to imagine sooner is more likely than later.
Lastly, let's not forget the troubling state of local governments throughout the nation. Local governments everywhere are cutting funding in a desperate attempt to avoid deficits. Sounds like 2001, right? But this is the good times! This is prosperity! If they're struggling in the best of times, what's going to happen when bad times roll around again? Then what? Higher taxes, of course, and fewer libraries open; but maybe that won't be enough. Maybe the long-term liabilities of the local government, specifically, the generous pensions of its millions of retirees and current employees, will become unbearable, even with higher taxes. Maybe those medical benefits which have been rising at 10-20% per year will no longer be affordable.
Who says local governments can't default on pensions and bonds? For many municipalities, counties and states, it might be the option that is forced on them. Appeals to the Federal government will fall on deaf ears, for as interest rates rise, so too will the amount of money the government must spend to carry that enormous burden of $8 trillion in bonds. It's currently around $175 billion per year--more than all government spending other than defense, Medicare and Social Security--and that's at the lowest interest rates in a generation. What happens when interest rates rise? Then the government spending is going to get squeezed by the need to pay another $100 billion in interest--or perhaps it will be another $200 billion per year. The leadership of this nation has put the fiscal house of the people in a terrible pickle with its profligate borrowing, and the bill is about to come due--not just on the national level, but on the local level, too.
As for the 2.2 million jobs added last year--can you tell me how many match the high wages of the millions of IT and corporate middle-management jobs which were culled in 2000-2002? Approximately 250,000 jobs have been lost in my home area, the San Francisco Bay Area, since 2000. The majority were high-paying jobs. I haven't found any statistical evidence to support the claim that an equal number of well-paying jobs are included in this 2.2 million national figure. It seems far more likely that this number represents churning, with high-paying jobs with benefits being replaced with low-benefit positions at much lower pay.
The great hollowing out of the industrial base of the nation has largely taken place; now, the hollowing out of the managerial and technical class is beginning, with dire consequences for middle-class security and income. Not to mention, of course, a dwindling tax base for local government as wages decline or stagnate. With Federal tax rates now at historically low levels for corporations, the majority of taxes are collected from middle-class and high-income workers on the payroll of traditonal firms. As these jobs migrate elsewhere or are simply phased out, then the Federal government will also find that its taxpayer base is shrinking. This will make reducing the enormous Federal deficit that much more difficult.
Yes, I know, it sounds so bleak. But isn't it time this indulgent, self-absorbed, short-sighted, corrupted nation finally faces the consequences of the past four years of horrendously poor fiscal policies? Perhaps the choice of ignoring it all is about to pass--and that would be a positive step. Painful in the short-term, no doubt; maybe even painful for a decade or longer. But the sooner we start dealing with the reality, the shorter the painful adjustment will be.
Commentary (March 12, 2005)
In the latest issue of Foreign Affairs (one of my favorite publications, I should note) is an article entitled "The Overstretch Myth, or How We Learned to Stop Worrying and Love the Current Account Deficit" by David Levey and Stuart Brown. The essay is an exemplary rendition of the "Standard Economic Explanation" for why the current account deficit is of little consequence.
We should start, of course, with the title, a smirking, somewhat patronizing reference to the subtitle of Stanley Kubrick's anti-war film "Doctor Strangelove." The suggestion is that the worthy experts are here to allay the doomdayers' foolishness. And indeed, the authors make some excellent points that the current account deficit, once direct investment is deducted, isn't quite so glaringly enormous.
The authors subtitle the core of their article "False Alarm," yet a close reading reveals that, far from excluding alarm, they sanguinely accept a collapse of the dollar as a distinct possibility. As they put it:
"Such a sell-off could result--as in emerging-market crises--if investors suddenly conclude that U.S. foreign debt has become unsustainably large. A panicky "capital flight" would ensue, as investors race for the exits to avoid the falling dollar and plunging stock and bond prices.
But even if such a sharp break occurs--which is less likely than a gradual adjustment of exchange rates and interest rates--market-based adjustments will mitigate the consequence."
The market mechanism, they explain, will be the rush of $4 trillion in U.S. assets currently held overseas back to the U.S. to reap the gains from a cheap dollar and presumably higher interest rates. They then add:
"The ensuing recession, combined with the cheaper dollar, would eventually combine to improve the trade balance."
So rather than explaining away the risks of an uncontrollable and mounting current account deficit, these worthy experts are actually conceding a meltdown is possible. The key word in their sanguine view of the aftermath is "eventually"--yes, the collapse of the dollar and the ensuing recession would undoubtedly "eventually" correct the imbalance, but how long will that correction take, and how many lives will be disrupted or ruined while these august academics collectively nod their heads?
The authors' work is deficient on several other critical accounts. First, they give not even a passing reference to the huge losses foreign holders of debt will suffer in their forecasted "gradual" devaluation of the dollar and the rise in interest rates. (Recall that bonds devalue in two ways: as a marker of the underlying currency, and as interest rates rise.) Like all other pundits touting the party line of "move along, there's nothing to see here," they state as a matter of fact rather than foolish faith that foreign governments have no choice but to recycle their trade surpluses into dollars, just to manipulate their own currencies.
In other words, they assume the Chinese and Japanese managers will accept a grinding loss of tens of billions each and every year in dollar and bond depreciation. The Asian central banks are currently giving the lie to this smug assumption, for they are slowly but surely broadening their currency portfolios away from the dollar.
The authors also ignore the possibility of these huge foreign holders of U.S. currency and bonds "weaponizing" their holdings by dumping them precipitously on the market as a foreign policy or crisis management gambit.
Their breezy assumption that $4 trillion in U.S. assets held overseas would suddenly liquidate and return to replace the fleeing foreign holders is suspect as well. What exactly do they think would happen if a few trillion in non-U.S. assets were liquidated? The foreign bond and stock markets would surely crash. But no doubt the authors expect the foreign sellers of U.S. bonds to jump in and save their own markets from collapse. Such a vast swap seems just a wee bit too convenient--not to mention unlikely.
Rather like the film they reference in their mocking title, it's hard not to conclude that the authors are "Doctor Strangelove"-like characters themselves, filled with delusions of their own precience and power, and utterly amoral about the consequences of the actions they so matter-of-factly accept: "the ensuing recession," etc., as if such a global meltdown and rebalancing is some sort of academic exercise. It will be far from academic to the millions laid off and the millions whose wealth will be impaired or wiped out--yet our worthy authors spare not a word for such consequences.
Instead of calming reasonable fears, they succeed all too well in proving the worry to be substantive. Their reassurances, like all those of the status quo economists, ring hollow.
Commentary: Why Inflation Appears Low (June 3, 2005)
Every small business owner and consumer has the queasy feeling that inflation is running considerably ahead of the "official" Consumer Price Index rate of 3%, but the misrepresentation has been a puzzle--until now. Alan Abelson's column in Barrons contains a cogent explanation:
"Shelter, you see, which accounts for about 30% of the core CPI (and nearly a quarter of the overall index) is measured not by the dictates of the marketplace, how much houses actually fetch when they're sold, but by a strange -- make that perverse -- yardstick called owners' equivalent rent. Homeowners are asked how much they think they could get were they to rent their abodes.So the speculative buying of real estate has created a huge supply of property available for rent, driving rents lower by 20% nationally. This in turn suppresses the 30% of the CPI based on housing.
Note that 35% of all home purchases nationally are second and third homes--pure speculation. Also note that 2/3 of the new mortgages in the San Francisco Bay Area are "interest only," which means the owners have deferred the actual costs for a few years. Finally, note that about 34% of all new mortgages and re-finances are adjustable loans, which means that the rates (and payments) will rise along with interest rates. Consider as well that even though low interest rates have made mortgages "affordable" (whatever that means), the tremendous rise in housing prices the past few years has dramatically raised the cost of buying a house--never mind the mortgage payment, how about the big increase in property taxes new buyers are paying?
Though the housing boom has skewed the data in favor of the status quo--borrow more, spend more, inflation is dead, long live speculative housing!-- it's doubtful the real rate of inflation can be masked for much longer. Then what happens? Perhaps what everyone fears--a rise in long-term rates and the deflation of the housing bubble.
For more on the housing bubble, the Federal Debt, the demographics timebomb and financial crises in Asia and Europe, please go to my weblog and scan the links in the left column.
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