(a conversation with Morgan le Fay, the author’s family pet and early-morning debating partner, in his arms in the photo up to the left)

PM:  Thank you, Morgan, for agreeing to an end-of-year chin wag, to figure out how to solve all the world’s problems and how to make some money along the way. The years are treating you well, seven strong with you still as gorgeous as the time you came to live with me. Newport Beach seems to suit you just fine.

MLF:  My pleasure, Mac. I am indeed gorgeous, the Princess of this household. And don’t you ever forget it! I am happy to sit here and watch you flap your gums, especially if you’ll scratch behind my ears while you are doing so.

But first let me tell you right up front that you are smoking something stronger than the fresh hay you feed me if you think you, me or anybody else can solve all the world’s problems.

You guys in the investment business, particularly the bond business, always look at life as a series of problems to be solved. It ain’t, Mac; it really ain’t. Rather, life is a journey to be enjoyed. Not all misfortunes are problems and even when they are, that doesn’t necessarily mean that you have to fix them. Sometimes, the fix can be worse than the problem!

PM:  My, you’re starting out on a metaphysical plane, Morgan. Where are you learning this stuff?

MLF:  It’s not a plane, Mac, but a space. You are so stuck in the distant mud, as your son Jonnie is always telling you (it’s hard to believe he’s almost 16 now; where does time go?!?!) . We’re living in the 21st century, and real men no longer live on planes, but in spaces. 

Haven’t you noticed that your colleagues at work are always talking about spaces, as in duration space, convexity space, as well as just how spacey you can be at times? I’m not starting out this discussion on a metaphysical plane, but rather a happy space. I want you to think more about being happy, Mac.

PM:  Okay, okay. Am I supposed to call this house on the bay that I’m renting a house or space? Do you like it?

MLF:  ‘Tis quite a fine space, which you may call anything you want, as long as you let me reign as the princess of the patio. I am, you know. Now enough of this chitter chatter. Let’s talk business! I want to brag about how the world’s monetary policy gods are implementing my famous Plan, which you graciously wrote up for me on these pages way back in November 2002. 1

PM:  You are indeed the Princess, Morgan, and you can brag all you want. Should I quote you back to yourself?

MLF:  I always like when you do that, almost as much as when you take me inside on cold nights and let me sleep in front of the fireplace. Fire away: 

PM: Here’s the sermon you preached, Morgan:

“Rather than the rest of the world ‘forcing’ America via a lower dollar to start living within its means, the time has come for the United States to ‘force’ the other two G-3 members via a high Euro and Yen to start living up to their means. Put differently, rather than a falling dollar forcing tighter Fed policy, the worry-warts’ forecast (hopes?) for years, the time has come for a rising Euro and Yen to force easier European Central Bank and Bank of Japan policy. Put differently still, for those who like their macroeconomics kept simple, the time has come for America to stick a lower dollar into the deflationary ears of the European and Japanese monetary authorities, until they scream ‘reflationary Keynesian aggregate demand uncle.’” 

MLF:  Pretty good call, eh, Mac? Two years later and America is still living beyond its means, so that putatively unsustainable current account deficit is still going strong. Which can’t be said for the dollar, of course; you can call the buck many things, but strong ain’t one of them. In fact, Mac, I submit that America has been doing exactly as I advocated, sticking a lower dollar into the deflationary ears of Japan and Euroland.

And the Japanese have cried “uncle,” or at least whispered it, printing up pot loads of Yen to buy dollars, so as to protest appreciation of the Yen. I wouldn’t call it a screaming “reflationary Keynesian aggregate demand” policy, but we should take what we can get.

In fact, Mac, since I introduced the Plan back then, it has become clear to me that China, not Japan, is the linchpin of America ’s ability to sustain the putatively-unsustainable current account deficit. Everybody focuses on the European Monetary Union and their cool new currency called the Euro, but the monetary union that matters is the de facto one between America and China : 8.3 Renminbi to the dollar for a decade.

China is the 13 th Federal Reserve district, at least from a financial perspective. It’s got lots and lots of labor at a fraction of the cost of labor of the other 50 states. And it’s got lots and lots of savings. And for reasons I can’t quite comprehend, the Chinese like to work long hours at tough jobs for low wages, making really neat things for Americans to buy, financing those purchases with savings from their miserable wages. You guys at PIMCO call it vendor finance, and I guess that’s what it is, kinda like your friends Cindy and Matt getting that fancy new TV, with no payments ‘til 2007.

PM:  Yes, Morgan, you did make a fine call, and your Plan continues to be implemented, on the installment plan. And you are dead right that China, not Japan, is the straw that stirs the drink in the symbiotic relationship between the United States and Asia. The United States and China have been running a de facto monetary union, and the rest of Asia, including Japan have chosen to shadow that monetary union, creating a de facto Dollar Bloc. These are not strangers, Morgan, as we hear all the time. They are people we know! And they aren’t acting out of kindness, either, as we also hear all the time: they are acting in their own best interests, as they perceived those interests, not kindness toward Americans.

Yes, the result is a kind one, just like you getting to have a playground overlooking the harbor. But make no mistake, Morgan, I ain’t providing you the space out of kindness, but my own self-interest: I like you and I derive great pleasure out of watching you hop about. Maybe that will not always be the case, but it surely is for now; and for the foreseeable future, which I think will be far longer than the FOMC measure of a considerable period. You and I, Morgan, are just made for each other. Same, too, with America and Asia.

MLF:  That’s a whale of a way to say you love me, Mac; I’d call you a narcissist, if it wouldn’t be a matter of the rake calling the shovel muddy. Explain to me, will you, just what Asia gets out of this deal? Why do they perceive sending us cool stuff on credit to be in their best interest?

PM:  Tough question, Princess, but I think the answer starts with the region’s mercantile history. It’s very hard for us Americans to understand it. It is a system the opposite of whose fruits you observe floating by in real time. It’s a system founded on the notion that it is better to be a lender than a borrower. What’s your best guess, Morgan, as to how many of those boats have got debt on them? Most of them?

MLF:  I have no idea, Mac, and quite frankly, I don’t give a damn. Tell me more about this mercantilism state of mind, which sounds very different than anything Billy Joel ever sings about. Just how does that Webster dude define it?

PM:  Here you go:

“An economic system developing during the decay of feudalism to unify and increase the power and especially the monetary wealth of a nation by a strict governmental regulation of the entire national economy. Usually through policies designed to secure an accumulation of bullion, a favorable balance of trade, the development of agriculture and manufactures, and the establishment of foreign trading monopolies.”

MLF:  Ah, just a fancy way of saying they are a bunch of misers, no? All work and no play type of people? Just the opposite of me?

PM:  That might be a bit harsh, Morgan. You’ve got to learn, as I preach to Jonnie all the time, to be a bit more courteous, a bit more politically correct in your manner of speaking. But your point is well-taken. Mercantilism does have a strong streak of Calvinism in it: the notion of sacrifice during life, so as to lay up stores of good will for the hereafter. But in the case of Asia, it’s not just a matter of sacrifice for the sake of sacrifice, it’s a love of foreign exchange reserves (gold bullion, in early times) for the sheer joy of them. You can’t, after all, cuddle up with a bunch of blips on a computer located in the bowels of a custodian bank.

Rather, it’s a matter of economic development: developing countries – and Japan was one for many years after the end of World War II – bootstrap themselves on the stairway to developed heaven by integrating themselves with countries with a higher level of technology and a more robust institutional system, notably the system of law.

As I said last month, 2 the easiest way to get rich is to go to school on the rich man. Accordingly, there is, in fact, a degree of rationality to the mercantilist model in Japan . It’s kinda like early in my career, when I busted my tail late into the night to make my boss look good, in hopes that he’d make a lot of money and feel sufficiently guilty to give me a serious pay raise. Call it an investment in the future.

That’s what China is doing now, as it transforms itself from a command economy to a market economy. America gets lots of cheap, cool stuff – hello, Wal-Mart! – and China gets American know-how, so as to move up the value-added chain more quickly. They finance our buying, but it ain’t an act of altruism. If they can avoid triggering American protectionism, China’s investment in America ’s consumer spending is actually an investment in its own long-term productive prowess. I’m not sure, but I think I probably have a bigger W-2 now than my first boss.

MLF:  In which case, I want Harry and David’s pears every month of the year, not just December, when they are rolling ‘round the hallways at your office. You make a pretty good case for the rationality of what China is doing, but why is Japan doing the same thing? Isn’t Japan now a developed country, grown up enough to shuck its mercantilist hair shirt? Isn’t it time for the Japanese to learn the joy of consuming more than they make, of living beyond their means? It’s fun, after all; don’t they enjoy fun?

PM:  Assuming those aren’t rhetorical questions, let me answer that yes, it is indeed odd, at least to the Anglo mind, that Japan remains stuck in the mercantilist bog. Part of the reason may be that they face a demographic reality that we Americans don’t understand: a shrinking population that is increasingly old. Yes, we have some of that, which is the underlying source of angst about Social Security. But not nearly so much as the case in Japan . America is blessed with a strongly-growing immigrant population, which blesses us with many, many babies. America indeed remains a melting pot of peoples. Japan is much less so, with only limited immigration.

Japan also has a rather skewed wealth and income distribution between the old and the young, with the old very much better off than the young, who are suffering from declining real wages, as Japan – to it’s credit! – weans its people off the notion of lifetime employment at the same company, at ever-rising wages based on seniority. 

Indeed, as our PIMCO colleagues in Japan explain, younger people in Japan tend to need serious subsidies from their parents in the process of setting up their own families. Thus, Japan increasingly looks like Switzerland: a very rich country, with a high standard of living, but one that is growing very slowly.

Indeed, Japan is, at the margin, appropriately de-industrializing, deploying the corporate cash flow represented by depreciation into the rest of Asia, notably China , rather than redeploying it in replacing and upgrading the aging, depreciating Japanese capital stock itself. In a way, Japan is assuming a role in Asia similar to the role of New York City and Silicon Valley in America : a rich, high-value-added hub. It’s a cool destination for a country, but once the destination is reached, it is very difficult for a nation to be a robust source of global aggregate growth.

In the end, Morgan, global aggregate demand growth is all about increased consumption per capita, and by definition, only emerging markets have the capita – to wit, lots and lots of young people! – to play that role.

MLF:  Stop, Mac, you are waxing philosophically ahead of me. Slow down! If China is not yet mature enough to want to shift from mercantilism to consumerism, and Japan is too demographically-challenged to become a nation of spendthrifts, to whom is America supposed to hand off the global aggregate demand growth baton? Europe? Are you kidding me?

PM:  I wish I knew, Princess, I wish I knew. In the fullness of time (my way of saying the long-term), the currently-emerging countries must receive the hand-off. That’s the way the world works in the fullness of time. After all, America was once an emerging country! The tricky thing is that time ain’t yet full. You are right, of course, that Euroland, at least so-called Old Europe, does not have the right stuff.

It’s got many of the same demographic challenges as Japan , as well as the anti-demand pain of falling real wages for the young, as cradle-to-grave socialist policies, including employment policies, give way to the reality of global capitalist competition. What is more, Europe is shackled with decidedly un-Keynesian aggregate demand policies, led by inflation nuttery at the ECB.

In this regard, Japan is a lot better off than Euroland, in that the BOJ is an enlightened reflationist, committed to printing Yen – including for the purpose of buying dollars – with no limit until the inflation dog finally comes home. In contrast, the ECB specializes in preaching the joys of deflationary pain and regrettably practices what it preaches, on its own score by refusing to print up Euros to sell against dollars, so as to temper deflationary appreciation in the Euro and one-step removed, in advocating that fiscal policymakers pursue pro-cyclical tightening in a deflationary lacuna.

And if it weren’t so sad, I would laugh at the ECB’s latest self-tied knot in its Calvinist shorts:

Headline inflation is above the ECB’s 2% target, rendering the ECB unwilling to ease (intervening against the appreciating Euro and/or cutting short rates), but the primary reason headline inflation is above the ECB’s target is administrated price hikes, as fiscal authorities put up taxes to try to appease the ECB’s call for fealty to the Growth and Stability Pact, which is fundamentally flawed in that it does not cyclically-adjust deficit structures.

MLF:  That’s called chasing your tail, Mac. I’ve seen dogs do it, and cats do it. But not grown up people. Heck, even I don’t do it! Rabbits are smarter than dogs and cats. You do know that, right, Mac?

PM:  I’ve no public opinion on that, Morgan. I have many dear friends who have dogs and cats as pets. I ain’t stupid! But you are right that the ECB is chasing its tail in a most silly way. I highly doubt that Euroland could be an engine of global demand growth even with proper Keynesian aggregate demand policies, but without such policies, I’m totally convinced that Euroland isn’t ready to grasp the global aggregate demand baton.

MLF:  So, the bottom line is that America ’s gotta keep carrying the load? Goodie! I like living beyond my means. But doesn’t that imply that the unsustainable U.S. current account deficit is actually sustainable, that the world hates it but can’t live without it? In the end, is that what my Plan is all about: sustaining the unsustainable until the world is ready for the unsustainable to be unsustained?

PM:  Bingo! As you said at the outset, not all problems, assuming they are problems, need to be fixed on the wire. The world is simply not ready for America to put on tight trousers, which would expose the rest of the world to be wearing no trousers. Your Plan is all about bridging to a day when the world is ready to start spending beyond its means.

And that day awaits, I think, the maturation of emerging countries, to the point where they have sufficient confidence in themselves to not just invest in themselves, but to encourage their peoples to enjoy the fruits of that investment. My best buddy, Mohamed, is working on a framework and timeline for when this will happen, and he’s promised to share it with you first, even before me. But what he’s already revealed to me is that time ain’t yet full.

MLF:  Cool dude, that Mohamed, even if his dog Malik wants to eat me on Sunday mornings, when he comes over for those long walks with you. What is it about Boxers: are they wired for weirdness? That dog scares the bejesus out of me. It is beyond me why you two guys let him lap that big tongue of his about your ears.

But enough about Malik; he’s just another force that will be sustained, even if he shouldn’t be, unlike Mohamed, who I really, really like. And his gorgeous daughter, too, who slaps me about the ears, just for fun. What is this thing Mohamed calls “externalities” about my Plan? Does he want to live outside, too, like me?

PM:  No, sweet Morgan, he doesn’t want to live outside. Rather, he’s concerned that the more the world monetary architects follow your plan, the greater is the risk of global bubbles in asset prices, both financial assets and property, which when they burst, will send the world into a deflationary death spiral. In which case, Morgan, your Plan will be viewed as colossally ill-conceived, if not just plain stupid. Better, he believes, that the Plan be wound down sooner rather later, and to be replaced by a more sustainable Plan, with less nasty externalities for the world. And your reputation, I might add, Princess.

MLF:  I appreciate that he’s worried about my reputation, even though it is just fine, thank you very much, given that you don’t let me have boyfriends. Just what is his better Plan? Does he believe global aggregate demand is sufficiently strong for America to drink the Calvinist Kool-Aid? 

PM:  Calm down, Morgan, Mohamed is a man of moderation in all things. He ain’t talking about chugging said Kool-Aid, just starting to sip it. His Plan doesn’t preclude your Plan, but rather would hopefully provide a place besides a post-bubble global deflationary depression on the other side of the bridge of your Plan.

MLF:  Fair enough, I suppose. I ain’t smart enough to forecast ‘round two corners, so it is also hard for me to forecast what happens on the other side of my bridge. Right now, I’m just in favor of not falling off the bloody bridge. I’m tired of this discussion: my Plan is the Plan du jour until somebody comes up with a better Plan.

I ain’t got any objection to that; in fact, I favor that. Better is better than good and my Plan is just good; but nobody else has got a plan that is better and can be, or will be implemented right now. I live in the right now, Mac, don’t you know that?

This discussion is boring me. What do you want to talk about instead: who’s going to replace Greenspan, or what the Sam Hill the President wants to do with Social Security? And by the way, who is this Sam Hill guy you are always talking about, but never have invited over to play with me? 

PM:  Stop being impetuous; you don’t need to pick up all of my bad habits, just some of them. What do you say we talk about Social Security, something that you know very well, even if your social security is privately funded by me. It isn’t so easy at the national level, Morgan, as Social Security doesn’t have a Sugar Daddy in the wings, as you do. May I tell you the bald truth about Social Security, Morgan? Are your tender – and yes, very cute, I hasten to add – ears ready for the unvarnished, unabridged truth?

MLF:  If I can handle you coming out here at 4 am in the morning in your skivvies to feed me, Mac, I can handle about anything. Fire away!

PM:  Social security is a welfare program, not a retirement program. Always has been and always will be. It is a social contract between generations, with the young funding on a pay-as-you-go basis an honorable duty to protect the old from a destitute journey into life’s sunset. As a matter of financial architecture, Social Security is not anything like the ERISA-grounded retirement plans for which PIMCO manages huge portfolios.

President Roosevelt “sold” Social Security as a retirement plan simply because it could not be politically sold as a welfare program, even though that is what it is: old people didn’t/don’t want to admit that they take “welfare” from their children, but rather want to believe that they are “getting a return” on what they “paid in.”

Thus, Social Security taxes are commonly called “contributions” and people – many who should know better! – talk about various scenarios of the rate of return on those “contributions.” This is the essence of current talk about how young people would be better off, getting a “higher return” on the Social Security taxes if they were allowed to keep those “contributions” and invest them themselves. Such talk drives me crazy.

Uncle Sam spends Social Security “contributions” the moment that they hit his bank account, just like he does all other tax revenues. Indeed, Uncle Sam has to float debt securities – like $100s of billions of them every year – so as to have sufficient cold, hard cash to pay his bills. The Social Security Trust Funds are nothing but an accounting apparatus, to which a credit is given in real-time for current payroll tax receipts in excess of current  Social Security payouts. 

Uncle Sam doesn’t invest the present positive difference, but spends it on other things. And even that excess is not enough, of course, which is why the Treasury has to borrow additional money. There are no Trust Funds, Morgan, at least in the context of the Trust Funds of those people you see floating by everyday in those fancy yachts while I’m at work. Uncle Sam runs a cash business, spending every bit of cash that comes in, plus that which he borrows.

And there, I want to stress, is nothing inherently wrong with this. There is no theoretical need for Uncle Sam to pre-fund future Social Security payments. They are not legal claims of America ’s individual citizens, but rather a moral commitment made through the political process. Indeed, the Supreme Court has explicitly ruled that “to engraft upon Social Security a concept of ‘accrued property rights’ would deprive it of the flexibility and boldness in adjustment to ever changing conditions which it demands.” (Flemming v. Nestor).

I do not, Morgan, have a “property right” in my expected future Social Security benefits. To wit, I can’t sue Uncle Sam for them. Accordingly, logic implies that there is no a priori reason that Uncle Sam should put aside cold, hard cash to make sure that he can pay my expected future benefits. The collateral, if I may call it that, backing my future benefits is nothing more than a bet that the democratic political process will decide to pay them. And, quite frankly, I see no particular reason that Jonnie’s generation should vote to send me a check as current law says Uncle Sam will.

By the way, Morgan, did you know that the symbol of America was not always Uncle Sam, that bearded dude? Prior to him, the American symbol was a chap named Brother Jonathan, a clean-shaven man created by the great 19th century political cartoonist, Thomas Nest. I should tell Jonnie about this sometime. He might be impressed. Not!

Back to the subject at hand….

MLF:  Cut to the chase, Mac. You really can be boring sometimes. Did you know that?!?!

PM:  Fair enough. Here’s the bottom line:

Social Security is a welfare program , a real-time income transfer program between generations, not a retirement plan or an investment plan. It pays out on a progressive basis, (lower replacement ratios at higher covered income levels, known as the “bend points”), and taxes on a regressive basis (higher tax rate on aggregate income for lower income levels, which are all covered income, with no social security taxes at all – only Medicare payroll taxes, as imposed by law signed by President Clinton in 1993 – on income above the covered ceiling, presently $90,000).

I submit that Social Security is the most successful social program ever conceived, as a welfare program. Unlike the case with my grandparents, Jonnie’s grandparents don’t have to worry about a painful, destitute old age. I’m more than happy that my Social Security taxes – not “contributions” – are providing such a safety net for both Jonnie’s grandparents and other children’s grandparents. I’d do it personally if Social Security didn’t exist.

MLF:  But wouldn’t it be more efficient for you to just do it personally, Mac, rather than channeling your money through Washington , where more than a little of it is probably flittered away? Your right-of-center partners at PIMCO are right, don’t you know, that Washington transfers money with all the efficiency of watering the potted plants here on the patio with a fire hose. They ain’t wrong, Mac; government really is an inefficient apparatus.

PM:  That’s true, Princess, very true: government is inefficient versus the private sector. But then, democracy is also inefficient relative to a dictatorship. Efficiency is not always good. And it is bad when it undermines the concept of the will of the people, as expressed through the democratic process. I really do believe, Morgan, in the notion that all men and women are created equal, and in the democratic concept of one person, one vote.

It would surely be more efficient for me to take care of my parents directly, rather than funneling the money through Washington . But there are two huge problems with that more efficient solution: (1) Mom and Dad, from a moral perspective, do not want to take “welfare” directly from me, while they are comfortable doing so indirectly, believing they are just “getting back” their Social Security “contributions” and (2) not all sons and daughters have either the will or the wallet to do for their parents what I would gladly do for mine.

Social Security binds us together as generations and as a civilized country. Yes, there is an element of coercion to it, but then so are a lot of other institutional arrangements in a civilized society. High-church libertarians just get too wrapped around the axle about such matters.

MLF:  Okay, Mac, if Social Security is a welfare program, why in Sam Hill is it not means-tested? Welfare for the rich funded by regressive taxes on the poor offends me! I live well here on the bay, but you don’t ask your colleagues to pay taxes to subsidize my outrageous lifestyle. If your payroll taxes have already been spent, mailed out to your parents’ generation, why should Jonnie’s generation send you and people like you checks, when you will clearly not need them?

Do you somehow think you are entitled to them? Are you a hypocrite, Mac? Doesn’t honesty say that you should stand up and say that your means provides the means for a comfortable retirement and that you reject taking welfare from the less fortunate? Are you a man or a mouse, Mac: squeak up!

PM:  Hush, Morgan. I don’t need to squeak, but rather shout: Means-test Social Security and means-test me ineligible! I have zero problem with the wonderful principled populist stance you are taking, Princess. You are absolutely right, period. You’ve been listening more than I thought during our 4-in-the-morning chin wags.

MLF:  That ain’t enough, Mac. Only the full truth can set you free. Are you willing to forego receiving Social Security benefits even without the President’s proposed bribe of letting you keep some of your payroll taxes and put them in IRA-like accounts, so as to inject steroids in your wealth-building mojo? You willing to go that far, ole mustachioed one?

PM:  Done, Morgan. Done! I don’t need to be bribed to do the right thing as a citizen. What is right is what is right. Politically, of course, this whole Social Security Reform debate will be a whiter shade of pale, as it should be in a democracy. But your point is the essential point, Morgan: equity and justice demand that reformers always have in the back of their minds that Social Security is a welfare program, and welfare is moral only when it is means-tested.

MLF:  Heavy stuff, Mac. I’d call you a limousine liberal, except that you drive a VW Bug. Can you be a Beetle liberal? Whatever, it’s too early in the morning for such existential stuff. You gotta get to work. Can I have the last word on that other subject you wanted to talk about – who’s going to replace Greenspan?

PM:  Certainly, Morgan. The floor is all yours, as I ain’t got much to say on that subject that I haven’t already said: It’s probably going to be Marty Feldstein, a good choice; it could be Glenn Hubbard, not a bad choice; and I wish it would be Ben Bernanke, a most excellent choice. But beyond that, I don’t really have anything to say now; but will in the months ahead, when I’m writing for myself and not chin wagging with you. How are you handicapping the succession race, Morgan?

MLF:  Can’t argue with your betting line, Mac. Gentle Ben – I love it when I call him that! – should be the man, but is unlikely to be the man. But the other two men would be fine, if they turn out to be the man. Unless, of course, the man turns out to be a woman, like me, which would be way beyond cool.

It’s a damn shame that Janet Yellen is a Democrat, though saying that is a paradox, because I wouldn’t like her so much if she cloaked herself in Republican ideologies. In that case, she’d be an elephant in a donkey’s halter. In which case, I wouldn’t want her to be Fed chairperson anyway.

PM:  Enough for now, Morgan. As you say, I gotta get to work. Wiggle your ears and say goodbye to our friends, Princess.

MLF:  Thank you, Mac. It’s been real. And to show you and everybody else that I ain’t just a pampered wisecrack, let me close on a serious note, in the spirit of the season:

May God bless you and keep you,

May God’s face shine upon you and  
be gracious to you,

May God lift up his countenance upon you,

And give you peace.


Paul A. McCulley 
Managing Director
December 16, 2004


1  “The Morgan le Fay Plan”, Fed Focus, November 2002.

2  “A Debtor’s Blessing”, Fed Focus, November 2004.   


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