Category Archives: Notes on Economics

Bizarre Anecdotes at the Fed

At its May meeting, the Fed prepared markets for a rate hike that it never intended to result in an inevitable move when it announced the bias toward tightening. But the FOMC did end up raising the FFR in June, despite the fact that April’s jump in the core CPI appeared to be a one-off event rather than an indication that inflation had begun to accelerate. So why did the Fed act?

As the transcripts reveal, the Fed’s new instrument failed to affect markets in the way the Fed anticipated:

I was startled by the extraordinary market talk after we announced an asymmetrical directive following the May meeting. . . We might as well have raised rates at that point as far as I am concerned. . . . Indeed, what we are looking at is a long-term interest rate that is moving up because market participants think the Fed is going to move (Greenspan, Transcript, June, p. 88).

Thus, because markets were anticipating a rate hike, some saw the increase as preordained, arguing that raising the federal funds rate was “largely a foregone conclusion” (Boehne, Transcript, June, p. 44). Others, such as President McTeeter and Vice Chairman McDonough believed that conditions did not merit an increase and that the Fed should show restraint until such time as inflation appeared to resurface:

[T]he public and markets everywhere are waiting for us to pounce on growth and job creation and stifle them. Since I do not believe we should do that, I believe that our challenge is to clarify out strategy – first to ourselves, then to the public and the markets. . . . we should not be in a tactical position of being constantly poised to attack an enemy that does not appear visible to me. We need to find a way to tactical symmetry – to a position where we, the public, and the markets think we are watchfully waiting but not looking for windmills to knock down (McDonough, Transcript, June, p. 48).

Thus, while some felt compelled to validate the market’s expectations in order to maintain credibility, others believed that a rate hike was unwarranted in the absence of troublesome news on the inflation front. After much deliberation, the FOMC felt compelled to move, voting to raise the FFR 25 basis points at the close of its June meeting.

To justify the June increase, members argued that despite a drop in the core CPI, there were reasons to believe that inflationary pressures were mounting. Some truly strange anecdotes were offered as “evidence” of these pressures. For example, President Broaddus relayed the following story:

One of our economists [from the First District] has a close friend who has a house in the Boston area. The friend got an estimate last year for an addition to his house but didn’t have the work done. He got an estimate again just recently, a year later, and it’s up about 30 percent. That’s really extraordinary!” (Transcript, June 1999, p. 40).

And President Minehan shared the following:

The job market for summer teenage employment is strikingly good if my 17-year old and his friends are any indication of that market” (Transcript, June 1999, p. 37).

No one offered any tangible evidence of pipeline inflation. Yet the majority – many of whom felt ‘boxed in’ by the May directive – clearly wanted to raise the FFR. Ultimately, they justified their move for the record by offering anecdotal evidence and impassioned commentary about the importance of credibility and the need to fulfill market expectations.


  1. Bell-Kelton, Stephanie. “Behind Closed Doors. The Political Economy of Central Banking in the United States.” International Journal of Political Economy 35.1 (2006): 5-23.



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Why didn’t Canada have a Banking Crisis?

The structure and performance of financial systems is path dependent. The relative stability of the Canadian banks in the recent crisis compared to the United States, where the recent crisis originated in the shadow banking system and spread to the universal banks, in our view reflected the original institutional foundations laid in place in the early 19th century in the two countries. The Canadian concentrated banking system that had evolved by the end of the twentieth century had absorbed the key sources of systemic risk—the mortgage market and investment banking—and was tightly regulated by one overarching regulator. In contrast the relatively weak and fragmented U.S. banking system that had evolved since the early nineteenth century, led to the rise of securities markets, investment banks and money market mutual funds combined with multiple competing regulatory authorities. The consequence was that the systemic risk that led to the crisis of 2007-2008 was not contained.

The historical origins of the U.S. system go back to the early national period when the states obtained the right to charter and regulate the banks. Supporters of Hamilton’s vision of an active federal government were able to charter the First and Second Banks of the United States, but opposition to federal control from a variety of sources including opposition from advocates of a narrow construction of the constitution, especially in the South, and opposition from the state chartered banks themselves, prevented the development of nationwide branching systems. Each state separately, jealous of its power to charter banks, prohibited branches of banks chartered in other states; an exclusion that was endorsed by the U.S. Supreme Court. The result was a fragile, crisis prone, banking system, but one that for all its weaknesses was deeply entrenched politically. Inadequate financing from a weak and fragmented banking system in turn led to heavy reliance on security markets for industrial finance. This may have contributed to rapid economic growth, but it also contributed to financial instability when stock market crashes and the failure of investment banks triggered financial panics.

Attempts were made to reform the system, but the fundamental structural weaknesses persisted. The national banking system was set up during the Civil War, but the state banks were allowed to continue, and to protect them the national banks were prevented from branching across state lines, resulting in America’s dual banking system. The Crisis of 1907 produced the Federal Reserve System, and the Crisis of 1929-33 produced Federal Deposit Insurance and an end to the gold standard. These were important reforms that contributed to stability, as did the rapid increase in federal debt in the portfolios of financial intermediaries during World War II. But despite these reforms the fundamental structural weaknesses of the U.S. financial system, a fragmented banking system regulated by a patchwork of regulatory agencies, survived intact. Although, some stability was achieved in the 1950s and 1960s, this system was undermined by the inflation of the late 1960s and 1970s. In the 1980s a weakened savings and loan sector collapsed with massive losses, but the crisis did not engulf the financial system as a whole. In this respect the Savings and Loan Crisis was more reminiscent of the troubles that affected, but were largely confined to, the savings bank sector in 1877-1878. Various reforms were put in place to deal with the savings and loan crisis, but again the fragmented banking and regulatory system remained in place. In short, even costly financial crises failed to generate sufficient political pressure for reform to overcome entrenched special interests.

The financial system recovered from the Savings and Loan Crisis and from a number of scares that might in different circumstances have triggered a panic: the Latin American Debt Crisis in 1982, the failure of Continental Illinois in 1984, the failure of Drexel Burnham (the junk bond investment bank) in 1992, and the failure of Long-term Capital Management 1998, among others. But the rapid growth of the “shadow banking system” in the late 1990s and early 2000s produced an environment in which major failures, although addressed by the Federal Reserve, ignited a panic. Opinions on the most important causes for the growth of the shadow banking system tend to diverge along political lines. The Report of the U.S. Financial Inquiry Commission (2011), reflecting the majority of Democrats on the Commission, attributed the growth of the “shadow banking system” to an ideological turn toward less regulated markets and political clout of regulated industries achieved through lobbying and campaign contributions. The dissenting Republicans put more weight on the Federal Reserve’s accommodative monetary policy and government housing policies.

What is clear is that the crisis of 2007-8 was…a return to the full-scale financial crises of the nineteenth century. Once again unregulated or lightly regulated sectors of the financial system, now dubbed the shadow banking system, proved to be the source of trouble. The details in terms of financial institutions and instruments were unique in 2008, but below the surface there were strong parallels with the nineteenth-century crises. True, prompt actions by the Federal Reserve and other agencies mitigated the damage. When a run on the MMMFs threatened, deposit insurance was extended, ending what might have been an extremely destructive run. Nevertheless, the macro-economic consequences of the crisis of 2008 rival those of the nineteenth-century crises. The Canadian story is very different.

The Canadian banking system began with note issuing branching banks which were more robust than their neighbours to the south. The system became stronger when double-liability was required to get a bank charter and as entry restrictions produced an oligopoly. By 1920 five large banks dominated the system and while new banks could enter the market they faced a formidable challenge in competing with the incumbents. Later in the twentieth century the Canadian chartered banks were able to absorb both the mortgage banks and investment dealers and become true universal banks. These institutions were regulated by an overarching regulator, OFSI, which basically contained the development of an unregulated shadow banking system and restricted the proliferation of securitization and off balance sheet entities. In terms of stability, to put it somewhat differently, the Canadian system benefitted from the “Grand Bargain” in which the Canadian banking oligopoly was protected from competition, especially from American banks, in return for tough regulation.

An attempt was made beginning in the 1980s to encourage the U.S. system to move in the direction of the Canadian system, but this did not happen. This reflected the legacies of the nineteenth century: a dual banking system, a strong shadow banking system, heavy reliance on financial markets, and multiple competing regulators. Even more basically it reflected longseated opposition to allowing the financial system to be dominated by a tightly regulated oligopoly. This opposition to the establishment of a British style oligopoly (which is embedded in the Canadian grand bargain) goes back to the beginnings of the Republic and once that option was rejected political economy considerations prevented it from ever being adopted.


  1. Bordo, Michael D., Angela Redish, and Hugh Rockoff. “Why Didn’t Canada Have a Banking Crisis in 2008?” The Economic History Review 68.1 (2014): 218-43. Web.

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Robert Shiller on the history of home prices


The late nineteenth century and early twentieth century saw many local bubbles surrounding the building of highways, canals, and railroads, bubbles that do not show up in the national numbers on our chart. Obviously, it is plausible that the land surrounding such construction projects would suddenly become valuable. Even in days gone by, when land was so abundant that one could buy it, in some places, for a dollar an acre, there could be real estate booms. If land prices were to go up to two dollars an acre near a new rail line, an investment could double in value, and this prospect could be quite exciting to investors. Regional real estate booms are nothing new.

The sharp fall in home prices after World War I probably had something to do with the great influenza pandemic of 1918–19, which infected 28% of Americans and killed 675,000 of them. This epidemic caused people to stay at home and not look for new homes. It must have damaged the economy and also distracted attention and conversation away from the housing market. There was also an unusually severe recession in 1920–21.

It is notable that there was no boom in home prices to accompany the sharply rising stock market of the Roaring Twenties. The famous Florida land bubble of the 1920s was not big enough to show up in these national numbers. Home prices were not carried along by the stock market and did not overshoot, nor did they drop when the stock market crashed starting in 1929. There was, however, a drop in nominal home prices after 1929; that is, home prices fell at just about the same rate as the Consumer Price Index fell. The drop in nominal home prices, when mortgage debt was not indexed to inflation, gave many homeowners negative equity in their homes and an incentive to default on their mortgages. In addition, the high unemployment rates during the Great Depression meant that many could not renew their short-term mortgages and so were forced to default on them and thus lost their homes. But we should not mistake the housing crisis of the early 1930s for a decline in real home prices. Real home prices showed remarkable stability over the whole boom-and-bust cycle of the stock market surrounding 1929.

This brings us to the most significant episode in the national home market until recent times: the sharp home price increases associated with the end of World War II. It is clear that there were large real home price increases at least in the big cities at this time, although the exact magnitude of the increases may not have been well measured.

This does not appear to have been a runaway speculative boom. Home prices did not overshoot their new postwar equilibrium, and they did not have to come crashing back down. Newspaper accounts of the housing market did not use the term housing bubble, nor did they feature stories of crazy homebuyers buying just about anything to stay ahead of the curve, like those we were reading about in the early 2000s. The story that one gleans from the newspapers just after World War II is quite different.

Government restrictions had severely limited the supply of new homes during World War II. After the war, returning soldiers wanted to start families; they were about to launch the Baby Boom. Prices of existing homes actually started increasing after 1942, before the war was over, probably because people anticipated the shortage of housing that was to follow. But, even though demand soared after the war, there was no real buying panic, as the conventional wisdom of the time was that construction would soon greatly increase the stock of available homes.

The Servicemen’s Readjustment Act of 1944, also called the GI Bill of Rights, immediately introduced the subsidization of home purchase for seventeen million people. This major government subsidy did not go away, and it helped lead to permanently higher home prices. But it did so in the context of the solidarity of the American people, and it never ignited a speculative atmosphere. President Franklin Roosevelt said that the GI Bill of Rights gave “emphatic notice to the men and women of our Armed Forces that the American people do not intend to let them down.” The people who bought at the high prices right after the war were those who felt that they could not wait to get settled in their new homes, not people who were speculating that prices would go up even higher. Other people simply found a temporary place to live and waited for the expected decline in home prices (which never came) or for their savings to increase to the point that they could afford housing. The fact that, after World War I, real home prices had gone through a protracted period of decline must also have served to diffuse any speculative worries. People must have remembered that episode in the aftermath of World War II. A widespread worry then that the Great Depression of the 1930s would reappear after the stimulus of the war ended further deflected any worries that home prices would soar.

It appears that people were for the most part not afraid of being priced out of the market, and that they did not fully anticipate the home price increases to come. They counted on new construction to prevent any severe price rise—and indeed, construction of new homes rose from 142,000 homes built in the United States in 1944 to 1,952,000 homes built in 1950. Even though this massive increase in supply did not stop price increases, the popular understanding seems to have been that it would.

It has been different in this century. We are increasingly feeling worried and vulnerable, and the market volatility that flares up from time to time, in both the stock market and the housing market, reflects this. Before the post-1997 boom, there were a couple of false starts (failed launches, so to speak), one in the late 1970s and one in the late 1980s. These were actually regional booms that did not extend so much to the nation as a whole. The 1970s boom was mostly confined to California, and the 1980s boom occurred on both the west coast and the east coast.

Figure 3.2 shows the path of real home prices for four U.S. cities. Prices in Boston and Los Angeles have gone through two dramatic swings, and at the end of the sample period shown, prices were soaring. But, in sharp contrast, prices in Miami and Phoenix completely missed the first of these two booms. Boston held much of its value increase—in 2014, remaining over twice its 1983 real value— but Miami and Phoenix hardly changed at all in real value between 1983 and 2014.


It is commonly said that there is no national home market in the United States, only regional markets. There is something to that statement, but it is not completely true and appears to be getting less true. While many markets in the United States had been highly stable and trendy, there were enough markets that were moving rapidly by the mid-2000s that the national series began to show signs of life, and it continues to be lively.

The period of home price increase starting in 1998 in the United States was concentrated in some states and metropolitan areas, and where it was concentrated, there were many stories about the psychological correlates of the boom. Stories abounded in the U.S. during the bubble years 2000–2006 of aggressive, even desperate, bidding on homes, of homes selling the first day on the market for well above the asking price, of people buying homes in a rush to beat the market—homes that they had sometimes hardly even had a chance to look at. People were afraid that the price of housing would soon rise beyond their means and that they might never be able to afford a house, and so they rushed to bid on homes. But, in other cities, where there was not a history of home price volatility, there were few such stories, and investors were relatively less reactive to home price changes.


  1. Shiller, Robert J. Irrational Exuberance. Princeton: Princeton UP, 2016. Print. 23-26


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The 10 essential causes of the global financial crisis

I. Credit bubble. Starting in the late 1990s, China, other large developing countries, and the big oil-producing nations built up large capital surpluses. They loaned these savings to the United States and Europe, causing interest rates to fall. Credit spreads narrowed, meaning that the cost of borrowing to finance risky investments declined. A credit bubble formed in the United States and Europe, the most notable manifestation of which was increased investment in high-risk mortgages. U.S. monetary policy may have contributed to the credit bubble but did not cause it.

II. Housing bubble. Beginning in the late 1990s and accelerating in the 2000s, there was a large and sustained housing bubble in the United States. The bubble was characterized both by national increases in house prices well above the historical trend and by rapid regional boom-and-bust cycles in California, Nevada, Arizona, and Florida. Many factors contributed to the housing bubble, the bursting of which created enormous losses for homeowners and investors.

III. Nontraditional mortgages. Tightening credit spreads, overly optimistic assumptions about U.S. housing prices, and flaws in primary and secondary mortgage markets led to poor origination practices and combined to increase the flow of credit to U.S. housing finance. Fueled by cheap credit, firms like Countrywide, Washington Mutual, Ameriquest, and HSBC Finance originated vast numbers of high-risk, nontraditional mortgages that were in some cases deceptive, in many cases confusing, and often beyond borrowers’ ability to repay. At the same time, many homebuyers and homeowners did not live up to their responsibilities to understand the terms of their mortgages and to make prudent financial decisions. These factors further amplified the housing bubble.

IV. Credit ratings and securitization. Failures in credit rating and securitization transformed bad mortgages into toxic financial assets. Securitizers lowered the credit quality of the mortgages they securitized. Credit rating agencies erroneously rated mortgage-backed securities and their derivatives as safe investments. Buyers failed to look behind the credit ratings and do their own due diligence. These factors fueled the creation of more bad mortgages.

V. Financial institutions concentrated correlated risk. Managers of many large and midsize financial institutions in the United States amassed enormous concentrations of highly correlated housing risk. Some did this knowingly by betting on rising housing prices, while others paid insufficient attention to the potential risk of carrying large amounts of housing risk on their balance sheets. This enabled large but seemingly manageable mortgage losses to precipitate the collapse of large financial institutions.

VI. Leverage and liquidity risk. Managers of these financial firms amplified this concentrated housing risk by holding too little capital relative to the risks they were carrying on their balance sheets. Many placed their firms on a hair trigger by relying heavily on short-term financing in repo and commercial paper markets for their day-to-day liquidity. They placed solvency bets (sometimes unknowingly) that their housing investments were solid, and liquidity bets that overnight money would always be available. Both turned out to be bad bets. In several cases, failed solvency bets triggered liquidity crises, causing some of the largest financial firms to fail or nearly fail. Firms were insufficiently transparent about their housing risk, creating uncertainty in markets that made it difficult for some to access additional capital and liquidity when needed.

VII. Risk of contagion. The risk of contagion was an essential cause of the crisis. In some cases, the financial system was vulnerable because policymakers were afraid of a large firm’s sudden and disorderly failure triggering balance-sheet losses in its counter-parties. These institutions were deemed too big and interconnected to other firms through counter party credit risk for policymakers to be willing to allow them to fail suddenly.

VIII. Common shock. In other cases, unrelated financial institutions failed because of a common shock: they made similar failed bets on housing. Unconnected financial firms failed for the same reason and at roughly the same time because they had the same problem: large housing losses. This common shock meant that the problem was broader than a single failed bank–key large financial institutions were undercapitalized because of this common shock.

IX. Financial shock and panic. In quick succession in September 2008, the failures, near-failures, and restructurings of ten firms triggered a global financial panic. Confidence and trust in the financial system began to evaporate as the health of almost every large and midsize financial institution in the United States and Europe was questioned.

X. Financial crisis causes economic crisis. The financial shock and panic caused a severe contraction in the real economy. The shock and panic ended in early 2009. Harm to the real economy continues through today.


  1. Causes of the Financial and Economic Crisis pages 417-419 (

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Winston Churchill on the economics consequences of the Treaty of Versailles



The economic clauses of the Treaty were malignant and silly to an extent that made them obviously futile. Germany was condemned to pay reparations on a fabulous scale. These dictates gave expression to the anger of the victors, and to the failure of their peoples to understand that no defeated nation or community can ever pay tribute on a scale which would meet the cost of modern war.

The multitudes remained plunged in ignorance of the simples economic facts, and their leaders, seeking their votes, did not dare to undeceive them. The newspapers, after their fashion, reflected and emphasized the prevailing opinions. Few voices were raised to explain that payment of reparations can only be made by services or by the physical transportation of goods in wagons across land frontiers or in ships across salt water; or that when these goods arrive in the demanding countries they dislocate the local industry except in very primitive or rigorously-controlled societies. In practice, as even the Russians have now learned, the only way of pillaging a defeated nation is to cart away any movables which are wanted, and to drive off a potion of its manhood as permanent or temporary slaves. But the profit gained from such processes bears no relation to the cost of the war. No one in great authority had the wit, ascendancy, or detachment from public folly to declare these fundamental, brutal facts to the electorates; nor would anyone have believed if he had. The triumphant Allies continued to assert that they would squeeze Germany “till the pips squeaked”. All this had a potent bearing on the prosperity of the world and the mood of the German Race.

In fact, however, these clauses were never enforced. On the contrary, whereas about £1,000 million of German assets were appropriated by the victorious Powers, more than £1,500 millions were lent a few years later to Germany principally by the United States and Great Britain, thus enabling the ruin of the war to be rapidly repaired in Germany. As this apparently magnanimous process was still accompanied by the machine-made howling of the unhappy and embittered populations in the victorious countries, and the assurances of their statesmen that Germany should be made to pay “to the uttermost farthing”, no gratitude or good-will was to be expected or reaped.

Germany only paid, or was only able to pay, the indemnities later extorted because the United States was profusely lending money to Europe, and especially to her. In fact, during the three years 1926 to 1929 the United States was receiving back in the form of debt-instalments indemnities from all quarters about one-fifth of the money which she was lending to Germany with no chance of repayment. However, everybody seemed pleased and appeared to think this might go on for ever.

History will characterise all these transactions as insane. They helped to breed both the martial curse and the “economic blizzard”, of which more later. Germany now borrowed in all directions, swallowing greedily every credit which was lavishly offered her Misguided sentiment about aiding the vanquished nation, coupled with a profitable rate of interest on these loans, led British investors to participate, though on a much smaller scale than those of the United States. Thus Germany gained about fifteen hundred million pounds sterling in loans as against the one thousand millions of indemnities which she paid in one form or another by surrender of capital assets and valuta in foreign countries, or by juggling with the enormous American loans. All this is a sad story of complicated idiocy in the making of which much toil and virtue was consumed.


  1. Churchill, Winston. The Gathering Storm. Boston: Published in Association with the Cooperation Pub. Houghton Mifflin, 1948. Print. 6-9.


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Classical Economics and Methodology

On Classical Economics

The methodological question at issues during the classical period were very similar to those that were late to agitate neoclassical and modern economists. The controversies in classical methodology included:

  1. Abstractions versus “reality
  2. Varying concepts of causation
  3. The role of mathematics
  4. The “scientific” claim of economics, and
  5. The practical relevance of classical economics

Adam Smith’s Methodology

Adam Smith’s Methodology was eclectic. The empirical, the theoretical, the institutional, the philosophical, and the dynamic were all intermingled. His definitions shifted, sometimes on the same page, and, in the course of developing his classic work, he drifted back and forth between difference conceptions of “value,” “rent,” and “real.” But, despite the numerous ambiguities in The Wealth of Nations commented on by Smith’s classical successors, as well as by the late scholars, he moved easily around the pitfalls without disaster, being sufficiently consistent during any given chain of reasoning to avoid errors in logic.

David Ricardo’s Methodology

With Ricardo economic took a major step toward abstract models, rigid an artificial definitions, syllogistic reasoning – and the direct application of the results to policy. The historical and institutional, and the empirical faded into the background, and explicit social philosophy shrank into a few passing remarks. Comparative static became the dominant – though usually implicit – approach. Ricardo declared: “I put these immediate and temporary effects quite aside, and fix my whole attention on the permanent state of things which will result from them.” Not only Ricardo, but also his disciples and popularizers, reasoned in comparative static terms – and they automatically interpreted the theories of others in comparative static terms as well.


1. Sowell, Thomas. On Classical Economics. New Haven: Yale UP, 2006. Print. 79-80.

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Classical Economics and Say’s Law

On Classical Economics

Say’s Law in Classical economic involved six major propositions:

  1. The total factor payments received for producing a given volume (or value) of output are necessarily sufficient to purchase that volume (or value) of output.
  2. There is no loss of purchasing power anywhere in the economy, for people save only to the extent of their desire to invest and do not hold money beyond their transactions needs during the current period.
  3. Investment is only an internal transfer, not a net reduction, of aggregate demand. The same amount that could have been spent by the thrifty consumer will be spend by the capitalist and/or the workers in the investment good sector.
  4. In real terms, supply equals demand ex ante, since each individual produces only because of, and to the extent of, his demand for other goods (Sometimes this doctrine was supported by demonstrating that supply equals demand ex post).
  5. A higher rate of savings will cause a higher rate of subsequent growth in aggregate output.
  6. Disequilibrium in the economy can exist only because the internal proportions of output differ from consumers’ preferred mix – not because output is excessive in the aggregate. In short, this implied that there was no such thing as an equilibrium level of national income.

The first three proposition were never in dispute among any of the recognized economists of the classical period, orthodox or dissenting. These propositions served to refute popular fears that the rapidly growing output and sharp depression of that period implied that some absolute limit to economic growth had been reached. The general glut economists were as zealous in refuting these popular notions as were the supporters of Say’s Law…

…The last three propositions were the focus of controversy. The fundamental disagreement was over the classical denial of an equilibrium aggregate output (number 6).


1. Sowell, Thomas. On Classical Economics. New Haven: Yale UP, 2006. Print. 26-27.

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