Cassandras and the Global Financial Crisis

<> <> Spirited Conversations: Nelson, 29 October 2009.

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<>Keywords: History of Ideas, Methodology & Philosophy;   Political Economy & History;

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<>This evening’s presentation is about two terms which are homophones. I shall begin by talking about prophets – spelt p-r o-p-h-e-t-s. Later I shall talk about p-r-o-f-i-t-s. Both have a number of meanings, not least the p-h-e-t kind.

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<>For instance, the biblical prophets were men who were – as the Concise Oxford Dictionary says – ‘inspired teachers [and] revealers or interpreters of God’s will’. Typically they were telling their fellow Hebrews that they were no longer following God’s path and they should change their ways. Famously, they were without honour in their own country, because they were often in conflict with the Establishment – the Temple and the secular authorities in Jerusalem – who sometimes took action to suppress the prophets – in a notable case, crucifying one.

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<>The Concise Oxford also gives as a second distinct meaning of a prophet as one ‘who foretells events’. It comes from the notion that a prophet is close to God, and since God knows the future, He or She is able to convey some insights to a faithful servant. That was not a role given to the Hebrew prophets, although there is an obvious sense in which practical men and women who are wise and who understand, and stick, to the fundamentals are likely to predict more of the future correctly than those who ignore the basics.

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<>The notion of the prophet with the gift to see the future probably derives from the Greeks. The most famous was the Delphic Oracle dedicated to the god Apollo. It was notorious for giving ambiguous predictions. The most famous was to Croesus of Lydia who was told that if he made war on the Persians, he would destroy a mighty empire. This prediction proved to be correct, except the empire that Croesus destroyed was his own.

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<>Almost as famous is the Trojan Prophetess, Cassandra, who again got her gift of foresight from Apollo. When she spurned him Apollo, unable to reverse the gift, decreed that while her predictions would be accurate, nobody would believe her. So when she warned against bringing the Trojan horse inside Troy’s walls, she was ignored. What would a mere girl know about warfare? Today, ‘the curse of Cassandra’ applies to those who give valid warnings which are disbelieved.

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<>Often we are not aware of the Cassandras until after they have been proved correct. Here I am referring only to those who have the ‘gift from the gods’. All sorts of people make wild predictions of doom and gloom; some are going to be right by accident. Those who matter are experts who know the fundamentals and apply them more rigorously, just as the Hebrew prophets did. A modern day prophet also depends on the accumulated knowledge over the years – albeit a far more massive literature than was available to the Hebrews.

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<>In these days God seems to have withdrawn from direct involvement in human endeavour, so no-one can claim to have a special relationship which enables them to predict the future. The withdrawal has been exchanged with the gift of scientific understanding (including of social phenomena). Insofar as today’s prophets have any claim to foresight, it arises from this science, this understanding of the fundamentals, a willingness to pursue their logic rigorously and, most importantly, the courage to speak out even if the message is not acceptable to those in authority – to ‘speak truth to power’ as a recent book on New Zealand public intellectuals was titled.

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<>Certainly before the crash happened there were thoughtful economists who were aware that the international financial system was problematic. The roll call includes Robert Shiller who coined the phrase ‘irrational exuberance’, George Akerlof, Paul Krugman, Joseph Stiglitz and New Zealander Robert Wade – as impressive a galaxy of today’s economists as you are likely to come across. Their thoughtful contributions are based upon earlier economists such as John Maynard Keynes and a lesser known, but increasingly respected, Hyman Minsky. Keynes’ works seems to have been banned in some of America’s most prestigious universities. Not surprisingly their sometimes eminent economics teachers do not have an impressive record analysing the Global Financial Crisis is concerned.

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<>I do not propose to discuss much why the international Cassandras were not listened to; one example will suffice. Robert Wade, who holds a chair in economics at the London School of Economics, got into a debate with a Times journalist Anatole Kaletsky, who now admits theat he got things terribly wrong. He blames his mistakes on being misled by economists. He should have listened to Wade instead of those who spouted the conventional wisdom.

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<>New Zealand’s conventional wisdom was little better. My local paper reprinted an article by Kaletsky; it has had no off-setting contribution from Wade. Nor did it report the Cassandras at the time, nor afterwards. It is extraordinary how those who got the boom embarrassingly wrong are still uncritically given opportunities to share their ‘wisdom’. After all, they might get it right one day, mightn’t they?

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<>The journalists do not generally fess up that they have contributed to misleading you – let’s give Kaletsky credit for doing so. Nor will they go to the Cassandras that they ignored in the past. The purpose of their publications seems to be to entertain and comfort; not to inform and provide guidance about the future. In any case, like Kaletsky, how would the journalists know? They just publish the conventional wisdom.

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<>Remember that in the early 1990s the Establishment made a concerted effort to squeeze their critics out of the media. It is not clear how the media responded, but around that time the critics of the conventional wisdom found it harder to get media access. Ironically, in 1998 a now retired editor of the Dominion complained that the economy was in still in difficulties and nobody told him it would be. There were economists saying these things, warning against the irrational exuberances of the interpretation of the upswing out of the Rogernomics Recession but nobody wanted to listen – or at least the media did not want to publish what they said. As the editor said, the self -censorship was costly.

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<>‘Rogernomics Recession’? Now there is an expression you dont hear much. Yet while the rest of the world flourished, between 1986 and 1993 the New Zealand economy stagnated – for over seven years. Per capita GDP was lower at its end than at its beginning, One of the reasons we dont discuss this stagnation, is that acknowledging the recession would undermine their credibility who want to repeat policies that are associated with the period.

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<>Another reason is that the fall in incomes did not apply evenly. Generous tax cuts were given to the rich whose real after tax income continued to rise roughly in line with what they had experienced in the pre-Rogernomics era. So they dont have a sense of the stagnation and decline that the majority of the community experienced. They would be astonished that in a four year period almost half the labour force ended up as unemployed at some time or other. It understandable that those who want further tax cuts for themselves do not want to draw attention to what happened last time.

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<>What about this recession? Did anyone in New Zealand forecast it or parts of it? Almost certainly, but their forecasts were not given much prominence. For instance, in 2005 a senior funds manager predicted ‘[l]ooking forward over the next 12 months, it is highly likely that one or two finance companies will default’. In 2006 National Finance 2000, Provincial and Western Bay Finance all failed. He was not alone. Some worries even surfaced in the media. However if you offset the occasional report of a Cassandra with the deluge of reports implying the sector and finance houses were sound, you get a sense of a misleading imbalance.

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<>Even so, ordinary investors has no comeback on the journalists. The information was available to them and their advisers. But accessing it required more diligence than just lazily reading a newspaper or watching TV. Democracies dont suppress their Cassandras, they ignore them.

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<>The problem with prediction is that the future is so dependent on events nearly impossible to predict. About a decade ago I began writing about a ‘millennium recession’ based on my reading of the world economic track and the underlying imbalances that were evident then. A millennium recession did not immediately eventuate, for I failed to predict the destruction of the Twin Towers and the way it strengthened the George Bush presidency so he could drive through major tax cuts which stimulated the economy out of the recession. I hope you will forgive me for not being an expert on terrorism – the CIA failed too.

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<>I also underestimated the fiscal radicalism of the Bush junior administration. Unlike his father’s – more like Ronald Reagan’s – it increased the US Government deficit by spending more (especially on warfare) and cutting taxes. This huge injection increased production in the US and the rest of the world, the world economy lifted and the millennium recession seemed to have been avoided.

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<>Or was it only deferred? The Bush measures did not address the structural imbalances which led to my original prediction – indeed they exacerbated them. Because US dollars are the international medium of exchange, a US government deficit injects cash into the world economy. To reduce that possibility of inflation, the US Government sells bonds (fixed-interest debt securities) to absorb the money. Although bonds cannot be used to pay bills, they can be easily converted back into cash, especially when interest rates are low. So the result of the US deficit was an enormous increase in the world economy’s financial liquidity and imbalances.

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<>Meanwhile other countries – China, Japan and the Middle East oil producers – ran large savings surpluses which they invested in the US, keeping its interest rates low. It might seem unwise to invest in a bank which was recklessly borrowing from the rest of the world and spending the proceeds on wars in Afghanistan and Iraq and lending the rest so that its American owners could consume goods and services. In fact, the overseas investors have taken a pounding from the falling US exchange rate. If inflation is the falling value of money, the devaluing US dollar is a form of inflation.

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<>Flush with the liquidity at low interest, the US financial institutions (and their equivalents in Europe) generated all sorts of fancy financial assets – including sub-prime mortgages – many of which are today called ‘toxic assets’. There’s a lot of talk about the need for better financial regulation. I don’t disagree, but given the surplus of liquidity (cash and near cash), I am sceptical that any regulation could have prevented all the abuses. It was a bit like putting teenagers into a casino with their pockets full of chips and telling them to restrain themselves.

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<>The result of these toxic investments were artificial profits for the financiers (that is the f-i-t kind). One estimate is they amounted to US$5 trillion over five years. It may not be right, but let’s use it for illustrative purposes. In which case output it would have been stimulated by about 3 to 5 percent of world GDP.

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<>What we are now seeing is the unwinding of those artificial profits. But the US$5 trillion of artificial profits must be removed from the financial assets of the world first. Hence the balance-sheet crisis. The monetary authorities tried to moderate the impact of the crisis by bailing out the financial institutions overwhelmed by their toxic assets. In effect the tax payers took over the artificial profits. I’ll come to the fiscal implications shortly.

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<>Today the core of the financial system sees itself saved, and appears to be proceeding on the basis that since things are back to normal, and they can get on to their usual practices, which include paying generous bonuses. To do this they have to ignore their critics, not to mention the many angry taxpayers who bailed them out. The London Economist described the extravagant bonus payments as ‘political suicide’.

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<>But if the banking system had collapsed, the system of payments would have, and so would have the entire economy. The taxpayers had to fund institutions whose previous behaviour was at best incompetent. Taxpayers were blackmailed.

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<>There is not too much of a consensus as to what needs to be done to the financial system in terms of practical detailed policy terms. I’d like to think that the finance sector is not as out of touch and as stupid as they present themselves. Perhaps they know the game will be up, so they are robbing the tills before they are sacked. Or do they think that the financial system is so powerful and adaptable they can ride out the storm of public abuse?

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<>Cassandras point out that the imbalances which precipitated the Global Financial Crisis are still there, so the world is still vulnerable to another great crisis. Not immediately, it will take a while for the irrational exuberance to wind up again. But it is possible that when the next crisis occurs, the fiscal positions of governments will be weaker than this time, so bailouts under blackmail may be less successful.

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<>The more immediate problem is that the Global Financial Crisis has compromised the productive economy. That is what a recession is about. The shortage of credit meant that investment and trade became more limited; that means less production and fewer jobs.

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<>Now you have been told that the recession is over because that is what people want to believe. Cassandras are more cautious. They are not into bumper sticker slogans, but careful analysis. It goes something like this.

<>The notion ‘recession’ does not have a precise meaning in formal economics. It usually refers to the phase in the business cycle between the boom and the trough when economic activity does not grow as fast as usual, and may even contract. Normally the economy rebounds so quickly that not a lot of attention is given to the trough phase before the rebound. The quick rebound is often described as a ‘V’ recovery. If the recovery phase of the business cycle is slower but ‘normal’, it can be called a ‘U’ recovery.

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<>Nobody seems to think the world is getting a V recovery – although some countries are, especially China (and, hence, Australia). Optimists think the general recovery will be a U, although there is a fear it may be a ‘W’, a recessionary downswing, followed by a short recovery, and then another downswing. The view arises from a belief that America’s fiscal injection (more government spending and lower taxes) has been enough to prevent a slump turning into a depression, but insufficient to lift the economy onto a sustainable growth path. The gloomier think that such fiscal injections are not sustainable without generating inflation.

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<>The claim that New Zealand’s recession has ended depends upon minuscule growth in a single quarter of real GDP, a statistic subject to measurement error. Over the next year unemployment, mortgage defaults and business closures will continue to rise at least through to the next year. Possibly there may be only a breather before there is a second downswing into the double dipper W.

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<>If the recovery is very weak, the economy runs along a kind of bottom sometimes described as an ‘L’. Such a trough can last quite a while. The Rogernomics Recession lasted over seven years (longer than the Great Depression, but not as deep), the ‘Long Depression’ of the 1880s almost seventeen years (but shallower than the 1930s). Notice that here the terms ‘recession’ and ‘depression’ are not simply referring to the downswing but also to the trough and recovery.

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<>Sitting under this is the fiscal crisis, not only here but in other countries especially the US and Britain. One source is the cost to the taxpayers of the financial bail outs – ultimately they have to write the artificial profits off their balance sheets. A second source is that measures to soften the recession – such as tax cuts and spending hikes – have added to the government debt, and hence debt servicing in the long run.

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<>In addition, the higher GDP track from the artificial profits cannot be sustained. If the world economy is likely to track out of the recession at about 3 to 5 percent lower than it went in, government spending track has to run that amount lower too, or tax levels has to be raised.

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<>This applies as much to New Zealand as any where else. We are going to see strenuous efforts to restrain government expenditure with less public spending than was projected (or promised) before the election. Every day there are reports of government actions which are examples of this restraint but you rarely see the news item put into the context of the fiscal crisis. For instant it was recently announced that the health budget will be cut a total of $1.5 billion over the next three years below that which was previously projected. That is the health sector’s contribution to the fiscal crisis. We shall be lucky if that is the last.

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<>Compounding the fiscal crisis are the demands for tax cuts. That may well be one of the reasons the conventional wisdom plays the crisis down. It is so obsessed with income tax reductions on the rich, that it will ignore any argument which suggests they would be imprudent. Ultimately, in the current circumstances tax cuts are a kind of Trojan horse which if brought into the city will destroy the welfare state.

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<>In my judgement, the current projections suggest the fiscal imbalance is so great that the burden of adjustment should not, and cannot, depend only on expenditure side restrictions. There will have to be rises in the tax burden including the possibility of co-payments and user charges.

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<>Now this forecast may be wrong. Perhaps something will turn up. Unfortunately the most likely events are on the downside. The world economy may go into a W or a L instead of a U recovery. There is a very real danger of high inflation, because key countries cannot wind back their monetary and fiscal injections. The fear for New Zealand is that the government will maintain a high fiscal deficit which will lead to an unsustainable debt path, while the engine of growth – the tradeable sector – gets crushed by the rising exchange rate.

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<>Unfortunately the national practice is to ignore the Cassandras and stick to the safe platitudes of the conventional wisdom, to ignore anything which contradicts that – even facts if necessary – to continue to rely on the prognoses of those who did not expect Troy to fall.

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<>Of course, Cassandra was wrong for nine and a bit years. But the loss when she proved correct more than outweighed the earlier gains – a bit like a financial crisis. Taking correct prediction into account leads to more prudent actions. So why do we ignore our Cassandras?

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<>One factor is laziness. If God, or whomever, has given us powerful tools of analysis which enable us to understand better the world in which we live, its complexity is such it is easier to resort to simplifications and slogans. So we repeat the conventional wisdom ad nauseam, rather than think through a critique. We assume someone else has done it, that the journalist has checked what that the person being reported has done an evaluation. However, typically the journalist relies on reputation conferred by the Establishment on the basis as to whether the ‘expert’ is supportive of its interests. Often the so-called expert’s thinking is little deeper than the journalist’s.

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<>In the 1980s I spent a lot of time years studying the arguments of the Rogernomes, going back to the primary papers they quoted (and sometimes misquoted). Their analysis seemed wrong. I dont mean that they had a hidden agenda to transform New Zealand – they had – but even given their objectives, their analysis seemed wrong. I thought they knew something I did not and I tried to find out what it was. Eventually I concluded that the Rogernomes just did not understand what they were talking about. Instead they took short cuts to conclusions consistent with their hidden agenda. There were sometimes terrible bloopers in their arguments; although it was not considered polite to mention them in public. This was one of the reasons why the economy performed so badly when it was driven by the Rogernomes. Reality did not match their theories.

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<>The Establishment has good reasons for preferring the superficial which confirms their prejudices to deep analyses which challenge it. Their power comes from a stability – ideological stability is a crucial part of that.. Unfortunately the story changes with time over time. I am struck by how the certainties of Rogernomics have been superceded and that people who were Rogernomes a couple of decades ago, now hold almost opposite views with equal certainty. They never admit the contradiction. Rather they ignore the change, and they ignore anything which might suggest they got things badly wrong – like the Rogernomics Recession.

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<>The conventional wisdom needs to be challenged and monitored. Every society needs to have an account of itself which is both stable and yet evolves, a paradox beautifully captured in Giuseppe Tomasi’s novel The Leopard, when its hero tells his nephew: ‘In order for things to remain the same, things are going to have to change.’ It is this evolution of the conventional wisdom which makes Cassandras so important.

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<>A baser reason for ignoring Cassandras is that the much of the conventional wisdom is self-serving. Take the claim that the housing market has recovered, and now is a good time to invest in housing. The fact is that housing prices are still over valued. They are most unlikely to rise at the rate they did in the last decade – it is possible they will largely stagnate for the next three and more years. It may still make sense to purchase your own house if you are starting a family, or if your life circumstances change; I cant tell you much about such decisions for they involve personal factors. What seems certain though, is if you purchase a house as an investment for renting out and capital gains you are not going to get a great return. Such an assessment is not great news if you are in the real estate business of selling houses. Better to encourage the public to invest; you still get your margin if they lose on the investment, the principle which underpinned the sub-prime housing fiasco.

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<>It is not only the real estate industry and other industries which act in a self-serving way. Lobby groups do too; I illustrated this earlier with the refusal of those who want to run a Rogernomics agenda to acknowledge the Rogernomics Recession.

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<>There is one final and major reason why the Establishment does not like prophets. The Hebrew prophets had an agenda of social justice which aimed to draw the attention to the Establishment’s focus on its own comfort thereby ignoring the struggles of those who were less privileged and underprivileged.

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<>This is nicely captured in a some paraphrases of the Jerusalem Bible by my good friend the Reverend Robin Lane.

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<>He suggests Amos 4:1-3 might be

<>            Listen to this word you cows of Remuera

<>            Lolling in your summer palaces on Waiheke,

<>            Oppressing the needy, crushing the poor,

<>            Saying to your husbands,

<>            “Bring us a glass of Bollinger”!

<>            …………………

<>            The day is coming to you now

<>            When the your bonds will turn to dust,

<>            And homes will go in mortgagee sales.

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<>Or Amos 5:22-24

<>            I despise your prayers to the GDP,

<>            Your worship of the share market.

<>            No more chanting about your stinking bonuses.

<>            But let justice flow like water

<>            And integrity like an unfailing stream.

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<>So the Hebrew prophets are about ethical understandings – quite different from the Cassandras which are about scientific understandings. As well as recognising the Cassandras we need to recognise the Amoses, those who remind us that there is not just a world that is, there is also a world that ought to be. We need to cherish both sorts of prophets, more than we cherish profits with a f-i-t-s.

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<>Have you noticed that we do when they are dead? I guess this is when they have left this country and gone to another, so now they may be honoured.

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<>I am not asking that we necessarily believe what the prophets say – perhaps in this secular world ‘public intellectuals’ is a better name for them. I am asking to respect their role. Respect means taking their pronouncements seriously, and carefully evaluating them.

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<>There is also the need for venues for the Cassandras to engage with the public, If the media is not going to provide them, then they have to be elsewhere. Blogs provide one such places – ‘Spirited Conversations’ another.

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<>But dont reject a public intellectual the easy way, because others have, or by attacking the person not the argument. That’s lazy. Demand a higher standard from the Establishment; you dont just want lazy responses, you want them to address the issue, not to ignore it. A public intellectual cannot ask for more. But in New Zealand we give them a lot less.

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