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Monetizing Debt.... Everyone Needs To Understand What We Mean

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Do you really understand what people mean when they say the US is monetizing debt?

I struggled at first, but think I have reached a basic understanding - so here is my explanation:

We normally think of money as paper or coin currency with some intrinsic value. Goldbugs will say money is fiat because countries stopped backing their currencies with gold and silver, however, we all accept that a dollar or pound was worth 'something' in exchange because we can buy goods and services with it. How much you can buy is controlled by inflation which is a function of increase in asset base and money supply. So for example, if your money supply increased and asset base stayed the same you would expect one unit of currency to buy less. Conversely if your asset base increased and money supply stayed the same each unit would buy more.

I've never really understood goldbugs desire for metal-backed currencies since the price of the reserve metal would have to float to deal with changes in metal availability, economic growth, exchange rates etc. I'll leave others to debate that.

The greatest financial 'innovation' of the past 20 years has been deregulation of financial markets which created a whole new class of securities based on derivatives. This was largely driven by the US which sought to maintain its economic dominance during the 1980s and then 90s. The motives now look murky but the headlines were plausible and centered on more efficient markets, greater liquidity, and all the other good sounding catchphrases. Skeptical France and Germany took different approaches resulting in socialized industry and finance. The scene was set for a race between the hare and the tortoise.

Most here are now aware that mortgages were securitized, i.e. the promise of house owners to pay off their loans, were packaged and sold as investments, with the underlying house value as security. These securities are derived from a contract between the house owner and the lender, hence the term Derivatives. There are many other forms of derivative such as Calls and Puts on Oil Price movements, grain prices etc. Now the point is this. These debts were turned into securities, which in turn are traded like assets. They have effectively been monetized. What is more, these 'assets' are now held in banks as securities and contribute to their financial stability ratios. Read that one again, debts are now held by banks as assets (Tier 2).

Now its fair to point out the house is a store of value. But what if house prices get inflated by a global event like low interest rates, and what then if prices fall in tandem across the world. Would you rather put your money in a bank underpinned by securities based on derivatives or one with cash, stock and gold?

This may read like a bad A-level essay .... I'm an engineer so feel free to award low marks out of ten and submit your corrections.

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We normally think of money as paper or coin currency with some intrinsic value. Goldbugs will say money is fiat because countries stopped backing their currencies with gold and silver, however, we all accept that a dollar or pound was worth 'something' in exchange because we can buy goods and services with it.

no, fiat has value because you have to use it to pay taxes and non-payment of taxes results in imprisonment.

How much you can buy is controlled by inflation which is a function of increase in asset base and money supply. So for example, if your money supply increased and asset base stayed the same you would expect one unit of currency to buy less. Conversely if your asset base increased and money supply stayed the same each unit would buy more.

you mention the supply of money - don't forget the demand (taxes) ;)

Edited by InternationalRockSuperstar

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Good post bpw.

Yes, it seems rather fragile to base reserve ratios on assets which can fluctuate a lot in price. It's like building a house on shifting sands.

IMO, it is a much better idea to have full reserve banking. The whole process of "putting money to work" sounds like marketing speak for creating and spending money on speculation.

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Do you really understand what people mean when they say the US is monetizing debt?

....These debts were turned into securities, which in turn are traded like assets. They have effectively been monetized. What is more, these 'assets' are now held in banks as securities and contribute to their financial stability ratios. Read that one again, debts are now held by banks as assets....

Banks have always held debts as assets - nothing new in this.

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I guess thats true, especially for those who are not savers.

no, fiat has value because you have to use it to pay taxes and non-payment of taxes results in imprisonment.

you mention the supply of money - don't forget the demand (taxes) ;)

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This may read like a bad A-level essay .... I'm an engineer so feel free to award low marks out of ten and submit your corrections.

I`m a complete layman in finance...its posts like these when I learn the most,even if there may be errors in them...

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I knew, that...just wondering what people mean when they say the US is going to escape the consequences of too much debt by monetising it.

MBS, CDOs and the credit crunch are all signs of too much debt used as assets, too little money to settle the debts as they come due.

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Dunno if this helps, but this shows how I think the direct monetization of debt puts cash into the economy and bank reserves. For the uk, think "Bank of England = FED" an "Debt Management Office = Treasury".

Debtmonetization.jpg

The second box relates to what the FED appears to be doing by stealth,( see Denninger, ). It seems to be buying large fractions of debt issue a week or so after the event, buoying up auction prices presumably by prior arrangement with the Primary Dealers in the capital markets who buy the debt off the Treasury and hold it for a few days to turn a profit when they sell to the FED...?

Bear in mind, extra reserves (say £175Bn ) are multiplied up in normal circumstances by (1/reserve ratio), which under normal times is about 1/0.08 = 12x.....

Now, 175Bn x 12 = ? A LOT OF EXTRA CASH TO BE LOANED INTO EXISTENCE.

EDIT: here's a link re stealth monetization:

http://www.nakedcapitalism.com/2009/08/mon...rmation-in.html

In a brilliant piece of investigative reporting, Chris Martenson (original article here) has uncovered that the Fed, merely a week after issuing $28 billion in 7 year bonds (which Zero Hedge discussed previously) via its puppet, the US Treasury, of which $10 billion ended up being purchased by primary dealers, has turned and bought 47% of the primary allocated bonds in Open Market Purchases. This is undisputed monetization removed simply via one primary dealer and less than 5 days of temporal separation in order to leave no easy trace. As Martenson points out:

"A more honest and open approach would have been for the Fed to simply buy them outright at the auction but this way, using "primary dealers" and "POMOs" and all these other extra steps the basic fact that the Fed is openly monetizing US government debt is effectively hidden from a not-too-terribly inquisitive US press and public."

The question is did the Fed implicitly tell the primary dealers they are merely holding the treasuries for a flip, and that it would acquire them immediately. Absent this $4.8 billion in effectively monetized bonds, what would the Bid To Cover have been for the primaries? Would this have been the second practically failed auction for USTs after the deplorable 5 year auction results a day prior? One wonders if there would have been 62% indirect interest in these bonds (which the day before had a measly 32.5% indirect bid) if the purchasers were aware of the Fed's immediate prompt monetization of a large part of the directs' balance.

Edited by chris c-t

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People seem to mean two different things when they use the term monetization.

1. Turning a thing into money.

2. Replacing a thing with money.

I'm not 100% sure the second is really correct, but I think it is the more common use of the word on this board. It tends to relate specifically to the replacement of government debt with new money. (QE / printing money).

Of course, that assumes that the new money is to finance govt. spending and borrowing, rather than the other way around.

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Thanks Chris - I'll try and understand this in writing:

Normal operation: the Treasury issues treasuries of various kinds, Tbills, etc., which are bought using 'real money' by the Markets. The 'markets' may be overseas governments, or domestic consumers like pension funds. In effect the government are increasing their debt levels by borrowing, after which the markets trade the treasuries as tho they are "money". Now i presume this new "money" appears in M2 or M3 which are measures of money in the market system? Nothing too worrying here since the US and UK are historically good creditors and pay back principle and interest with real money. The 'net' part of the transaction here is the interest paid on the loan.

The normal model works fine if your economy is in good shape and there are no problems with paying back the loan. There is of course a caveat, and that is inflation, if the treasury interest is less than the rate of inflation then the lender is effectively getting a negative rate of interest since their buying power is reducing. We would all be pretty circumspect if we invested enough money to buy a house in Tbills only to find it was worth .9 houses when they matured. of course, this is the situation today with treasuries paying 1-2% and real inflation running at 4-8% depending on the asset class (e.g. clothes vs. houses, i.e. CPI vs HPI).

Now, the second box Denninger shows there is something sneaky going on. He is referring to quantitative easing which sounds like passing a large turd. The Treasury is now selling to the capital markets, foreign governments, and now the FED (via indirect means). The FED has become the lender of last resort. More important is to realise the FED is buying US debt. Likewise the BOE is buying Debt Management Office debts. So where is all the money coming from? And, where do these new treasuries end up. Is it true that the FED buys the treasuries from the banks a week or so after issue? If so, I presume the banks make a profit (i.e. taxpayer ends up with a loss), also does the Fed exchange real money for the promissory notes? If so, where does it come from? I presume it means the FED is creating money i.e. 'printing' it.

The final point about leveraging through fractional reserve banking is also important. It means we are 1) printing money at a time when the economy is shrinking, and then 2) leveraging it n-fold. If this is true, then inflation has to take place. Yet we don't see any sign of it because the rate of monetary inflation is less than economic deflation. Do I have that right? And if so, what happens when the deflation stops? Do we see a surge in inflation? If so I am am starting to understand how countries like Argentina got into a huge mess with double digit inflation.

So there you have it, the FED and BOE are currently passing a large turd with the Taxpayer being made to swallow it. :ph34r:

Edited by bpw

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The Treasury is now selling to the capital markets, foreign governments, and now the FED (via indirect means). The FED has become the lender of last resort. More important is to realise the FED is buying US debt. Likewise the BOE is buying Debt Management Office debts. So where is all the money coming from?

Just computer digits created by the FED or BofE, increasing their balance sheets accordingly.

And, where do these new treasuries end up. Is it true that the FED buys the treasuries from the banks a week or so after issue?

The Fed / BofE hold the Treasuries or gilts outright on their balance sheet too.

If so, I presume the banks make a profit (i.e. taxpayer ends up with a loss), also does the Fed exchange real money for the promissory notes? If so, where does it come from? I presume it means the FED is creating money i.e. 'printing' it.

Yes, they credit the accounts of the primary dealers with newly electronically born money.

The final point about leveraging through fractional reserve banking is also important. It means we are 1) printing money at a time when the economy is shrinking, and then 2) leveraging it n-fold. If this is true, then inflation has to take place. Yet we don't see any sign of it because the rate of monetary inflation is less than economic deflation. Do I have that right?

There is apparently an enormous fight going on between (inf/def)lation, but the powers that be DO have the tools to tip it into the favour of inflation if they so wish (and I believe they would rather have inflation than deflation, because it is more easily controllable.) Foe example, the BofE could start to charge banks interest (instead of paying interest) on the huge reserve balances they now leave overnight with the BofE. This would be like pass the parcel with a money bomb.

And if so, what happens when the deflation stops? Do we see a surge in inflation? If so I am am starting to understand how countries like Argentina got into a huge mess with double digit inflation.

I think the key is that once the Money Velocity picks up, we will see a surge in inflation. This means the relending of all the newly created dosh up to the reserve ratio. Of course, the powers that be could also lower the banks' reserve requirements (happened in Saudi last year) but this increases the exponentiation once it gets going so could be very dangerous.

I don't think there is an effective means of destroying the newly created QE money.

So there you have it, the FED and BOE are currently passing a large turd with the Taxpayer being made to swallow it. :ph34r:

Exactly, as I see it, you'd better make sure you dont appear to have huge amounts of savings (means testing for everything will be on its way soon!). Also be prepared to have your income and expenditure taxed to the extreme. It will be a lot harder to save for the future soon.

Edited by chris c-t

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it is very simple.

You issue, I.o.u's, in exchange for some earnest work, goods and services, promising to pay back with extra work goods and services in your currency.

You then print money, which has no work goods and services to back it up, and buy up your IOUs on the market.

Thats the defintion of montarising the debt.

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I think Chris makes some great points there. The amount of money, the Bank of England has printed out of fresh air, has to be put into perspective. The whole idea here, is that the burden of debt, and the vast inflation of housing, outstrips peoples income and ability to service huge often fraudulent ponzi/bubble phase debts.

This means, debt deflation is inevitable, which supposedly means a decline in house prices as defaults take hold, a decline in expansion of credit, a decline in incomes, which means a decline in house prices through foreclosure and default, which means a decline in credit, which means a decline in funny money incomes etc etc

The Bank of Englands aim, is not only to prevent debt deflation, but also to expand lending to similar levels as 2007. A hundred and 75 billion, is 175,000 million, which is an incredible number. This is money completely backed by no goods and services. And it normally would have vast multiplier effects, of around 1.5 trillion, as the new money creates huge new reserves for the monopoly banking sector to lend out.

But the argument is that the bank's losses are even bigger, and therefore the money will not be lent out....

Edited by brainclamp

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Oh, by the way to make my point about reserve balances, the FED publish this:

http://www.federalreserve.gov/releases/h41/Current/

which has the lines:

Millions of dollarsreserve balances of depository institutions at            Week ended   Change from week ended     WednesdayFederal Reserve Banks                                     Aug 5, 2009 Jul 29, 2009  Aug 6, 2008  Aug 5, 2009Reserve balances with Federal Reserve Banks                 718,034   -   46,586   +  707,676      719,511So, you see on a year ago, the reserve balances have gone up from $48Bn to $718Bn..
Edited by chris c-t

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I think Chris makes some great points there. The amount of money, the Bank of England has printed out of fresh air, has to be put into perspective. The whole idea here, is that the burden of debt, and the vast inflation of housing, outstrips peoples income and ability to service huge often fraudulent ponzi/bubble phase debts.

This means, debt deflation is inevitable, which supposedly means a decline in house prices as defaults take hold, a decline in expansion of credit, a decline in incomes, which means a decline in house prices through foreclosure and default, which means a decline in credit, which means a decline in funny money incomes etc etc

The Bank of Englands aim, is not only to prevent debt deflation, but also to expand lending to similar levels as 2007. A hundred and 75 billion, is 175,000 million, which is an incredible number. This is money completely backed by no goods and services. And it normally would have vast multiplier effects, of around 1.5 trillion, as the new money creates huge new reserves for the monopoly banking sector to lend out.

But the argument is that the bank's losses are even bigger, and therefore the money will not be lent out....

... and no-one will want to borrow. Though it may take a bit for "asset illsuion" to wear off... i guess this is what is driving the current government sponsored bounce.

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This may read like a bad A-level essay .... I'm an engineer so feel free to award low marks out of ten and submit your corrections.

I`m a complete layman in finance...its posts like these when I learn the most,even if there may be errors in them...

Oh my.

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... and no-one will want to borrow. Though it may take a bit for "asset illsuion" to wear off... i guess this is what is driving the current government sponsored bounce.

True, but the QE money cannot be destroyed...so ..... eventually.....

http://jsmineset.com/2009/03/25/in-the-news-today-147/

There is no means to drain this from the monetary system as the Fed would have you believe. It is in the system, not in a make believe black hole somewhere. It is staying in the system, and it will destroy what is left of the system...
Edited by chris c-t

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True, but the QE money cannot be destroyed...so ..... eventually.....

http://jsmineset.com/2009/03/25/in-the-news-today-147/

If the housing market never recovers [reflation fails] then won't that money effectively re-capitalize the banks and keep them afloat as they write-off loans and cover losses in the future?

I guess it comes down to whether you see reflation or deleveraging on the horizon.

Edited by roman holiday

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For those interested in this. Here's an excellent film on the subject. (Been posted on here several times before)

It's in 8 parts. Quite a long watch but well worth it.

Money as Debt II Promises Unleashed

NB. This is the sequal to Money as Debt. Also worth watching.

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Like your approach. I studied engineering (EE) at university, but once I got out, I started writing and have never looked back. But I appreciate the way you approach a topic; go the base, then build upon truth. That works. A lot of posters on this forum start with a conclusion and then try to justify it; doesn't work.

To take your piece a step further, the problem here is a money quantity issue, not what "backs" the money. Who controls the quantity? Having banks create money out of nothing -- or worse, other debt (as you point out rightly) -- is insane. It's like having the fox guard the henhouse. Only the federal legislature should control the quantity of the ULTIMATE public resource -- money. Only the are electable. We can't elect bankers.

Do you really understand what people mean when they say the US is monetizing debt?

I struggled at first, but think I have reached a basic understanding - so here is my explanation:

We normally think of money as paper or coin currency with some intrinsic value. Goldbugs will say money is fiat because countries stopped backing their currencies with gold and silver, however, we all accept that a dollar or pound was worth 'something' in exchange because we can buy goods and services with it. How much you can buy is controlled by inflation which is a function of increase in asset base and money supply. So for example, if your money supply increased and asset base stayed the same you would expect one unit of currency to buy less. Conversely if your asset base increased and money supply stayed the same each unit would buy more.

I've never really understood goldbugs desire for metal-backed currencies since the price of the reserve metal would have to float to deal with changes in metal availability, economic growth, exchange rates etc. I'll leave others to debate that.

The greatest financial 'innovation' of the past 20 years has been deregulation of financial markets which created a whole new class of securities based on derivatives. This was largely driven by the US which sought to maintain its economic dominance during the 1980s and then 90s. The motives now look murky but the headlines were plausible and centered on more efficient markets, greater liquidity, and all the other good sounding catchphrases. Skeptical France and Germany took different approaches resulting in socialized industry and finance. The scene was set for a race between the hare and the tortoise.

Most here are now aware that mortgages were securitized, i.e. the promise of house owners to pay off their loans, were packaged and sold as investments, with the underlying house value as security. These securities are derived from a contract between the house owner and the lender, hence the term Derivatives. There are many other forms of derivative such as Calls and Puts on Oil Price movements, grain prices etc. Now the point is this. These debts were turned into securities, which in turn are traded like assets. They have effectively been monetized. What is more, these 'assets' are now held in banks as securities and contribute to their financial stability ratios. Read that one again, debts are now held by banks as assets (Tier 2).

Now its fair to point out the house is a store of value. But what if house prices get inflated by a global event like low interest rates, and what then if prices fall in tandem across the world. Would you rather put your money in a bank underpinned by securities based on derivatives or one with cash, stock and gold?

This may read like a bad A-level essay .... I'm an engineer so feel free to award low marks out of ten and submit your corrections.

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Right. As I understand it -- and my knowledge is very thin in this area -- but when the mortgage-back derivative market collapsed, essentially everyone was owing everyone a titanic amount. Estimates are wild, but some say 140 trillion dollars, some say 2-3 times that amount. Privately owned central banks injecting 10 T into this mess in order to clear up some of these debts isn't really going to fix much.

Look at it from this perspective, if your neighbor came over and said, "I need to refinance my house, but my bank just won't do it. How about giving me $100,000 to pay off my bank loan, and I'll give you a 30-year note for same at a reasonably high rate of interest -- let's say 10%. Oh, don't worry, if I default, then you'll be first in line of my creditors."

Would you shell out $100,000 in this climate? Way too risky! Here in the US, there is even a question that the new administration may void such private contracts at will. This happened already, it's not some fearful speculation. No one knows which way this is all going to go. The outcome has so much to do with intricate politics in every major nation. There are only two things that are for sure:

1. The outcome under the current debt-money system -- the average person's standard of living in the US and UK is going to decline sharply.

2. That there is a way to fix this, namely forbid governments from borrowing. If they can't raise it from taxation, they can't buy anything. No More National Debt!

I think Chris makes some great points there. The amount of money, the Bank of England has printed out of fresh air, has to be put into perspective. The whole idea here, is that the burden of debt, and the vast inflation of housing, outstrips peoples income and ability to service huge often fraudulent ponzi/bubble phase debts.

This means, debt deflation is inevitable, which supposedly means a decline in house prices as defaults take hold, a decline in expansion of credit, a decline in incomes, which means a decline in house prices through foreclosure and default, which means a decline in credit, which means a decline in funny money incomes etc etc

The Bank of Englands aim, is not only to prevent debt deflation, but also to expand lending to similar levels as 2007. A hundred and 75 billion, is 175,000 million, which is an incredible number. This is money completely backed by no goods and services. And it normally would have vast multiplier effects, of around 1.5 trillion, as the new money creates huge new reserves for the monopoly banking sector to lend out.

But the argument is that the bank's losses are even bigger, and therefore the money will not be lent out....

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I think the answer to your first question is no.

Remember, the banks bought into this housing inflation bubble like no other entity. If they can't re-inflate, they are holding huge negative assets.

In response to your second; I guess I see a combination of both. The banks see it as the best compromise among bad choices. In reality, this is a partial Biblical Jubilee where debts are forgiven every 50 years. We are seeing it right before our eyes, but no one wants to use those terms lest we have massive defaults among mortgage payers.

A Reuters story last week said that about half of U.S. mortgages will be underwater within 18 months, double from what it is today. Delinquencies are spiking in all mortgage categories to historic highs. Make no mistake, the system is still collapsing. I think central banks are only trying to manage the collapse as best they can.

Again, the prime cause is national debts. This level of interest payments by governments is totally unsustainable.

If the housing market never recovers [reflation fails] then won't that money effectively re-capitalize the banks and keep them afloat as they write-off loans and cover losses in the future?

I guess it comes down to whether you see reflation or deleveraging on the horizon.

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I think the answer to your first question is no.

Remember, the banks bought into this housing inflation bubble like no other entity. If they can't re-inflate, they are holding huge negative assets.

In response to your second; I guess I see a combination of both. The banks see it as the best compromise among bad choices. In reality, this is a partial Biblical Jubilee where debts are forgiven every 50 years. We are seeing it right before our eyes, but no one wants to use those terms lest we have massive defaults among mortgage payers.

Our banks look to be going the same way as the Japanese ones. I am not so sure about whether they should be called "zombies" but I guess they will survive. What will not survive is the merry-go-round of credit/debt extension of yesterday, which has to be a good thing; the debt cycle and with it consumer psychology are in the nascent stages of being broken. I hope that when reform comes, fractional reserve banking, will be ditched or seriously revamped. It has to be one of the main culprits here.

Whether the US government could issue its own money, I am not sure. Don't you think there are political obstacles to this? Namely, that democratic government American style is very limited and seeks to limit all sorts of powers. Wasn't one of these constitutional limits on the issuance of money where it had to be coined in monetary metal; in a sense it is external to government because it could be considered "natural" as opposed to an artifice of goverment. Wouldn't the constitution need to be revamped for your monetary model to be instituted?

A Reuters story last week said that about half of U.S. mortgages will be underwater within 18 months, double from what it is today. Delinquencies are spiking in all mortgage categories to historic highs. Make no mistake, the system is still collapsing. I think central banks are only trying to manage the collapse as best they can.

Again, the prime cause is national debts. This level of interest payments by governments is totally unsustainable.

I agree, the system is irreparably damaged, I do not see us going back to normal anytime soon. The bond kings at Pimco are talking about a "new normal" and a generation of stagnation. When you consider that the super-bubble of credit/debt expansion these past twenty years was abnormal in the first place, maybe we could say we are just returning to normality, one which our frugal grandparents would understand.

Would you agree that growth is over-rated? imo of more importance for a monetary system is stability. This latter was sacrificed to the former. I wonder if money has to be intrinsically valuable if the monetary system is to be stable, so that at some times people will want to save it and at other times spend it.

Edited by roman holiday

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