The US Crisis: “The Great Depression of 1929-1933”
Tue, 28 Sep 2010 02:34:00 +0400
“What’s past is prologue”W.Shakespeare
The United States of America was the world’s financial center and leading industrial nation in the 1920s. It is for this reason that the Wall Street Crash in the Fall of 1929 triggered the severest and most prolonged economic crisis in the whole capitalist world. Americans describe this systemic crisis as the Great Depression. Though it is known exactly when the crisis began it’s rather unclear when it ended. The crisis is believed to have finished in 1933 with the remaining years of this decade marked by recovery. As a result, many regard the entire 1930s as the period of the Great Depression. Reforms carried out by the team of F.D. Roosevelt who came to power in spring 1933 made it possible to overcome the crisis. The New Course is an illustrative example of successful emergence from the world’s deepest crisis.
US financial pyramids or how the bubble was blown out.
A scheme designed and implemented in the 1920s by Charles Ponzi is among the first and well-known scams in the US. Ponzi paid out ‘dividends’ to investors from amounts paid by new clients found by his associates who convinced people that Ponzi had a secret strategy for currency speculations or upon recommendations by investors already involved in the scam. Ponzi promised his investors 60 percent per annum (compared to the then interest rate of about 5 percent). In this way he managed to collect approx. $8 million in a relatively short period of time and involve several thousand people in his pyramid. To the investors’ great disappointment, their funds were simply stolen and Ponzi himself was arrested and imprisoned.
This rather simple scheme of Ponzi’s became the first sparrow in an entire flock that left their nest in 1927-1929. Significant events that laid the immediate foundation for the 1929 crisis were under way in the stock market and the sector of corporate financial organizations. This period is best described by the term “prosperity”. The second half of the 1920s was marked by a strong growth of stocks, higher personal income levels, increasing production and declining unemployment rates. The stocks index doubled from 1927 through January 1929 and by the Fall of 1929 added another 20 percent.
Many experts warned that such a spike in stock prices was very dangerous for the country’s economy but the victorious cry from the stock exchange, cheerful voices of the newly rich owners of securities and optimistic speeches by people who were then ruling the country, presidents C. Coolidge and H. Hoover, completely muffled concerns expressed by skeptics. The universal use of credit stimulated rising stock prices. Stock exchange loans or, in alternative wording, margin trading in securities, became widely spread. It meant that the buyer of securities could pay the entire price at once or get a loan from their broker to pay for these. In turn, the brokerage house credited only part of the securities price and the part covered the buyers themselves was called ‘the margin’. It should be noted that at those times brokerage houses received stock prices while crowds of their clients made transactions by cable. Brokers’ information was delivered to sea-going vessels by radio.
In late 1920s the share for which brokers provided their clients with loans reached 90% of the entire price. This meant the buyer paid cash only for 1/10 of the price of securities. Clients readily used this service and paid an interest on this loan as it was almost immediately compensated by a higher price of purchased stocks. The client became the owner of stocks which, however, remained as security with the brokerage house. This scheme generate huge profits for people who were after easy money. Without having enough resources to give loans to their clients, brokers took out loans from a variety of banks secured by the very stocks owned in fact by their clients but maintained as security. Given the high return of the so-called broker loans the market drew not only American banks, but also foreign credit institutions. This resulted in the same pyramid. As long as stock prices went on rising all pyramid levels got huge profits and never thought that stock prices could not grow endlessly.
An uncontrolled proliferation of investment trusts served as another driver for the stock exchange boom. Investment companies (trusts) issued their own securities to raise funds from small investors. Later resources so accumulated were invested by the trust into a well-picked investment portfolio that included a variety of assets (primarily, leading companies’ stocks, the so-called ‘blue chips’). Thus, by paying a modest fee small investors were relieved of a difficult choice of what stocks to invest their money in. Besides, the investment trust had a good portfolio to reduce the risk of investment loss. Everything would have been just great but for realities of the 1920s which offered no ‘pink glasses’ prospects for small investors.
People who appreciated the potential of owning an investment company rushed to open them and started collecting huge amounts of investors’ money right off. Different people, from J.P. Morgan, Jr. to swindlers of various class took this up as there were then no laws regulating this area. And, since there were no laws regulating an entire area of activity, investments could dispose of the funds they had raised at their own discretion. Investment companies paid themselves large commission fees for anything they named – portfolio management, purchase and sale of securities etc.
In addition, investment trusts’ stocks greatly fluctuated as they had their own market. Managers practiced keeping part of the stocks for themselves and affiliated companies. Then they used rumors to blow out these stocks’ prices and eventually sold them overpriced. Using their own easy money investment companies rocked the entire stock market (if only they had known what this would result in).
There is a notion of ‘leverage’. Imagine the following situation. An investment company issues its securities worth $300 million in total in the following proportion: 2/3 of the amount is represented by bonds (fixed return instruments), and 1/3 – stocks themselves. The entire amount is invested in a portfolio of industrial companies’ stocks. Let’s assume that the portfolio’s market value has doubled and is $600 rather than $300 million. Since the portfolio’s value has doubled, it means the investment company’s securities have also doubled in price. But the price of bonds will not change considerably as they pay a fixed rate. Practically, the entire profit generated by the portfolio will affect the stocks issued by the investment company. Thus, these shares will cost about $400 million rather than $100 million (1/3 of the total value). It means the leverage effect was fourfold.
In continuation of the example above. Let’s assume that stocks of the investment company above are owned by another investment company with an identical capital structure (1/3 of stocks, 2/3 of bonds). It follows that the second company’s stocks will have a double leverage which will have an eightfold effect. Therefore, people in charge of the company, on top of the pyramid, will be getting huge returns indeed. That’s why entire networks of investment trusts with a much more complex interaction pattern were created at that time.
Isn’t this a pyramid? The foundation – stocks of manufacturing companies, a substitute for hard cash capital, gradually covered by layers of exclusively paper-based, fictitious capital with practically no value of its own. Let’s imagine that at a certain moment stock prices of industrial companies took a sharp course for depreciation. You might have already guessed what this scheme will experience. Right, the leverage will have the opposite effect, and stocks of the investment companies involved in this link will fall as much as they used to grow.
Let’s have a look at another important issue now. Why did stock prices rise at such a fascinating pace? It’s very simple. The growth of industrial companies’ stocks was supported by an unprecedented demand for them (which in fact exceeded supply). This huge demand was met by investment trusts that built their pyramids around these stocks. Besides, investors who got broker loans (90 percent) were simply scrambling for stocks of reliable companies. Bullish action sped up the crazy rally of prices. They started buying shares of firms they had chosen in advance and spread rumors of incredible growth they were to show soon. In those years such actions almost doubled the price of stocks they had selected and later sold.
And, if companies’ stocks are secured by things other than real manufacture, increased production capabilities, sector development etc. this means only one thing – a bubble is blowing out and will inevitably burst. The question is when? This is what skeptics and analysts who already understood that the crash was inevitable tried to warn about. But virtually nobody listened to or heard them.
It all came like a thunderbolt from a clear sky… the beginning of the Great Depression.
Wall Street, 1929
The lightning flashed on 21 October 1929 when over 6 million stocks were sold during a frenzied session at falling prices, but this fact was treated by the public skeptically. The thunderbolt broke out on 24 October – and this day went down in history. Stock prices slumped an hour after the session opened, and by noon stocks were selling in a panic. Some companies’ stocks could not even go for 1 cent. Brokers lost their minds carrying out a huge number of sell orders from their clients. In addition, protecting their own interests, they were selling stocks of clients who failed to pay in or increase their margins. As technical support was at that time not quite perfect, to put it mildly, broker networks could hardly sustain the flow of information that kept on arriving. Prices started lagging behind real time by two hours. Chaos spread to the OTC market. Stock holders were horrified throughout the country in expectation of new prices with minutes of waiting felt like hours, hours like days. Some were seized with unrestrained hysterics, others tried to commit suicide but everyone was waiting. Some stock exchanges couldn’t stand the pressure and closed.
It was now that everyone thought of J.P. Morgan, Sr. and 1907. Stockbrokers and bankers asked the renowned Morgan House for help. J.P. Morgan, Jr. was then in Europe and T. Lamont was in his stead in the firm. He called an urgent meeting with heads of New-York’s five largest banks that dealt with securities and had abundant financial resources. Bankers chipped in to collect a certain large undisclosed amount. It was for this large amount that they started buying shares. This step slowed down the fall for some time but it soon turned out that the amount they entered the market with was absolutely negligible as compared to the capital pumped into it over the past years. Stock prices resumed their depreciation as early as on 29 October. This day was recorded in the Guinness Book because there were $16,400,000 worth of shares sold in New-York Stock Exchange. By end of 1929 nobody had any illusions left. Prices continued falling, this time without any particular spurts typical of late October 1929. Decline in the US industry suddenly became more pronounced. Stocks of European companies were caused to fall by the disaster that started in the United States. Prices began going down in commodities and food markets. The crisis was gaining impetus.
The stock exchange crash made a hole in the small bourgeoisie’s purse. This group included qualified workers, the intellectuals, working farmers. But the scale of the crisis was so great that wealth of richer people, middle-class bourgeoisie also decreased. But people who lost on the stock exchange crash represented a minority of the American nation. Wide masses directly suffered from these events only a little. They only gloated over those who lost their wealth by giving their hard-earned money to be managed by investment trusts. If only they had known that this would not end with the stock exchange crash and would radically change consciousness of the entire nation which would start to use such terms and ‘before 29’ and ‘after 29’ because it gave a start to the Great Depression – a prolonged systemic crisis that would result in poverty and endemic unemployment, humiliation and starving of tens of millions of people and that would take a long and painful way to recover from.
Banks’ fate during the crisis.
There was a large number of banks in early 1920s in the US. They included dozens of large banks and thousands of small local institutions. It was even in the years of economic rise that some banks were taken over by larger institutions or simply closed down every year. But after October 1929 banks’ bankruptcies developed an incredibly large-scale nature. Their bankruptcies meant that both companies and individuals that maintained their accounts with such banks lost some or all of their money. At best, their deposits were frozen for a long time.
A variety of abuses was rife in the banking sector. However, the banking crisis had more profound reasons. Practically all banks ended up between two fires: withdrawal of deposits and a slump in their asset base. Banks’ assets mainly included securities and loans secured by them. In the context of the crisis these stocks fell in value by several times and some became valueless. The bulk of debt secured by farm and urban real estate appeared to be bad and security hopelessly depreciated.
The final hit was dealt to the banks in 1931-1933 by depreciation of their bond portfolio, their last reserve of liquidity. In particular, major banks maintained large portfolios of governmental and other bonds of Asian and Latin American countries while coupon payments and retirement were terminated. Pressurized by withdrawal of deposits banks were forced to put their assets, relatively liquid bonds, in the market causing their market value to fall. In summer 1932 many banks throughout the country did their best to keep away depositors willing to withdraw their funds. In October 1932 the Governor of Nevada closed all banks for two weeks to help them avoid bankruptcy. However, the situation with banks reached rock bottom and ended up in a banking crisis. Experts believe that the banking crisis started in Detroit where a major local bank went broke. Pressure on all banks in the city and state forced the Governor to close all local banks to maintain public order and security. Pressure on banks went from state to state and they stopped returning deposits in many cases without closing down in the hope of a miracle.
The US during the Great Depression.
The American economy beat more and more negative records:
- decline of industrial production from the peak to the trough was 56 percent in MoM terms, or more than in any other country affected by the crisis;
- import contracted by 80%;
- unemployment rates among the working population reached 85% with over 13 million jobless people;
- US metal manufacture was operating at 12% of its capacity.
Ranks of the unemployed were increased by people who failed to repay credits taken out on security of their land and real estate, thousands of farmers and their family members. Gutter children and vagrancy became common. The number of ghost towns with all businesses closed and no jobs started growing in the country. People left their homes to move to a place they felt was better. But production was either significantly reduced or altogether terminated by a large number of different enterprises all over the country. There were strikes, demonstrations, hunger marches taking place throughout the country. Increasingly richer groups of the population were overwhelmed with horror and fear of the future.
Let’s have a brief look into the mechanism for transition of a stock exchange crash into the deepest economic crisis ever. Plummeting stock prices and the need or disability to fill up the margin drove large masses of people to cut consumer spending. A sudden decline in demand forced companies to reduce production, cut jobs, downgrade investment programs. Many firms appeared unable to repay loans taken from banks which, together with money withdrawn by individuals and companies, caused a few waves of bank bankruptcies. In this chain (of course, with more links and complexity) a deterioration in each next link had impact on links above with fascinating speed and intensity. Psychology of entities involved in these processes is not insignificant for economy. Prosperity both triggers and is supported by optimistic attitudes. And, the other way around, pessimism born by a crisis only aggravates it.
The government was absolutely unprepared for a crisis of this scale and nature which was the first most powerful systemic one rather than just cyclical (like all other crises before the Great Depression). Its thinking was based on notions of a different epoch when politicians believed that everything was put right by itself in economy. They used ideas applicable to cyclic crises in belief that the crisis was useful by destroying the weakest and inefficient businesses and creating room for the strong and efficient. The jobless were guilty of their own unemployment as they didn’t agree to work for a lower wage. This system is described as a policy of nonintervention in the context of political economy. It was only in mid 1930s that British economist J.M. Keynes called the state to actively fight the crisis, unemployment and downtime of businesses. His speech became a turning point in economic theory and politics.
It is still disputed in the US to what degree President H. Hoover and Secretary of the Treasury A. Mellon were to blame for the stock exchange crash growing into the Great Depression. Hoover’s and Mellon’s public speeches are not, to put it mildly, impressive. Hoover was persuading his nation to be more patient and wait a little more convincing them that the economy would start its recovery any day now, if not in the next month, then for sure in the next quarter or year. Mellon’s words that the crisis would soon eliminate itself especially annoyed people because he was a member of one of America’s richest families.
Of course it cannot be claimed that the government and the Congress didn’t appreciate the situation at all and didn’t stir a finger. In January 1932 they launched the Reconstruction Financial Corporation, a state entity that would use its own funds for urgent measures to deal with the falling economy’s sore spots. But it didn’t have enough time to deploy its operations before the Presidential and Parliamentary elections of 1932 after which Hoover left the White House, and the Republicans were stripped of their majority in the Congress. Any anti-crisis measures needed budgetary resources, but the century-long wisdom required that a non-deficit or at least low-deficit budget be maintained. The economic crisis caused a slump in tax revenues, and the government was wary of increasing spending in this situation. A ‘wise’ financial policy turned out erroneous in this case which needed bold solutions that would break away from tradition. It became Roosevelt’s historical merit that he welcomed such solutions.
Urgent steps that helped the situation to stabilize.
Franklin Delano Roosevelt
The period between elections and inauguration of the new president expired on 4 March 1933. Franklin Delano Roosevelt, a member of the Democratic Party, previously the Governor of New-York, became the new President. He won a convincing victory in the November 1932 elections over the Republican candidate, Hoover. Franklin Delano Roosevelt is among the most prominent statesmen of the 20th century. He led America out of the Great Depression. One cannot but pay their respect to Roosevelt at least because his entire life, starting in early 1920s, he was fighting with poliomyelitis that made him a cripple capable of moving about only in a wheelchair.
Operations of Roosevelt’s administration during the first months of his presidency looked like those of a fire brigade. Their top priority objective was to save the banking system. Pursuant to a law passed during the First World War, Roosevelt closed all banks of the nation on 6 March 1933 for three days and extended the term on 9 March. Next day the Department of the Treasury in conjunction with the Federal Reserve System was instructed to analyze the position of each individual bank and open relatively healthy banks. On 11 March the President made a speech to the press and the next day on the radio explaining the government’s actions and banks’ prospects in detail. As a result, the panic started subsiding.
It was on 15 March that about two thirds of banks opened their doors while the rest were in for bankruptcy or takeover by healthier institutions prepared to assume their liabilities along with assets. The Reconstruction Financial Corporation suddenly become more actively involved in sanitation (recovery) of banks. The measures they took were very far from liquidating the crisis but, at any rate, they managed to save the banking system whose paralysis threatened to derail the entire economy. However, sanitation of the banking system required more drastic reforms. The Banking Act of 1933, the so-called Glass-Steagall Act, was prepared and passed through the Congress with unprecedented promptness. It was signed into a law by the President on 21 June 1933. This law still remains the foundation for US banks’ operations, its main provisions are intended to reinforce stability of the banking system and prevent banking crises.
Commercial banks were not allowed to deal with stocks as such transactions put integrity of depositor funds at risk. This meant a demarcation line was drawn between commercial and investment banks which could issue and trade stocks for industrial corporations but could attract deposits no longer.
The FED was granted new authority control banks that were not allowed to pay interest on current accounts. The FED introduced certain limits on the interest rate payable on term deposits. This severely restricted risky operations of bankers willing to promise a high return and benefit from speculations. The stock exchange credit that played a negative role in the stock exchange crash of 1929 was subject to regulation.
Economists believe that another novelty was the most significant of all. It was establishment of the Federal Deposit Insurance Corporation and the National Depositor Protection System. Banks had to transfer a certain fraction of deposits to a special insurance fund managed by this government agency. In case of bankruptcy depositors were paid a compensation from the fund up to a limit established by law. It should be noted that this threshold is rather high at $100,000 per account per bank. Maintaining accounts in several banks can increase the level of protection. The success of this remedy was striking: starting in 1934 bank bankruptcies rapidly decreased while depositor losses became a thing out of the ordinary.
There was a new law that came into effect in May 1933 against dubious and fraudulent scams abusing general public’s trust. It established strict liability of a company that issued stocks to be placed in the market for completeness and reliability of information about its position and business. Later these urgent measures were deployed into a legislative system that included the Securities and Exchanges Commission on the federal level which still plays the role of the government’s central tool for controlling stock issue and securities markets. The National Recovery Administration was set up in June 1933 to combat the economic crisis. It was to become an intermediary between each industry’s businesspeople and employees. The Administration played a known role in creating trade unions capable of cooperating with the government and businesses. The law passed in May 1933 required a system of voluntary cooperation between farmers and the government in terms of keeping down superfluous production that caused the prices and farms’ income to fall, and rationally using land and other natural resources.
A lot was done with haste and unskillfully in these first months. Governmental bureaucracy was rapidly expanding. But, in general, enthusiasm and involvement of the government and the Congress that contrasted with Hoover’s years made a strong impression on the country. People felt to some degree that there was a light at the end of the tunnel.
Look at the Dow Jones chart which is a typical touchstone of American economy’s development. Note how powerful the bearish wave was and how much time the economy required later to recover.
The Dow Jones index 1920 to 1956
Roosevelt and his team taking the New Course.
By late 1933 hasty measures started to fit into a system of reforms unofficially described as the New Course. Neither Roosevelt nor his advisors claimed to have an ideological way of acting. They were guided by common sense rather than a plan and followed people’s sentiment. And people demanded that the government strip oligarchs and major capitalists of a significant share of their power as they, in the nation’s opinion, were to blame for the economy’s disastrous condition.
The New Course followed more or less consistently till the Second World War changed American capitalism without affecting the foundations of social order. Principles of private ownership, market economy and political democracy remained in force, but their operation underwent significant changes, The New Course involved rejection of the government’s nonintervention in economy and transition to active governmental regulation. Roosevelt himself and his most far-sighted contemporaries understood that the capitalist system was at stake.
The New Course required large spending from the federal budget. Its expenses increased in 1933-1937 by 2.2 times. Revenues were far behind this growth and the deficit was covered by large domestic borrowings. The public debt grew from 22 to 36 billion dollars in four years. The level of prices changed little over this time so the increase in spending and debt was real rather than on paper. It scared not only conservative people habitually believing that the budget deficit and debt growth were a certain path to the nation’s grave. Roosevelt and his team played boldly and assured people that economic recovery justified their financial policies. One can say they intuitively felt the vital thesis of Keynes’ economic theory: in the context of widespread unemployment, underutilization of capacities and resources, deficit finance is not only acceptable but also required to overcome depression and stagnation in economy. One only needs to know a reasonable limit for money spending and monitor its effective use.
As a speaker Roosevelt was too experienced to state directly that he supported budget deficit and debt growth. In his addresses he invariably emphasized that the government was striving for financial stability but invariably offered more new programs that required money. The Congress grumbled and even stormed at times but yielded to the government’s requirements. Over five years spending to keep up agriculture increased almost fivefold, to sustain employment – sevenfold. This financial policy involved pumping money into economy, printing bills and increasing funds in bank accounts. This expectation eventually turned out to be correct in principle. Let’s put it this way: the deflationary potential was so high in the economy that money supply could be increased without the risk of causing inflation.
In 1934 they set up the Federal Housing Administration as a special government agency intended (in order to decrease banks’ risks related to long-term loans) to insure mortgages given out by banks and other financial institutions to construction companies and borrowers. A mortgage is a financial document used to set out legal relationships arising in case of a mortgage loan. This loan is given for a long term, often for at least 20 years. So that banks were not afraid of getting bogged down in such loans a government corporation was created to buy mortgages from banks and resell them to investors interested in long-term investments. Officially this corporation is named the Federal National Mortgage Association, while average Americans gave it a female name of Fannie Mae.
Many other things were done in addition to above: a government system of social security was created for the first time in the US (pensions at old age or in case of loss of the breadwinner), unemployment benefits were introduced, the unified minimum wage was established, child labor was prohibited. Even if some of these legislative rules were complied with poorly, their very existence was of great value. The second half of the 1930s remained difficult for America, pre-war production never reached the 1927 levels, unemployment was constant at 8-10 million people. Nevertheless, the Great Depression gradually wore off though it was only the war and war economy that completely did away with it.
Roosevelt became first and only US President elected for this office four times. It was only after his death that a law prohibiting one person to hold this position for more than two terms was enacted.
The main thesis of Masterforex-V new investment theory is that any global economic crisis is viewed as the completion of the next wave of an uptrend of economic development triggeringa decline (correction). Investors have to fix their profits in this very period. In fact, the issue of criteria, reasons and first manifestations of economic crises for investors is not like economists’ scientific abstraction – it means specific application of these criteria to the current market conditions to be able to fix profits in time at first signs of a crisis and exit from an investment which will rapidly depreciate as soon as the crisis starts.
The Department for Fundamental Analysis and Investments of the Masterforex-V Academy believes that the Bubble effect is among the first signs that a crisis will soon begin. It was, to a certain degree, there before any crisis and showed itself in an exaggerated form before the Great Depression.
Interestingly, some oligarchs of those times already knew or had a hunch about this. They not only avoided financial ruin during the Great Depression but also managed to keep and, later, increase their capital. This fact drew interest of the US Congress’ commission which called them to give testimony. The answer given by J.P. Morgan, Jr. deserves our attention. To a question: “How did you manage to keep your capital during the stock exchange collapse?”, he told a story that happened to him. Morgan said something to this effect: “Every day, on my way to my Wall Street office I have my shoes shined by one and the same shoeblack. One day he asked me what stocks would be rising in the near future. I was taken aback by the question and asked him why he needed that. The shoeblack told me that he kept his savings in railway company stocks so he wanted to know if he should keep these stocks or buy others. After this talk I hurried to my office and gave an urgent instruction to sell all assets at the current price. Soon, stock prices slid down”. Morgan finished his story with this phrase: “If it is even shoeblacks that start trading stocks, professional investors should leave the stock market (i.e. fix profits as soon as possible)”.
The financial ‘bubble’ means a rapid appreciation of assets unsupported by relevant fundamentals (such as reports on release of a new product or discovery of an oilfield). A bubble is characterized by three components: rapidly growing prices of financial assets, expanding economic activity and constantly increasing money supply and credit.
The bubble can be explained by “the balance sheet effect”. Changing prices of financial assets directly affect balance sheets of households, firms and financial intermediaries. When blowing out or collapsing, the bubble triggers higher or lower value of credit security, respectively. Players actively use credit for stock speculations at a peak of the financial boom. When the trend reverts, leverage ratios suddenly spike. Borrowers start receiving requests for additional security, while banks – for higher capitalization to comply with capital adequacy ratios. Falling prices in the stock exchange worsen financial results and balance sheets of all players without exception forcing them to cut current spending. Spending is used to serve debt rather than consume. Redistribution of revenues triggers a contraction in total demand and economic growth rates. There are a few feedback loops when the financial pyramid is collapsing. Firstly, lower sales and higher unemployment decrease turnover of goods which further undermines cash flow and suppresses consumption. This mechanism is described as “financial accelerator (lever)”. Secondly, a decrease in current and expected revenues from assets is reflected in their falling prices. This creates a spiral of debt deflation.
In this figure you can see the place taken in history by the Great Depression of 1929-1933 among what was previously described in a series of articles “History of Global Crises”. All cyclical crises are correctional phenomena of global economy that occur in separate sectors or separate countries without any significant impact made on global processes. On the contrary, systemic crises are corrections of superior level and affect all production, economic and political aspects of practically all countries of the world to a certain degree.
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