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Ron Hera, founder of Hera Research, LLC, and the principal author of the Hera Research Newsletter holds a master's degree from Stanford University and is a member of Mensa and of the Ludwig von Mises Institute. A native Californian, Ron is a self described "escapee" from Silicon... More
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  • The Unholy Alliance Of John Maynard Keynes 13 comments
    Feb 10, 2012 4:31 AM

    Perhaps the greatest modern champion of central economic planning was the 20th century English economist John Maynard Keynes. Keynes, who was a political socialist and for a time a central banker, advocated the idea that the government should play a large, active role in the economy. Among the consequences of Keynes' economic theories, whether intended or unintended, is the fact that Western economies today are characterized by large, central governments, central banks and massive debts.

    According to Dr. Andrew Gelman, Professor of Statistics and Political Science at Columbia University, "the law of unintended consequences is what happens when a simple system tries to regulate a complex system. The political system is simple. It operates with limited information (rational ignorance), short time horizons, low feedback, and poor and misaligned incentives. Society, in contrast, is a complex, evolving, high-feedback, incentive-driven system. When a simple system tries to regulate a complex system you often get unintended consequences." Professor Gelman's statement seems equally apropos to central banking.

    Government policies based on Keynesian theories and the institution of central banking form a nexus of central economic planning. Control of the central planning process is a winner-take-all proposition for businesses. In the U.S., the result is an unholy alliance of the U.S. federal government, the Federal Reserve (along with the largest U.S. banks) and the largest U.S. corporations. The logical chain beginning with Keynes' fundamental idea that government, supported by a central bank, should play a large and active role in the economy sets the stage for a centrally planned economy and ultimately produces a corporate state.

    The U.S. economy is locked in a downward spiral of economic decline. By growing in size, and by engaging in ever larger economic interventions, the U.S. federal government became itself a material cause of the recession that began in 2007. By attempting to grow the economy through monetary expansion, i.e., consumer spending fueled by debt, the Federal Reserve destroyed savings and fueled a series of disastrous economic bubbles, culminating in the housing bubble. At the same time, the largest U.S. banks engaged in reckless lending and high-stakes gambling on hundreds of trillions in over the counter (OTC) derivatives. OTC derivatives, which amount to risky, largely un-backed wagers, were the root cause of the "too big to fail" doctrine that has virtually bankrupted Western governments since 2008. By seeking ever greater influence over Washington D.C. and by seeking to generate higher profits by cutting production in the U.S., the largest U.S. corporations undermined the U.S. market and economy. The U.S. federal government did virtually nothing to prevent the destructive developments because of the influence of the largest U.S. corporations.

    Following Keynesian economic theories, the policy response of the U.S. federal government to the recession that began in 2007 and of the financial crisis that began in 2008 was to expand the government further and at a more rapid pace. In other words, some of the root causes of the economic imbalances that lead to the recession and financial crisis (the relative size of the government and the resulting economic distortions) were compounded. As a consequence, the so-called "double dip recession" in the U.S. that began in the second half of 2011 will be longer and ultimately more severe than the economic downturn of 2007-2009.

    Baltic Dry Index (BDI)

    The Baltic Dry Index (BDI) indicates international shipping returning to crisis levels. Since the U.S. is the world's largest economy and has a large trade deficit, the BDI suggests that the U.S. is in a recession.

    Leviathan: The Size of the State

    Originally a sea monster referred to in the Bible and, in demonology, one of the seven princes of Hell, as well as its gatekeeper, the name Leviathan was adopted by the English philosopher Thomas Hobbes to refer to an artificial political order, i.e., to the institution of the state. Hobbes was concerned with the distinction between individual rights and the powers of sovereign governments and he elaborated the idea of the social contract. When a government taxes its citizens, it implicitly asserts the right of the government over the property rights of individuals and presupposes that the government can make better use of economic resources than households, individual entrepreneurs, businesses and private investors.

    In theory, the government's use of economic resources accomplishes goals that privately owned businesses cannot, such as national defense or emergency response services, i.e., things that, by their nature, are not economically productive or profitable but still necessary for society. In contrast, embarking upon idealistic projects such as "creating jobs" or "expanding home ownership" encroaches on the productive elements of the economy. However, governments are inefficient compared to privately owned businesses due to the absence of competition. Further, the record of history suggests an inability on the part of central planners to make superior economic decisions.

    Government encroachment on the private sector, like a self fulfilling prophecy, often magnifies the reasons why government intervention was originally believed to be necessary. For example, when the U.S. federal government became involved in education through federally guaranteed student loans, the result was that the cost of a college education rose towards the limit of what students could borrow and repay during their careers simply because the loans were guaranteed by the government. The guarantees produced more and riskier loans, larger loans and higher education costs.

    When the U.S. federal government promoted home ownership for minorities and the poor, mortgage loan guarantees resulted in higher home prices and contributed to the sub-prime lending debacle where banks originated loans to unqualified borrowers in order to sell them to government sponsored entities (GSEs), i.e., to Fannie Mae and Freddie Mac, and to investors as collateralized debt obligations (CDOs) and other mortgage backed securities (MBS).

    Banks were certainly to blame for knowingly making bad loans, which is fraud, but the conditions that made the problem possible existed substantially because of government intervention in the housing market, i.e., opening the door to fraud was an unintended consequence of policies intended to increase lending to unqualified, low income borrowers. Of course, the U.S. federal government did not compel lenders to commit fraud, thus accountability for the U.S. mortgage disaster is shared by the federal government, which interfered with the free market, pursued misguided policies and failed in terms of regulatory oversight and law enforcement, and by banks, which engaged in widespread mortgage related fraud.

    Governments redistribute wealth and manipulate economic activity through taxes, subsidies, guarantees, regulations and so forth, but they do not produce new wealth. Government spending may be for good purposes, or at least stem from good intentions, but it unavoidably favors businesses with close ties to the government over those that are taxed but that do not benefit. Despite the theoretically higher moral purposes of lofty government undertakings, government programs that overlap the private sector divert economic resources to businesses that have the favor of politicians minus the cost of government, thus producing economic distortions and a net loss of wealth for society.

    The Rahn curve is an economic theory proposing that there is an optimal level of government spending, 15% to 25% of gross domestic product (GDP), to maximize economic growth.

    Rahn Curve

    As the government grows larger, economic growth is curtailed and, eventually, the economy contracts, crushed under the burden of government.


    As the government grows in size relative to the economy, not only is economic growth compromised, but the potential for, and the cost of, government waste, fraud and abuse increases.

    How the Government Destroys Jobs

    While politicians extol the theoretical benefits of ever more government control of the economy, e.g., through increased regulation, from the standpoint of individual entrepreneurs, businesses and private investors, the government is a nuisance, an impediment to wealth creation, and the source of countless costs and risks. The larger the government becomes relative to the size of the economy, the more it tends to discourage economic activity. Although roughly 70% of U.S. jobs are created by small businesses, ranging from family owned businesses to high technology startups, the burden of government falls disproportionately on them because they have fewer resources with which to administer and to demonstrate compliance with government regulations.

    When large companies are audited or investigated by any of several government agencies, their accounting, legal and compliance departments are well equipped to deal with such matters. However, when a small company faces the same hurdles or seeks government permits, licenses or certifications, its operations are directly impacted and the associated accounting, legal and regulatory compliance costs can cause the business to lose money or to fail. In the event of an audit or investigation, small business owners in the U.S. generally seek to comply immediately and often pay fines or penalties without contest in order to end the government's interference. While large companies can afford to dispute the government, small businesses face the equivalent of extortion.

    As a practical matter, small businesses in the U.S. are permitted to operate at the sole discretion of government bureaucrats that can effectively shut down small businesses without any evidence of wrongdoing. Setting aside the fact that small business owners live in constant and well justified fear of their own government, the result is a stifling of economic activity and a net loss of jobs. For example, traditional small businesses in the U.S., i.e., sole proprietorships, increasingly avoid hiring employees.

    Free market competition and the inherent uncertainty of economic conditions provide ample risk for startup businesses. A disproportionately large government relative to the size of the economy damages economic activity and discourages investment in new businesses. The aggregate overhead of government regulations and regulatory compliance, along with taxes and potential penalties, e.g., the 2010 Patient Protection and Affordable Care Act ("Obamacare"), increases business costs, amplifies business risks and further increases the burden of regulatory compliance. The result of systematically increasing the costs and risks of doing business-in lock step with the size of government-is to reduce the rate of business formation and to encourage investors to look elsewhere to find returns.

    Total Government Spending (Federal, State and Local) Percent of U.S. GDP

    If the U.S. government, currently almost 45% of GDP, desired to create jobs, the correct policy would be to greatly reduce the countless regulations, taxes and fees that encumber small businesses. The path to job creation is for the government to reduce job destruction. Since no political will to reduce the size of the government exists, however, continued shrinking real GDP and permanent workforce reduction can be expected.

    Money Out of Thin Air

    Central banks, such as the Federal Reserve, are examples of central economic planning, i.e., they control the money supply and exercise centralized control over the value and cost of money through interest rates, bank reserve ratios, monetary inflation and by other means. In contrast to the government's central planning for the putative public good, the Federal Reserve engages in central planning for the benefit of banks. Like the U.S. federal government, the Federal Reserve, through monetary mechanisms, distorts spending and investment patterns, redistributes wealth and preempts the financial and economic decisions of households, individual entrepreneurs, businesses and private investors.

    When a central bank increases the money supply beyond the level necessary to support a sustainable economy or population growth, it destroys the value of savings and wages by diluting the value of money and causing prices to rise. Wall Street embraces the Federal Reserve because easy monetary policies provide an inexpensive way to finance operations and to expand, but there is a cost. Inflationary monetary policies favor speculators over savers and debt over genuine capital formation.

    Banks do not create wealth. The structure of the financial system, where debt-based money is created ex nihilo, virtually guarantees banks a piece of the action whenever wealth is created. When debt service (principal and interest payments) is attached to the income streams of consumers and businesses, excess production is diverted from capital formation into the coffers of banks. The Federal Reserve, therefore, is at the core of a system where, over time, wealth accrues to banks while capital formation is reduced, ironically increasing the need to borrow. The majority of entrepreneurs and businesses have little choice but to borrow and, even if they are successful, the economy as a whole may still suffer due to increased debt levels relative to GDP.

    Keynesians embrace the Federal Reserve's un-backed, fiat money because it permits the government to borrow and spend freely based on the theory that stimulating the economy through deficit spending produces economic growth at a faster pace than debt accumulates. However, as a function of debt service, the number of dollars that must be borrowed and spent to generate each new dollar of GDP becomes larger as the total amount of debt grows.

    Marginal Utility of Debt (Nathan A. Martin)

    The result is debt saturation where further debt funded increases in GDP are impossible and where, therefore, existing government debt cannot be retired, i.e., the result of Keynes' theory, taken to an extreme, is government insolvency and sovereign default. Default, of course, can take the form of monetary inflation in order to debase the currency and reduce the real value of debt, e.g., the Federal Reserve's monetary easing and continued accommodative monetary policy.

    Keynes and the Corporate State

    The U.S. economy is anything but a free market today. In fact, the U.S. government increasingly resembles an oligarchy in which the oligarchs are large corporations, i.e., a "corporatocracy". Thus, the illegitimate offspring of the grand government envisaged by Keynes and the institution of central banking is a corporate state.

    Without a large government, businesses have little incentive to influence it, but with the government (local, state and federal) representing nearly half of the U.S. economy, influencing the government is a mission-critical objective for every company. The size of government implied by Keynesian economics provides motive and opportunity but only the largest corporations have the means to succeed.



    Citigroup Inc


    Citigroup Inc


    Columbia University


    Bain & Co


    General Electric


    Bain Capital


    Goldman Sachs


    Goldman Sachs


    Google Inc


    Bank of America


    Harvard University




    IBM Corp


    Blackstone Group


    JPMorgan Chase & Co


    JPMorgan Chase & Co


    Latham & Watkins


    Credit Suisse Group


    Microsoft Corp


    EMC Corp


    Morgan Stanley


    Morgan Stanley


    National Amusements Inc


    HIG Capital


    Sidley Austin LLP


    Kirkland & Ellis


    Skadden, Arps et al


    Marriott International


    Stanford University


    Price Waterhouse Coopers


    Time Warner


    Sullivan & Cromwell


    UBS AG


    UBS AG


    University of California


    The Villages


    US Government


    Vivint Inc


    WilmerHale LLP


    Wells Fargo


    Total Primary Dealers:


    Total Primary


    Political campaign contributions indicating U.S. Federal Reserve Primary Dealers (Source:

    The goals of businesses seeking to influence the government include winning government business, mandating consumption of products and services (from child car seats to health insurance), avoiding taxes, guaranteeing profits, creating regulatory loopholes, protecting markets, eliminating competition, socializing losses and so forth.

    The influence of Wall Street over Washington D.C. through political campaign contributions, corporate lobbyists and revolving doors (where the same individuals alternate between closely linked private sector jobs and government posts) is almost absolute. Lobbyists are intimately involved in writing legislation that is often rubberstamped by the U.S. Congress, i.e., passed without reading or meaningful debate. The largest corporations support political candidates through campaign contributions and by funding political action committees that, among other things, use corporate public relations tools for political purposes (propaganda). Key government posts are consistently held by individuals with clear conflicts of interest and the existence of such conflicts is routinely ignored.

    The current reality of the United States is that the largest corporations have hijacked the Keynesian central planning powers of the federal government and have used these powers to encourage ever larger and more direct interventions in the economy for their own benefit, as well as laws and regulations that serve as a barrier to free market competition. U.S. regulators, such as the Securities and Exchange Commission (SEC), Commodities and Futures Trading Commission (CFTC) and the Food and Drug Administration (FDA) appear to have been captured by the industries they are intended to regulate. Government regulators selectively enforce regulations, often against small businesses and growing companies, such as organic dairy farmers, protecting the interests of the largest corporations from small businesses, free market competition and consumer choice.

    The largest U.S. corporations (including oil companies like ExxonMobil and Chevron; drug companies like Johnson & Johnson, Pfizer and GlaxoSmithKline; agribusiness companies like Archer Daniels Midland, which are heavily subsidized by the U.S. federal government; agricultural biotechnology companies like Monsanto; military contractors like Lockheed Martin, Northrop Grumman, Boeing, Raytheon and General Dynamics; and banks like Bank of America, J. P. Morgan Chase, Citigroup, Wells Fargo, Goldman Sachs and Morgan Stanley) have not only been the beneficiaries of government expansion, deficit spending and central economic planning, but, considering political campaign funding practices, have become the de facto oligarchs of America.

    A Downward Spiral

    The decline of the U.S. economy is the logical outcome of Keynesian economics, which enshrines central economic planning and embraces central banking. The unholy alliance of the federal government, the Federal Reserve and Wall Street has all but eliminated capitalism and has transformed the United States from a burgeoning free market economy into a failing corporate state.

    The U.S. federal government, the Federal Reserve and Wall Street each played a role in the progression from central economic planning and central banking to a corporate state. Politicians used Keynesian economics to justify big government, a welfare state and budget deficits. The Federal Reserve sought to grow the economy through monetary expansion, focusing on consumption but ignoring debt levels and inadvertently encouraging financial speculation. At the same time, Wall Street sought higher profits both by eliminating production (and jobs) in the U.S. and by sparing no expense to influence the government. The resulting corporate state undermined capitalism and the free market in the United States and produced a downward spiral of economic decline from which there is no escape without fundamental reforms.

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Comments (13)
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  • H. T. Love
    , contributor
    Comments (19536) | Send Message
    An excellent summation. I've thumbed the article.


    Let's hope your articel receives wide attention.


    10 Feb 2012, 07:42 AM Reply Like
  • Economic Analyst
    , contributor
    Comments (3777) | Send Message
    Nice report, very educational.
    10 Feb 2012, 09:26 AM Reply Like
  • RMF - Rethinking Modern Fin...
    , contributor
    Comments (165) | Send Message
    Excellent summary of where we are today! Sad indeed.
    10 Feb 2012, 02:02 PM Reply Like
  • E.D. Hart
    , contributor
    Comments (1117) | Send Message
    well written, and I agree in nearly every respect. The article does not mention that both parties are about equally responsible for the oligarchy of the corporate state. Republican borrow and spend vs Democrats tax and spend has led us equally to this place. Both parties, and the American public, share the responsibility.
    12 Feb 2012, 01:09 AM Reply Like
  • robert.b.ferguson
    , contributor
    Comments (10491) | Send Message
    Well done! Kudos to you. Succinct, informative and presented in a simple manner that even a politician could understand if they wanted to. Thanks.
    13 Feb 2012, 10:14 AM Reply Like
  • jhooper
    , contributor
    Comments (8161) | Send Message
    Well it can be argued that lenders "knew" the loans couldn't be paid back. The increases in home prices was supposed to be one of the sources of repayment. Thus, a risk was taken that home prices would continue to increase, and a default on payments didn't mean that the principal wouldn't be repaid via the sale of the property.


    Taking a risk and making a mistake is not fraud in the way I promise to sell you a toaster knowing full well what I sold you in no way would ever function as a toaster.


    Another interesting thing, is that if stimulating aggregate demand improves the economy, then the housing boom should have never busted. These "fraudlent" lenders did very much what we wished the primary dealers would do right now. People pledged "assets" for advances, and these advances were "spent" into the economy. At the end of the day, consumption is not what stimulates economies, but rather gains in productive knowledge is what stimulates an economy. For only production gains is what will sustain consumption increases, and thereby lead to an improved standard of living. The only way for a gov to stimulate an economy, is to have some secret store of production knowledge no one else in the economy has. If govs really had such stores, they wouldn't hoard them, they would use them, and if they did, then they wouldn't need a populace to support them.


    Gov has one, and only one logical role in an economy. It is to protect the citizens from illegitimate force and fraud, but to allow it to do so it must be allowed to use force. Force is always dangerous, thus to prevent the gov from using that force to oppress the populace and then to engage in fraud to hide its oppression, it must have checks and balances imposed on it by dividing its power at different levels of the electorate. Then and only then can a gov contribute to the society gaining productive knowledge.
    13 Feb 2012, 10:48 AM Reply Like
  • Ron Hera
    , contributor
    Comments (68) | Send Message
    Author’s reply » Both the Keynesian focus on aggregate demand and the Keynesian cross are limited concepts. AD is the fundamental reason for the U.S. focus on consumer spending (and, by association, consumer confidence). Demand, by itself, however, does not bring about sustainable growth and increased demand isn't necessarily good. In fact, increasing demand can be an economic distortion, which is the case in every bubble, and it can lead to unstable credit growth followed by a recession.


    For the economy to function in a stable way, domestic production must increase in a sustainable relation to domestic demand. It is assumed in the Keynesian cross that demand/consumer spending stimulates supply/domestic production, which feeds back into wages. Unfortunately, this is not the case because wages are not tightly coupled to demand. Globalization (outsourcing and offshoring) and the trade deficit, for example, make the assumption entirely false. While it is understood that the sustainability of supply and demand in particular sectors is subject to many potential limitations and special circumstances, what is often overlooked is that sustainability on the macro level also has limitations that can be expressed as a trade deficit or as a monetary phenomena, such as inflation or unsustainable credit growth.


    The U.S. policy focus on consumer spending, which is based on the concept of AD and on the Keynesian cross, and the related application of behavioral economics at the macro level (while ignoring credit growth and the trade deficit), is flawed and doomed to fail. In fact, it has failed and is so misguided that it has undermined the credibility of the Federal Reserve and of the U.S. federal government.


    What is needed is a drastic reduction of debt levels and reduction of the trade deficit, e.g., an increase in domestic production (supplanting imports or increasing exports). Unfortunately, the present distortions, having accumulated over roughly 4 decades, are vast in proportion. The damage is done. A consumption based economy with a relatively strong currency has little to export. This is the end result of giving economic and monetary policy priority to AD. There is no way, for example, without another Great Depression or a hyperinflationary collapse of the U.S. dollar, to bring the U.S. dollar close to parity with the Chinese RMB [Arguably, Nixon initiated the era of the trade deficit both by closing the gold window and by opening trade with China].
    15 Feb 2012, 03:55 PM Reply Like
  • jhooper
    , contributor
    Comments (8161) | Send Message
    "There is no way, for example, without another Great Depression or a hyperinflationary collapse of the U.S. dollar, to bring the U.S. dollar close to parity with the Chinese RMB"


    This should not be the goal. The Chinese are willing to hurt themselves to sell us cheap goods, and then use those dollars to buy dollar denominated assets. Right now, the use most of those dollars to buy gov bonds. What we could do is leverage that up, and use the savings from the subsidies they are providing us to invest in other mfg that the US does better than anyone else. High tech, nat resources, etc. In order for that to happen we would have to gut the regulatory agencies, and transfer that power back from the executive to the legislative and judicial branches. This would knock the bottom out of production costs, and productivity would soar. The capital that is then being used to fund gov which gov uses to fund nonproductivity would move to productive activities, and the result is that the Chinese funded our recovery.


    We don't have to worry about other countries subsidizing their trade to us, if we are smart enough to take advantage of it.
    15 Feb 2012, 04:09 PM Reply Like
  • robert.b.ferguson
    , contributor
    Comments (10491) | Send Message
    jhooper: Greetings. We wouldn't have to gut the regulatory agencies we would only have to make sensible, effective and efficient regulations and enforce them equally for all participants. As long as the Chinese insist on a dirty currency peg we will never reach currency equilibrium at a market driven level.
    15 Feb 2012, 04:17 PM Reply Like
  • jhooper
    , contributor
    Comments (8161) | Send Message
    "effective and efficient regulations"


    This describes a pricing mechanism, and this is the problem with gov regulations, they are blind to prices. Thus the logical role for gov would be to regulate in the since that it prevents force and fraud not in the since it is going to get business from making investment decisions that are "too" risky.


    So when I say "gut", I mean the eradication of all regulations based on the false premise that people in gov, who have no clue about prices, can somehow prevent private players, who are intensely atuned to prices, from making bad investment decisions. This sort of power makes the regulator judge, juror, and executioner, and as such destroys the presumption of innocence.


    If such rules are going to exist, then the division of power should allow the states to do this, and the role of the fed gov will be to regulate commerce in the sense that it will "make commerce regular". In other words, it will deal with state laws that effectively throw up trade barriers. This concept has been almost entirely lost, and what we have now is the fraud that somehow gov at any level, but especially the federal level, can somehow regulate business so that business won't make any bad investment decisions. To which I say, "REALLY?"


    The resulting power for regulators is the power to punish people for making mistakes based on the judgment of the regulators, rather than using the court system that requires people to bring evidence to prove whether one person has harmed another.


    If we did this, we could trade with the Chinese, get cheap products subsidized by the Chinese populace, use the savngs from $3 clothes instead of $30 clothes and invest in other things that we do well. They could make cheap clothes for low wages and we make high end aircraft that require more skill and more wages (comparative advantage), for example (no way to know for certain, but markets find a way - who predicted Apple's success a few years ago or the products they would make).
    15 Feb 2012, 04:46 PM Reply Like
  • robert.b.ferguson
    , contributor
    Comments (10491) | Send Message
    jhooper: Greetings. I agree with you. We are speaking at cross purposes. I was addressing the roll of regulatory agencies like the EPA. While we should be preventing paper mills from dumping arsenide into rivers in WI we shouldn't be allowing them (The EPA) to regulate CO2 based on pseudo science and massaged data. After all CO2 isn't a pollutant and most life on the planet wouldn't exist with out it. That is the regulatory functions I was addressing. Some is needed but now it's out of control, politicized and has detrimental effects because of that.
    15 Feb 2012, 04:57 PM Reply Like
  • jhooper
    , contributor
    Comments (8161) | Send Message
    Agreed. The problem is specious reasoning. It goes something like this, "if we can rules that can prevent property from being damaged, then we can rules that prevent people from making bad decisions."


    We can gut the regulatory agencies of the latter, and you would see productivity go parabolic. We could also ratchet back regulations via expropriation taxes, ie no corp inc tax, and everyone pays 5% of income (no more $10k fees to get my taxes done), you would then have a situation where the cost of production just dropped at the same time the incentive to produce just went up. The wealth explosion would be staggering.
    15 Feb 2012, 05:04 PM Reply Like
  • robert.b.ferguson
    , contributor
    Comments (10491) | Send Message
    jhooper: Greetings. Indeed it would. Investment capital would flow into our economy from around the world once again and all would prosper. Except those who won't invest in themselves and we would still hear the same lament about the rich not paying enough to support them.
    15 Feb 2012, 06:08 PM Reply Like
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