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Fractional-Reserve Banking: From Goldsmiths To Hedge Funds To…Chaos

by John Rubino on May 21, 2014 · 24 comments

From Chapter 15 of The Money Bubble, by James Turk and John Rubino:

Banking didn’t start out as a reckless, parasitical plaything of a moneyed and politically-connected aristocracy. In the beginning, in fact, bankers weren’t even bankers. They were jewelers and goldsmiths who had to maintain their inventory with vaults, guards etc., and offered storage services to others with valuables to protect. So the original banks were, in effect, very safe warehouses.

Eventually some goldsmiths noticed that the paper receipts they gave to their customers to evidence the valuables left in storage began to circulate as currency alongside their countries’ coins. A shopkeeper accepting these receipts in payment knew that he could go to the goldsmith to redeem them for gold and silver, and also recognized that a paper receipt was more convenient to use as currency than were pieces of metal. Gradually these receipts became a widely-accepted form of payment, circulating among buyers to sellers and saved like other forms of wealth.

The goldsmiths then noticed something else about their new paper-money invention: Only a tiny fraction of their clients asked for the return of their valuables in any given period, which led to a bright – but legally and morally-dubious – idea. Why not start issuing receipts in excess of the gold and silver on hand? The goldsmiths could spend this currency themselves or lend it to others – thus inventing the business/consumer loan. Henceforth the total gold and silver in the vault (the goldsmith’s reserves) would equal only a fraction of the receipts circulating as currency.

“Fractional reserve banking” was thus born of deception if not outright fraud, because for the receipts to retain their value the goldsmiths had to pretend that those paper claims to gold and silver were backed by an equal amount of metal and were therefore of equivalent value. They were not, of course, because a tangible asset is more valuable than a promise to pay a tangible asset, particularly when the latter outnumbers the former.

The goldsmiths, having evolved into more-or-less recognizable bankers, then realized that more deposits equaled more profits. So they began paying people for deposits of gold and silver rather than charging for their storage, thus inventing the interest-bearing account.

The resulting system had some inherent dangers, most obviously that it tempted bankers to lend out ever-greater multiples of deposits, increasing the odds that they would be unable to meet withdrawal requests and collapse. This happened frequently early-on, eventually leading governments to regulate the amount that a given bank could lend against its capital.

For a sense of how this works, imagine a bank with $100 in capital that is required to hold a reserve equal to 20 percent of its loans outstanding – which based on experience is usually more than enough to satisfy a typical day’s withdrawal requests. In our example, the bank can lend 4/5ths of its depositors’ money, or $80, while 1/5th, or $20, remains in reserve. Now here’s where it gets interesting: When our hypothetical bank makes a loan, the recipient deposits the proceeds in another bank, which can lend out 4/5ths of that deposit. The recipients of those loans make deposits in other banks, and so on, until a huge multiple of the original deposit base has been turned into circulating currency.

The result is an “elastic” money supply. When borrowers are optimistic and want to increase their borrowing, banks in a fractional reserve system can in the aggregate offer them immense amounts of new credit. So the money supply, instead of being determined by the amount of gold, silver or other bank capital in the system, can expand dramatically to accommodate an energetic society’s demands.

But it can also contract dramatically. If an economy that has greatly increased its money supply through bank lending suddenly takes a downturn or is unnerved by an unexpected crisis, borrowers will pay off their loans or default on them and banks won’t replace them, while depositors seek the return of their cash. These actions cause the money supply to collapse, potentially all the way back to the level of base money in the system. The result of this fluctuation in the supply of circulating currency is a recurring series of booms and busts that wipe out businesses, individuals, and banks and frequently send the general economy into recession or depression.

Fractional reserve banking was, in fact, a major cause of the Great Depression. To condense a long, complex story into a single paragraph, the extra currency that was printed by the belligerents during World War I (which ended in 1918) was recycled through the fractional reserve banking system and massively amplified via the process we’ve just described. This tsunami of new credit caused the Roaring Twenties boom in asset prices – especially global equities – that popped in 1929, destroying the pseudo-wealth created in the previous decade. The collateral supposedly guaranteeing bank loans evaporated and sentiment turned negative, sending the fractional reserve credit machinery into reverse and collapsing both the banking system and the real economy.

Today’s situation is much, much worse. To see how, click here:

Money Bubble 3D cover web 550

{ 14 comments… read them below or add one }

Johan Rebel May 21, 2014 at 7:46 pm

Historically there is not that much evidence for the goldsmith story. It’s more like a parable or an anecdote. The same applies to the idea that bartering lead to money because it was more convenient. Historically credit is much more prevalent than money, and most exchange was done on the basis of keeping score/running accounts. Settlement was often on the basis of “paper” claims (based on claims to stored grain, for instance). In fact, gold was hoarded by temples and rulers, and paper money was guaranteed by the metal still in the ground on the “king’s” land. Commerical banking was based more on money-changing and on letters of credit than on hoarding jewelry and gold, even though gold played a role (in coins and jewelry). The gold smith usually made jewerly and I think there are few actual historical accounts of gold smiths turning into the Medici’s.

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Douglas M. Green May 21, 2014 at 7:47 pm

The following revelation may only make John’s article above even worse. Banks are not constrained by the amount of customer deposits they have. The Bank of England recently came out with a few videos explaining that deposits do not create loans. Loans create deposits. A bank can make a loan by putting digits in someone’s account even if that bank has zero customer deposits. So banks are far stronger of a force in expansion and contraction than “intermediaries” between savers and borrowers the way Krugman and others have portrayed them. Perhaps this contributes to the reason why Krugman and his fellow keynesians are idiots pushing a model that does not work (see Japan). In any case, check out yesterday’s article at ZeroHedge titled “Banking Buffoonery, Modeling Mysticism And Why Paul Krugman Should Be Sweatin’ Bullets.”

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theyenguy May 21, 2014 at 8:47 pm

Yes indeed the situation is much worse, and this is by God’s foreordain plan from eternity past. The replacement for the Banker Regime’s Money Manager Capitalism is the Bad Bitch of Totalitarianism; she is described Revelation 17:3-4, the Scarlet Harlot who rides the Scarlet Horse

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ditkofan May 22, 2014 at 2:43 am

I would have more confidence in Mr. Rubino’s stories about the invention of fractional reserve banking if he would give specific examples of who these “goldsmiths and jewelers” were who invented it and when they lived. I assumed they lived in the Italian Renaissance, circa 14th and 15th Centuries, when trade and commerce started picking up again in medieval Europe after centuries of very little economic growth. Since Mr. Rubino and his partner James Turk claim to be experts on the long history of money you think they could fill us in on specific names and dates for examples to back their arguments.

Mr. Rubino doesn’t like fractional reserve banking since it creates way to much credit/currency in circulation and therefore he says “The result of this fluctuation in the supply of circulating currency is a recurring series of booms and busts that wipe out businesses, individuals, and banks and frequently send the general economy into recession or depression.” Sure it does, but this has been going on apparently since at least the Italian Renaissance which started over 600 years ago. Please note that Western Civilization and the rest of the world has been getting much richer and prosperous since Michaelangelo was painting the ceiling on the Sistine Chapel in Rome. (Despite the evils of fractional reserve banking in Italy at the time.) Can Mr. Rubino help us out and explain some great period in world history where millions of people got steadily richer with no fractional reserve banking where the banks only loaned out the currency that equaled the exact amount of gold and silver they had on deposit? Of course no such period in history exists. Were the masses of people better off in the ancient Persian, Hellenistic, Roman and Mongol empires when there was no fractional reserve banking, no credit and no currency? No. In the those days only a tiny elite of military rulers and their soldiers and a few merchants had any real money (gold and silver) and there was no significant credit or currency in circulation. Everybody else lived in relative poverty on a small farm and survived by bartering their farm products like animals and grain for what few manufactured goods were available. The rise of fractional reserve banking must have had a large part in putting and end to all that ancient poverty and making more people richer over time; at least increasing prosperity and fractional reserve banking have been happening together since the14th Century. Is fractional reserve banking and the rise of the modern world just a coincidence? I don’t think so. They are intimately related.

If fractional reserve banking is the price we have to pay to live in a rich, modern culture I accept that. Of course this type of banking can be abused and lead to depressions like Rubino says but I’ll take the boom and bust cycle that goes with fractional reserve banking over the poverty and misery that most people lived in prior to the invention of fractional reserve banking. The booms and bust cycle was prevalent in pre 1933 America but the booms were always longer than the busts so over time there was a net gain in prosperity. The busts were actually healthy since they purged the economy of the excessive debts, misallocations of capital and excess capacity that always built up in the previous boom part of the cycle. Any Austrian School economists will tell you that, including I assume Mr. Rubino and Mr. Turk who cleave to that school of economic thought.

In my view, what we need is a system like the period in America about 1870 to 1933 that had some fractional reserve banking among private bankers and vast economic growth and wealth creation for the masses of people, both at the same time. This unique period in world history is the best example we have of a true economic Golden Age. J. P. Morgan was a fractional reserve banker. Was he an impediment to America’s economic development in the 19th Century? No, he wasn’t. He loaned lots of fractional reserve currency to help build American industry in those days.

What we didn’t have however from 1870-1933 was excessive government interference in the economy with regulations on business and the modern day practice of the Federal Reserve printing billions of dollars out of thin air to maintain a welfare state. History shows we can do well when fractional reserve banking is left in the hands of the private bankers who have constraints placed on them by the free market. For instance, a private banker should know the business conditions in his community and credit worthiness of his local loan seekers and loan the bank’s money accordingly. But what we don’t need now is our current system where a remote group of central bankers at the Federal Reserve can print billions of dollars in currency and dump it in the national economy with little control on how it will be used.

I don’t think we can recreate entirely America’s economy as it was before 1933. However, we can work to nudge it that direction and away from the centralized madness we have now. Meanwhile, if Mr. Rubino can describe to me how a modern industrialized economy can operate with no fractional reserve banking at all I am willing to listen.

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PaperIsPoverty May 22, 2014 at 3:47 pm

Wow!! Way to conflate some massive historical trends! Never mind the discovery of the New World, the Enlightenment, the collapse of Eastern empires, democratic nation states, the advent of public health, the discovery of cheap fossil fuels, railroads, and the Industrial Revolution. No, children, we owe our modern Western standard of living to the process of loaning out money we don’t actually have.

1870 to 1933 is an odd time period to cite. The 1870s involved what was referred to at the time as the Great Depression, 1907 saw a financial panic, 1920-21 was a very severe (if short-lived) recession and the rest of the 1920s set up the conditions for the collapse of the 1930s. What we did have were enormous technological and industrial advances and continued settlement of the plains & west of the country. We do not owe this growth in prosperity to JP Morgan. The monopolists of the Gilded Age stymied progress, not advanced it.

If we didn’t have profligate bank lending I think we’d have more direct investment, in which capital is provided in return for a future percentage of profits for some period of time. This would lead to far less malinvestment and would keep finance connected to the real world.

Personally I’m not against any and all fractional reserve lending, but let’s not deify it, and let’s certainly not give it credit for centuries of progress. Those reaping the profits from such lending will invariably push toward the situation we have now — essentially, zero reserve lending — which is clearly disastrous. Finance has now grown into a parasite that will kill its host, and it did it by infecting us with debt through fractional reserve debt creation.

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Chris May 22, 2014 at 2:48 am

By having the fractional reserve banking system, we are now faced with the prospect being blown up by a financial nuclear disaster followed by a real nuclear disaster when war is fought between nuclear weapons countries. We should not never have allowed the financial nuclear bomb to be built.

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pipefit9 May 22, 2014 at 3:55 pm

Why can’t they declare all fiat currencies null and void and roll out some new fiat to replace them all? Everyone without tangible stores of wealth will have nothing, but that is how it has played out in the past as well.

Why would they engage in nuclear war? That destroys wealth. More likely they passively do nothing while a billion or two starve to death, while they take steps to further consolidate their grip on the world’s resources.

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ditkofan May 22, 2014 at 10:26 pm

I don’t want to overstay my welcome here and keep posting lengthy essays on this fractional reserve banking topic. Its time to move on. But, another reader did respond to my first post below and I answered him. Since his response and my answer have, strangely, not been included in the thread below I am going to post them here now since I have some time tied up in this affair. After this I am going to do what the fractional reserve banker, Walter Thatcher, did in the opening to the movie “Citizen Kane”: I am not going to answer any more questions.

Response to my earlier post below:
PaperIsPoverty

Wow!! Way to conflate some massive historical trends! Never mind the discovery of the New World, the Enlightenment, the collapse of Eastern empires, democratic nation states, the advent of public health, the discovery of cheap fossil fuels, railroads, and the Industrial Revolution. No, children, we owe our modern Western standard of living to the process of loaning out money we don’t actually have.

1870 to 1933 is an odd time period to cite. The 1870s involved what was referred to at the time as the Great Depression, 1907 saw a financial panic, 1920-21 wa s a very severe (if short-lived) recession and the rest of the 1920s set up the conditions for the collapse of the 1930s. What we did have were enormous technological and industrial advances and continued settlement of the plains & west of the country. We do not owe this growth in prosperity to JP Morgan. The monopolists of the Gilded Age stymied progress, not advanced it.

If we didn’t have profligate bank lending I think we’d have more direct investment, in which capital is provided in return for a future percentage of profits for some period of time. This would lead to far less malinvestment and would keep finance connected to the real world.

Personally I’m not against any and all fractional reserve lending, but let’s not deify it, and let’s certainly not give it credit for centuries of progress. Those reaping the profits from such lending will invariably push toward the situation we have now — essentially, zero reserve lending — which is clearly disastrous. Finance has now grown into a parasite that will kill its host, and it did it by infecting us with debt through fractional reserve debt creation.

11:47 a.m., Thursday May 22

My answer to PaperisPoverty.

Thanks for writing. I appreciate your interest.

I don’t deify fractional reserve banking (FRB) or claim it is responsible for all progress in the last 600 years. I was trying to lend some counterbalance to Mr. Rubino and similar writers (who I mostly agree with) who are always bashing FRB like it is the root of evils in the world. FRB was invented and grew up with the modern world and has helped in making that world richer and materially better for most people. I’m still waiting for somebody to disprove my statement that there has never been a long period of history where millions of people slowly got richer without FRB. The statement can’t be refuted since no such period exists in history as I documented. The growth of modern technology, especially since the Industrial Revolution (started circa 1820 in England) is more directly responsible for human material progress as you suggested than FRB, but FRB played its part in the Industrial Revolution in a positive way. What good would it have done to invent steam engines and the like if there was no way too economically mass produce them and get them to market? That takes business entrepreneurs and businesses run on loans and credit. Here’s a fact most people don’t know: Steam engines were actually first invented in ancient Greece and Rome thousands of years ago but they were just short lived curiosities that didn’t catch on. Maybe that was partly because the ancient Greeks and Romans didn’t have any FRB bankers to subsidize their creators and bring them to a mass market.

It’s FRB that provided much of the credit and loans that undergirded and facilitated the Industrial Revolution. FRB has always been part of the modern world and can’t be separated from the modern world today. If it somehow was we would be living under the primitive conditions that existed prior to the invention of FRB about 600 years ago.

There’s nothing odd about 1870 to 1933 in America if you looking for the most economically productive period in the history of planet Earth. A nation of poor subsistence farmers was transformed in a short period of time into the richest and most powerful nation in the world, light years ahead of anything seen before. Large smoke-stack industries were created that gave millions of former dirt farmers and sharecroppers much better paying factory jobs. All this progress was greased, expedited and facilitated by FRB in private industry e.g. J.P. Morgan. You back up my point that the recessions in the Gilded Age were all short. The government didn’t interfere in a recession and the free market economy quickly re-balanced itself and ushered in the next long expansion / boom phase where more wealth was created. Most recessions since the 1930s have been much longer and the expansion phases less robust, all due to government interference in the marketplace.

When you deny the contributions of J.P. Morgan and his peers to American material progress you are speaking like a typical Keynesian faculty lounge economist, socialist or other believer in collectivist economic systems. I don’t blame you too much for that. Bashing the business leaders of the Gilded Age by calling them “robber barons” and so on has been standard propaganda in America’s public school system since the 1930s because it serves the aims of the collectivist state we’ve had since then. But, the historical facts show otherwise.

J.P. Morgan and company were all great free market entrepreneurs. They were the leaders, movers and shakers of the Gilded Age (1870 – 1933) that improved the lives of millions of Americans as I already said. Without them the factories and railroads that built America would simply not have existed. The government and poor people don’t create factories and railroads and steam ship lines. Only rich, ambitious, smart people like J.P. Morgan can do that. Please show me some examples where J.P. Morgan, Henry Ford, J.D. Rockefeller, Andrew Carnegie, Commodore Vanderbilt etc seriously delayed America’s economic progress in the 19th Century.

Whatever sins the “robber barons” have on their hands was offset by their enormous contributions to America’s economic growth. Also, the “robber barons” donated most of their untold millions when they died to charitable trusts, many of which are still with us today, e.g. the Ford Foundation. The public school propaganda usually leaves that fact out of the curriculum.

One of the attacks on the Gilded Age tycoons is that they controlled monopolies sometimes. Yes, some of the Gilded Age leaders had monopolies but as I said in my earlier posts here, they could only keep their monopolies by keeping their prices low to keep out competitors. It was J.D. Rockefeller’s competitors who brought the anti-trust suit against Standard Oil, not his customers who appreciated his low oil prices. History shows the only monopolies that can exploit and price gouge their customers are the ones owned or backed by the government, like the phone company AT&T before it was broken up.

J.P. Morgan and company did exactly the opposite of what you say. They advanced the industrial modern age with all of its attendant material progress for the masses of people. They didn’t stymie it. If you do as I have done and read up on the economic history of America in the 19th Century you will likely agree with me. But make sure you read the histories written by free market economists and historians and not the ones written by the Paul Krugmans of the world or your public school teachers.

One final note about FRB: The late 20th and early 21st Century versions of the Gilded Age tycoons are William Gates, Steve Jobs, Jeff Bezos etc. I’m sure like their predecessors they too have used the services of FRB to help build their businesses.

Lewis Forro

Virginia Beach, VA

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Bruce C May 23, 2014 at 2:19 am

No one who understands “FRB” would say that it doesn’t have it’s advantages (and its disadvantages), especially during the early years of its cycle and for those who are most connected to the banking system. The problem is that it is an inherently unsustainable system with a limited “life span” and that it literally steals wealth from the users of the currency.

As you probably know, the US Federal Reserve Bank is the third central bank in US history. There have been many other banking cartels before them in other countries. The US “Founders” understood their sordid histories and the the power of “the mint”, which is why the Constitution explicitly forbade the Congress from allowing banks to control the money supply. Well, that didn’t happen.

The basic, undisputed fact that the US dollar has lost about 96% of its value since 1913, when “the Fed” was born, means that the dollars earned in 1913 have lost 96% of their buying power, simply by existing in, say, a safe deposit box at a bank. Why should that be? Why should the value of one’s work or production lose value over time? How can that mean that FRB/central banking facilitates wealth creation? It doesn’t. It does, however, facilitate commerce, which is English-speak for “a treadmill of debt.” Under FRB one cannot possibly re-pay a loan without more money having to be borrowed to pay the interest.

Before you claim that post 1933 is muddled with too much government interference, consider the fact that your golden age from 1870 to 1933 was after gold contracts were re-instituted by the US Supreme Court. Gold contracts were not honored during and after the Civil War because so much FRB occurred to “fund” the war that the currency lost 75% of its value between 1860 and ’65. The government didn’t want to settle its defense contracts in gold, it wanted to use currency, so it got the Supreme Court to nullify them.

By the way, when the “Robber Barons” executed big transactions, like in the sale of their businesses, they demanded payment in gold, not fiat. And Henry Ford himself said that if people knew how the banking system worked they would revolt (or something like that). There are many other examples as well.

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Bruce C May 23, 2014 at 5:16 pm

I’d like to add that, in the modern vernacular, that there is never a shortage of money to invest in good ideas. This nonsense about progress would have been curtailed if not for FRB is, well, nonsense. Talk to any entrepreneur about seeking financing and you’ll understand that a good product/service and business plan is all it takes for cash to come tumbling down. FRB is not necessary.

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Johan Rebel May 23, 2014 at 3:46 pm

I posted some lessons from history above, not in reponse to diktofan, whose post wasn’t yet visible. I took no position on FRB, although I do think inflation of credit instruments or money instruments benefits certain people at the expense of others, in a manner somewhat analagous although subtler to counterfeiting. In terms of economic progress I do think finance and institutions played an important role, but I think the story is far more complex than FRB. I think more even and more just progress is possible without FRB (though not without finance), even though energy & technology playes a far greater role. However I would rather point to the manifold institutions that played a role historically (even though I am do not have undivided support for all of them):

1-Parliaments, because the creditworthiness of democracies was always higher than those of corrupt authoritarian regimes or royalty.
2-Limited liability corporations, where the construct of a legal person was no longer tied to actual people, magnifiying the scale of enterprises.
3-Equity accounting, in which the worth of an enterprise can be expressed as surplus of assets and goodwill over liabilities at the end of everyday.
4-Equity shares, made possible by accounts (b/c otherwise the value of a share cannot be known and it would be difficult to trade them), and trading them in stock exchanges.
5-Banking & finance, especially international banking with letters of credit, bills of exchange, and stable institutional arrangements which made possible large scale enterprises where profits were only reaped many years later than that liabilities were accepted.
6-Public institutions which guaranteed that legal contracts and deeds were not merely whims of those who yielded the most power at any instant.

Though this is only a rudimentary list, I think it is important to note that concepts such as credit taken on by the people at large (democratically) are subject to erosion in wartime of should a large part of the population feel dispossessed and disenfranchised and repudiate odious debt. Even more important is to note that much of western institutional life is founded on double book-keeping and honest balance sheets (assets/liabilities) and transparent financial reporting. Since Enron and Lehman etc. we know that we live in a culture that prefers not to think honestly about debts and liabilities, but prefers creative accounting, wealth “creation,” (all wealth is the product of natural resources and work: it is not produced ex nihilo) and putting off long-term liabilities: otherwise we would be writing off a lot of unsustainable practices and investing like mad in a sustainable economy. Accounting does not just mean a perhaps boring activity, but also implies responsibility.

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Jason Carter May 23, 2014 at 1:15 am

The prosperity and move from $3 per day wages throughout history is attributable to the discovery and use of oil, I believe. To attribute prosperity to fractional reserve banking does not make mathematical sense. It is this liquid energy with high btu content that has increased worldwide standards of living, not fractional reserve lending. If I lend out $1.00 that I didn’t have to begin with and demand that the nation pays me $1.05 back, even though there is only $1.00 in the whole economy, who is richer for this? Only those connected to the central banking system. Everyone else is less rich. This system only works as long as debt can continually expand. At some point, the money supply and debt will have to go parabolic to avoid a debt deflation spiral that happens when new debt can no longer be added, such as 2008. This model of money creation is nothing more than a wealth extraction mechanism and is designed for eventual self-destruction, either through high inflation, stagflation, or deflation.

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luisgdelafuente May 30, 2014 at 3:24 pm

I think growth is driven by value creation. Value is one of the most interesing concepts in economy for many reasons. Value is not equal to price (eg money) but to personal improvement and expectations. Industrial revolutions created huge value because they helped to improve dramatically people´s lives (water, electricity, telephone, etc.).

Money should be just a way to exchange value, and credit a tool to bring money from the future. Real issue I think is that right now, a huge portion of the economy is just into money trading with almost no value creation. We need a new revolution that improves people´s lives in meaningful ways (not just entertainment!).

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iakovos July 4, 2014 at 7:20 pm

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