Winner of the New Statesman SPERI Prize in Political Economy 2016

Tuesday, 29 March 2016

Why high house prices are partly down to austerity

Diane Coyle, in reviewing Rowan Moore’s book Slow Burn City: London in the 21st Century, focuses on the idea that forever rising house prices could gradually kill off what is now a vibrant city. As housing gets steadily more expensive, getting people to work there will get more and more difficult. In the meantime, young people who can afford to buy get more and more into debt. I wonder whether soon mortgage providers will become more interested in the wealth of borrowers parents than in the borrower’s own earning capacity. (This is not just a London problem: see here about New York for example.)

The reason for this that everyone focuses on, understandably, is stagnant housing supply. However, housing can also be seen as an asset. Just as low real interest rates boost the stock market because a given stream of expected future dividends looks more attractive, much the same is true of housing (where dividends become rents). Stock prices can rise because expected future profitability increases, but they can also rise because expected real interest rates fall. With housing increasingly used as an asset for the wealthy, or even as a way of saving for retirement, house prices will behave in a similar way. A shortage of housing supply relative to demand raises rents, but even if rents stayed the same falling expected real interest rates raise house prices because those rents become more valuable compared to the falling returns from alternative forms of wealth.

That is why a good part of the house price problem comes from the macroeconomy: not just current low real interest rates, but also low expected rates (secular stagnation). The idea that house prices are tied down by the ability of first time buyers to borrow (and therefore to real wages or productivity, modified by changes in the risks lenders were willing to take) seems appropriate to a world where the importance of the very wealthy was declining, and most people could imagine owning their own home. We now seem to be moving to a more traditional world (remember Piketty) where wealth is more dominant, and with low interest rates that may also be a world where renting rather than home ownership becomes the norm for those who are not wealthy and whose parents are not wealthy.

There may be factors behind secular stagnation (low long term real interest rates) that we can do little about, but there are things we can do right now that will raise interest rates, and thereby tend to lower house prices. The most important of those is to stop taking demand out of the economy through continuing fiscal consolidation (aka austerity). This boost to demand that comes from ending fiscal consolidation will allow central banks to raise interest rates more quickly. While central banks may only be able to influence real interest rates in the short term, because so much uncertainty exists about what this long term involves the short term may have a powerful influence on more distant expectations.

We can also have some positive influence on the longer term by increasing public investment, including forms of public spending (that may not be classified as investment) that encourage private investment. It should also include building houses where (or of a kind) the private sector will not build. That will have beneficial effects in terms of raising real interest rates in both the short and longer term.

Ever rising house prices lead to unprecedented high levels of private debt, and also destroy the dream of many young people to own their own home. One answer is to build more houses, but another is to run better macroeconomic policies. That house prices continue to rise during a period of fiscal austerity is not an anachronism. It is not a bug but a feature of an age of austerity.



43 comments:

  1. This is a great post. I hope you've read some of Kevin Erdmann's amazing analysis of the US housing market.

    The one factor you didn't emphasize, which Kevin might have, is the relevance of the replacement cost of a home. In an ideal world, where there are few legal restrictions on building, the market price of a home cannot rise substantially above its replacement cost. While increasing future expected rents and falling expected long-term real interest rates certainly drive house prices, do not forget about the third leg of the deadly stool: regulatory barriers to creating more housing.

    That supply limitation hurts us in three ways:

    1. less available housing in high productivity areas. We have literally created a scenario in Silicon Valley where people flee prosperity!, moving to Phoenix for lower housing prices.

    2. fewer jobs for construction workers. If it's not legal to build in desirable areas, then there is less building.

    3. higher home prices.

    In other words, high home prices are merely a symptom of an incredibly destructive process of self-deprivation, where we deprive ourselves of additional workers in high productivity areas and jobs to build homes for them, in the name of ... what? Keeping my neighborhood the way it was 50 years ago? At what price!

    It would be great for more economists to recognize how destructive these well-meaning land use restrictions are.

    Thanks,
    -Ken

    http://idiosyncraticwhisk.blogspot.com/2015/10/housing-series-part-65-reasoning-from.html

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    1. I agree. The key question is how much supply limitations are there for good reasons, or are unavoidable, in major cities.

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    2. Alternatively housing could be built a short distance say up to 100 miles and invest in high speed trains,roads and other infrastructure,getting rid of regulations will not add a single penny to the purchasers pocket,but cheaper housing with good transport will!
      That also provides better infrastructure for satellite business to thrive.
      Because building in dear/high demand places means a delay in falling house prices because they are assets!

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  2. "rising house prices could gradually kill off what is now a vibrant city. As housing gets steadily more expensive, getting people to work there will get more and more difficult."

    As if this was a development that could become a problem in the future! It is a huge problem now, the result of a gigantic failure of financial regulation and housing and infrastructure policy.

    The average student in low-rent Berlin or Vienna probably has a higher standard of living than the average single professional in high-rent London. The student can afford to live in a studio or decently sized and well-maintained shared apartment in Berlin, and still have a budget to enjoy the amenities of the city. The single professional can hardly afford a studio or one-bed room in London. The low rents are a major reason why Berlin is "cool" and an attractor to the European non-careerist youth in a way that London is not. Today London is "vibrant" perhaps from a business perspective, from the perspective of a global elite, but not from the perspective of a young median- or low-income person who doesn't already own a home in London. The median- or low-income person is hardly able to enjoy the amenities that the "vibrant" city is offering.

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  3. Where a city like London is concerned even building many more homes will probably not have the desired outcome on prices due to agglomeration effect. It will simply make London the place to live and work...or buy to let!

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  4. To put up interest rates now to bring down the price of houses would be a brutal and damaging action, as it was in the late seventies when Milton Friedman advised this to control inflation by restricting the creation of money by banks. It has always been a terrible way of controlling inflation, damging businesses and households alike.

    House prices have been inflated by the quantitative easing programme and the help to buy programme. With fiscal help from the government, banks can create more money for mortgages as the government is underwriting a fraction of the loan. It is a sort of perverse socialism for the finance industry, and maybe for the sellers of houses.

    It has proved one thing, that government intervention can cause inflation, ie house price inflation, especially as house demand is outstripping supply and council housing offers few options.
    People are in a situation where they either take the crippling debt, or stay with their parents unable to start their lives. The debt is the choice between a rock and a hard place. Those who have taken it on will suffer their own micro debt deflation or forclosure with a rise in interest rates, and this could cause another financial crisis.

    House price inflation began with the big bang, Lawson 1987. Building Societies could act as banks, the conflict of interest arose when those who could act as brokers also had an interest in profits and shares. There was an incentive to lend as much as possible 100% mortgages. In 1979, a couple could not borrow more than 3 times their income. It rose to many times that, and the incentive on both banks and sellers to make a profit sent house prices soaring. Many booms and busts of the 80s led to negative equity and forclosure. This had not happened in the pre Keynesian era when the banks were regulated and public spending and wages were relatively higher. This is the reconstruction that is needed, not higher interest rates.

    One other cure, apart from regulation of banks, and well paid job creation, would be to build exclusively public housing at nominal rents, as this would help the homeless, but also act as a calming effect on house prices in general.

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    1. I'm not arguing that we should put up interest rates now to bring down house prices. I'm arguing that governments should spend more, which will have the inevitable effect of allowing interest rates to rise earlier than they would otherwise have done. Big difference.

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    2. We certainly need more spending, that will tend to put up interest rates and that will tend to pull house prices down, especially if much of that spending is directed towards housing. Overall this is desirable but we shouldn't ignore the negative consequences, particularly for those who have recently taken on mortgages, often at the limits of their income, who could then be faced with both rising repayments and negative equity. Supporting a fiscal expansion with a parallel monetary expansion would mitigate the interest rise and these effects but we will probably also need targeted measures to aid owner occupiers who get into trouble.

      Considering housing impacts of interest changes reinforces my view that MPC decisions on rates are not just a technical matter of judging the inflation path but have significant distributional effects and hence are inherently political.

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    3. I would add that as well as bank regulation, there is also a strong case for shifting taxation from earned income towards property, particularly at the top end, and ultimately for a land value tax. This would help to curb house price rises. It would also tackle inequality, to which rising residential property prices have contributed significantly, as both Piketty and Stiglitz have shown.

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    4. How can government spending increase interest rates?
      Banks create money according to their confidence that it will be repaid (or bailed out), loans create deposits. They look for reserves later. Without regulation, they are not constrained much, hence the inflated house prices.
      Governments outside the Eurozone are sovereign currency issuers, they are not constrained, so the loanable funds theory does not make sense. If there is no competition for funds, why would interest rates change when government spends.
      It would seem to me that the only way to make housing affordable would be for governments to spend creating well paid employment, and to control bank lending, so that income debt ratios come down.

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    5. You have been reading too much MMT. In the real world the central bank targets inflation by managing demand. If demand increases because governments spend more, interest rates will tend to rise. Carney has said as much.

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    6. I do not read any particular school of thought blindly. I put these questions in the hope of learning.
      It is just that some economists have said that interest rates go up when governments spend because of the loanable funds theory and crowding out, due to competition for funds. Paul Krugman has said that there are patient and impatient people, implying that there are limited loanable funds, and implying that government spending crowds out private investment. He has been criticised for not either understanding, or admitting what the Bank of England tells us, that Banks create the money they lend. When these theories abound, it is not surprising for someone like myself, (not an economist), to ask questions of those who are good willed enough to be running a blog, whether they be MMTers, mainstream, new Keynesians or otherwise.
      You may have a different explanation to the above which might help me. It seems however, that it is not always so, because Japan has had a zero rate of interest with high deficits. The government can control inflation with well targeted taxes.

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    7. I wonder if it is strictly true that central banks need to manage demand. It is true that they sell bonds to banks to mop up reserves to control the interbank rate.

      If people are receiving more government money through employment in the public sector, benefits or services, the need for bank loans falls, so demand for bank created credit falls. the sectorial balance charts show this, that household debt rises with more deficit spending and falls with less. http://www.coppolacomment.com/2015/03/repeat-after-me-sectoral-balances-must.html
      People will not use expensive credit if they can use government money that reaches their bank account. I think that it is the demand for bank money that falls, rather than demand in the market place.

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    8. I have got that the wrong way round! The sectorial balances show that household debt FALLS with more deficit spending, and RISES with less deficit spending.

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  5. I think the processes of housing pricing are not talked about enough. For almost everyone, all other things being equal, buying when one can afford to do so, is the rational choice.

    What I mean is, if you can afford to take on a mortgage and then live somewhere. Even if house prices fall significantly, as long as you are not forced to move or get repossessed, you will always be better off. Even if, after 25 years of paying a mortgage, the property is worth less than you paid for it, you still own your home. Whereas if you'd rented for that time, you would have no asset at the end of your 300 monthly payments. The only way that this would not be true is if rents were significantly less than mortgage payments. And of course, currently rents are often higher than mortgage payments.

    As this is true, people go to significant lengths to get enough of a deposit in order to buy. (Mostly raising money from parents / family etc.) What this does is to distort the classical supply/demand balance as demand is artificial supported.

    Now, I'm just an interested amateur, and these are my observations, I am sure real economists have looked at this properly and more importantly quantified it, but the problem is that it is not a self-correcting market at all. As Wren-Lewis observes, we are moving back to a more traditional world where only the wealthy get to own their homes.

    I agree with Wren-Lewis's conclusion above about the effect of Austerity but the housing crisis requires multiple responses. We need housing to be affordable. Ultimately, high housing costs make a small number of people increasingly weathy and everyone else much poorer.

    AFZ

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    1. Not sure there is much evidence that rents are < mortgage payments + the return foregone on equity owned in the property. Paying the principle on a mortgage is a forced means for households to save. Thats one behavioural argument for buying over renting.

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    2. I don't know what the evidence is but in theory it's really clear cut. Would be happy for someone to show me I'm wrong.

      Let me demonstrate this with a worked example:

      So I buy a house and my mortgage repayments are £1000/month. That means over the course of 25 years, I will pay £300,000. If at the end of 25 years, my house is worth £150,000, I have in cash terms paid 200% of the buying price. So theoretically I could save for 25 years and then buy it cash.

      In order to save £150,000 over 25 years, if I can get 4% on my savings, I need to save £295/month. In the meantime I need to find somewhere to live. I will only be better off if my rent is less than £705/month. (i.e. the rent needs to be 30% less than the mortgage nominal payments).

      Now, a mortgage payment of £1000/month at 5% will give me a mortgage of £172,000. Hence the buying option is still better even if the house drops in value by 13%!

      Obviously if the interest rates go up, the equation changes but the principal stands that for most people, most of the time, buying will make them better off in the long term, unless rents are significantly cheaper than nominal mortgage payments. (For 8% savings rate and 10% mortgage rate, I would need to save £166/month and the house I could buy would have to cost no more than £110,000. (Even RPI inflation running at the previous average of 3.9%, never mind the real rate of house price inflation, would make the house worth over £400,000 in 25 years time)

      AFZ

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  6. Your logic could also work in reverse – high house prices constrain the use of fiscal policy because of risk of negative equity. Perhaps this was part of the thinking in the policy response during the financial crisis . It is of course an even bigger problem today.

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    1. Tell that to the tulip growers,asset prices will only drop once,no more savings(QE) are available to invest and since the amount of money in the system to getting a return on it!increases daily with austerity it drives the prices on,not constrain it at all.it may well stimulate crashes in other sectors,as tulips are abandoned for what seems a better investment!

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    2. ps see commodity prices? for money exiting one tulip for another! and now looking for a new HOME!

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  7. A stable population won't need more houses. The children will take over the grandparents home and their children will take over their parents home. Just those with more children will have to buy from those without.

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    1. Drivel. We don't have a national housing market. We have local ones. In the short/ medium term, demand changes locally based on job growth etc. Nowt to do with population trends.

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  8. Simon,

    You argue that interest rates are artificially low because of insufficient fiscal stimulus (i.e. austerity). I suggest (as Warren Mosler has argued) that the GDP maximising rate of interest is actually zero. That is, what’s the state doing implementing so much fiscal stimulus (or if you like, printing and spending so much base money into the economy) that it then has to borrow some it back so as to raise interest rates and damp down demand? Strikes me there’s a self contradiction there.

    Re Warren Moser, hope you don’t mind me plugging his appearance in Milton Keynes on 13th April. For those who want to meet him, tickets are here:

    https://www.eventbrite.co.uk/e/audience-with-warren-mosler-tickets-23899462937

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  9. You don't have the right diagnosis - based as it is on price for lending rather than what can be lent, to whom and for what.

    See how the New Zealand Central bank deals with a property bubble - increases deposit requirements and reduce loan to value levels:

    http://blog.shelter.org.uk/2015/06/time-for-the-bank-of-england-to-join-the-macroprudential-party/

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  10. House prices have doubled in real terms in the UK over the last 20 years, whereas they're remained stable in Germany, Japan and Switzerland (See The Economist house price index). But the latter three countries have also seen interest rates fall. That suggest to me that there are a number of significant factors influencing house prices other than interest rates.

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    1. Of course there are other factors: anything that influences supply or demand. I was simply pointing out one factor that is hardly ever mentioned.

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    2. The main factor in unaffordable UK housing is the Town and Country Planning Act 1947.

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  11. A missing element in this analysis is the shift towards private rented property, which has offered an attractive asset class with a return that has included capital gain. This injection of capital has further boosted prices, creating a spiral of vindicated expectations and priced-out aspiring home owners. Even Osborne has recognised the need to curb 'buy to let' although I suspect his measures will do more to squeeze out small owners with one or two properties than to deter corporate investment, which seems to be growing, particularly in sectors such as student housing.

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    1. I'm not sure its a missing element, but just the detail on the same process: housing becoming an asset. Like all assets, you then get the problem of incorrect beliefs (house prices will always rise).

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  12. This argument only makes sense if home ownership is a public policy goal. If the goal is a more modest "access to housing" via rentals, then a rise in house prices due solely to declining interest rates should concern no one. Rents in that scenario wouldn't change relative to incomes.

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    1. A good point, to which I think there are two responses. The first is that it should be a public policy goal. The second is that the process of moving to a rental only world involves significant redistributions (including between generations) which we should be concerned about.

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  13. Hi Simon.

    I think low real interest rates partially helps explain the attractiveness of homes as an financial asset in the post-crisis period. But it is not the most important explanation and it certainly isn't very useful in explaining the very large increases in house prices relative to income/GDP that occured in the UK prior to the crisis (basically since the 1980s) when real interests were higher/normal. The main causes of house price increases in the UK and other, particularly Anglo-Saxon liberal economies, has been deregulation of the financial sector in the 1980s, 1990s and 2000s combined with the removal or erosion of taxes on capital gains/land value. Lending against property is attractive for banks vis a vis firms because loans are collateralised and Basel rules mean less capital is required. Meanwhile housing has become by far the most desirable form of saving for households because capital gains (on first homes) is not taxed, unlike all other financial assets. Also our rental market is one of the most poorly regulated in the world, meaning home ownership is the only way of gaining a secure long-term 'home'. So increased demand and increased supply of effective purchasing power (via mortgage financing) meets finite supply of land = house price inflation: https://medium.com/@neweconomics/why-you-can-t-afford-a-home-in-the-uk-44347750646a#.sebjxdwiy

    Josh Ryan-Collins
    New Economics Foundation

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  14. I think there is more to this than macro-policy. The concentration on wealth in London is related to deindustrialisation outside London which is linked to globalisation. Historians are the people to consult on how this happens. They look properly about how societies rise and economies grow - and decline. They already know about economists suddenly call 'secular stagnation'. When it comes to theory, if it has to, Marxian theory has more to say about this than neo-classical theory.

    Which brings me to Port Talbot.

    I hope mainstream economists don't draw on orthodox theory and free trade when
    advising on this matter. You must consult many, including Sinologists who will tell you that Chinese dumping is related to a large state sector in steel. The steel industry in China was built on state subsidy. We cannot afford to lose steel, it is critical for the manufacturing base of this country.

    This is where economists can do something more useful than what they advised during the New Labour era (free trade, free capital flows, light touch regulation in the City).

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    1. I never suggested that house prices were just about interest rates, but simply that right now its a factor. On Steel, I would simply note that this government is stopping the EU dealing with the problem of China dumping

      http://www.huffingtonpost.co.uk/entry/steel-tata-javid-eu-dumping_uk_56fbbdd1e4b0c5bd919a9215

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    2. "this government is stopping the EU dealing with the problem of China dumping"

      That is BS.

      The EU commission set the dumping tariff at about 13%.

      That is the value *the EU commission considers is sufficient to set Chinese steel on a competitive par with EU steel*. Not anybody else - the EU commission. That wonderful organisation you are so fond of.

      So as far as the EU commission is concerned any problems in British steel manufacturing is down to the inability to compete in a global market.

      That's the EU looking after the EU steel industry. By selling it down the river.

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    3. Thanks Simon, for this. I hope the government's hypocrisy is made clear in the media. Another example where you have to keep up your good work! Personally I doubt whether Britain has the muscle to deal with China in international trade rounds; this is where we need the EU. Unfortunately this is another example of the UK undermining good work that the EU does. This was done, unfortunately, under both the Conservatives and New Labour. I think a big battle was lost in the 1990s; essentially France and Germany lost against the UK (backed by the US). G and F wanted less expansion, but more consolidation and convergence - including political and fiscal union.

      A lot of problems can be traced back to this.

      NK.

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    4. I suspect the anti-nuclear fanaticism of Germany and Austria is one of the root causes as Port Talbot's woes, as fear that these countries could kill Hinkley Point C in the European courts led the UK government to rope the Chinese government into the project on the basis that "to defeat a bully we need a bigger bully".

      Hence Cameron's kowtowing to China at the expense of our steel industry...

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  15. Have I missed something, or wouldn't higher interest rates increase the cost of buying a property? I mean through raising the payback cost over the life of the mortgage.

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    1. If the house prices stayed the same this would be true. But they won't - a fixed amount per month can service a mortgage on a much more expensive house if the interest rates are lower.

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  16. The crocodile tears of a microeconomic fundamentalist runneth over?

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  17. Don't forget higher interest rates would clobber claimants and the low waged with mortgages.

    Support for Mortgage Interest (SMI) – From 1 April 2016, the SMI waiting period will return to the pre-recession length of 39 weeks, but the capital limit will be maintained at the higher level of £200,000. From April 2018, new SMI payments will be paid as a loan. Loans will be repaid upon sale of the house, or when claimants return to work. Payments will accrue interest at a rate tied to the OBR forecast of gilts.

    Not good news for steel workers with mortgages who may soon be unemployed.

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  18. I guess we should also take into account the effect of real interest rates on the price elasticity of housing supply. Falling real interest rates should raise both house prices and land prices. Consequently
    developers have a speculative incentive to postpone land development during a period of falling interest rates. The real option of postponing land development derives its value from the possibility that the present value of profit from future development may exceed the profit from immediate development. According to Eric Levin, we should expect the price elasticity of house supply to be lower where interest rate movements (rather than income or demography) cause the change in house prices. See http://www.tandfonline.com/doi/abs/10.1080/02673030903215860

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