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March 20, 2005
The Volatility Problem
After mining data from the Panel Study of Income and Dynamics, a database produced by the University of Michigan that tracks the incomes of the same families over a 40-year period, scholars have concluded that incomes are much less stable - i.e., much more volatile - today than they have been in the past. "There has unequivocally been general upward-trend income volatility since at least 1975," said Bruce A. Moffitt, the Krieger-Eisenhower professor of economics at Johns Hopkins University, who, with Professor Gottschalk, wrote one of the first papers on income volatility in the 1990's. "It accelerated in the 1980's, turned down in the early 1990's, and then accelerated into the end of the 1990's."
According to a measure of volatility constructed by Jacob S. Hacker, a Yale political scientist, which tracks the five-year moving average of family incomes, income volatility rose 88 percent between 1978 and 2000...
"The problem in the past few decades," Professor Moffitt said, "is that volatility has risen while real incomes haven't risen." What's more, income volatility has grown significantly for those who can afford it least. A series of articles last year in The Los Angeles Times, written by Peter G. Gosselin, who worked closely with Professor Moffitt and other scholars, reported that in the 1970's, income for middle-class Americans tended to fluctuate by 16 percent a year. But in the 1980's and 1990's, middle-class incomes fluctuated an average of 30 percent. For those whose earnings placed them in the bottom fifth, income volatility rose from 25 percent in the early 1970's to 50 percent in recent years.
Part of the solution? Maintain the existing defined-benefit social security system, of course.
As we learn more about income volatility in the information age, some scholars say, Social Security - an insurance program designed for the industrial age - may be even more essential...
"Social Security provides a vital kind of insurance," Professor Hacker said. "The real issue lurking behind this debate is whether we should have a program that provides the bedrock protection against economic risk."
I'm not going to dispute any of this, but it as at least worth pointing out that volatility is not the same thing as risk. That is obvious in the case where increased ups and downs in income are perfectly predictable, but that isn't really what I have in mind. What I have in mind is the perfectly straightforward observation that volatility of returns in financial assets can actually reduce the risk associated with fluctuating labor income by providing a means of diversifying total income.
It is true that an appeal to income diversification is not all that helpful to those of us who favor a private account option for social security reform. Steve Davis and Paul Willen have a very nice, and accessible, paper on the issue, and find that broad equity returns do not appear to be highly correlated with occupation-level income shocks. Furthermore, what benefits there might be would likely accrue to higher-income individuals.
Still, not a lot of research has been done on this issue, and I would ask this question: If muting the impact of labor-income volatility is a motivating factor for supporting the social security system, is a program intrinsically tied to both aggregate and individual labor-income fortunes the sensible way to go?
There is also this, from the Times article:
Because of other longstanding trends in the economy, strong income volatility can wreak greater havoc now than it did in the past...
Why? Many families already rely on two incomes. What's more, fixed commitments have risen as a percentage of total income.
Again, maybe so. But can't we be just a bit skeptical? Working more because we consume more is a choice. I make that choice all the time. So do you, I bet. What's the problem? (The same would go for endogenous income volatility associated with the choice to move in and out of the labor force, change employment circumstances as a life-style choice, and so on.)
Here's a simple smell test I can't help but employ. Any time a learned study seems to conclude that economic welfare has declined relative to the 1970s, it's time to start asking digging deeper. The facts may be right. What they mean is much trickier proposition.
A couple of other random points about the Times piece.
-- I meant to mention this before, but I was slightly amused that one of the poster-boys for the LA Times first article on the problem of income volatility was one Paul Fredo, a financial analyst, whose income fluctuated a lot, between $200,000 and $120,000. It looks to me that it is people in this income class that are likely to bear most of the burden of closing the social security financing gap. (Think removing the ceiling on income subject to payroll taxes, reducing benefit indexation for "high-income" folks, and so on.) So much for the helping hand of government in his case.
-- The "Bruce A. Moffitt" referenced in the NYT article is actually Robert A. Moffitt.
-- The NYT article leads with this sentence:
Judging by the polls, President Bush's plan to transform Social Security from an insurance program that guarantees a minimum income into something more closely resembling a 401(k) investment program isn't going very well.
That is a highly selective reading of the polls. More on that to follow.
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March 14, 2005
Old Business: Defending "Defending Mankiw"
A confluence of personal and work-related responsibilities made for very spotty blogging last week. I'm back, but there are few pieces of unfinished business to which to tend. First up is my earlier post regarding Greg Mankiw and Phillip Swagel's March 3 pot-shot at critics of President Bush's desires on social security reform -- more specifically, Brad Delong's and pgl at Angry Bear's complaints about my comments.
At issue -- or at least what was at issue in my post -- was the following passage from Mankiw and Swagel:
The introduction of personal accounts will involve some transition financing, but this increase in the budget deficit won't place a new burden on future generations. These deficits are just an acknowledgment of promises that were made long ago.
In his original comments on the subject, DeLong followed this up with an earlier passage from Mankiw's textbook about deficits increasing the demand for loanable funds, raising interest rates, and so on. I cried foul at this comparison, and Brad cried foul back in a comment to my post.
You chopped your quote from me off too early. The next paragraph is:
"We worry about the budget impact and effect on national saving of the Bush Social Security plan because there is a chance that it will significantly diminish national saving and lower economic growth. If holders of defined-contribution private accounts regard them as close substitutes for their other assets in a way that promised defined-benefit standard Social Security was not, then the Bush plan will be yet another budget-busting shift of the tax burden that will slow economic growth.
Well, creative editing is a hanging offense if it distorts another's position, and I had no intention of doing so. But my criticism was much more narrowly drawn. What I objected to was not the omitted paragraph above, but the implication that somehow Mankiw was not being true to his school by claiming that the specific form of debt that might be involved in the conversion of future benefits will be economically neutral. Pointing out that most instances of deficit finance are non-neutral does not imply that it is so for every policy. Mankiw (and I) can live quite comfortably with both statements, and to present them as if they are in conflict is pure misdirection.
DeLong is, of course, correct in noting that it all comes down to whether "holders of defined-contribution private accounts regard them as close substitutes for their other assets in a way that promised defined-benefit standard Social Security was not," a point he repeats in his march 12 post "Mankiw 0, Liberals 3." (I can't seem to get the permalink thing working.) But my second point remains.
That second point is this. If debt issued to represent promised future benefits are not viewed as perfect substitutes by beneficiaries, then it is hard to see why the same sort of assets held in the social security trust fund should be.
pgl notes DeLong's comment about substitutability, but adds this:
Mankiw claims some households are liquidity constrained. Now I’m not sure if the Bush plan would relax those liquidity constraints precisely because Bush refuses to give specifics. But if it does and if one believes liquidity constraints are important as Mankiw does, then how can one appeal to Ricardian logic.
I'm not sure if Mankiw is still appealing to this argument or not -- it's not in the Wall Street Journal article in question. Certainly if the debt were to take the form of individual-specific "recognition bonds" that are otherwise non-marketable, there would be no impact. That, though, is an issue related to the substitutability of promised benefits, about which I agree reasonable people can disagree.
The main point of my post was that I find it difficult to reconcile the argument that converting promised benefits into explicit debt is non-neutral with the position that those promises are inviolable. In the case of liquidity constraints, the existence of promised benefits have no economic impact, as the consumption and saving plans of constrained individuals are not contingent on the receipt of future benefits. (Unless, of course, the future income represented by those payments is the reason for the constraint, which I find hard to believe is what anyone has in mind.)
In short: If I really believe that I am going to be paid the benefits promised at the time I pay my social security taxes, it is an act of bad faith on the part of the government to renege after I have done my life-cycle planning contingent on the expectation of the receipt of those payments. But if that is so, issuing a paper promise won't affect my behavior. If that piece of paper does affect my behavior, then I must never have believed the promise in the first place. I guess I'll leave to the philosophers to determine whether a promise not believed is really a promise. But I think the economics are clear.
P.S. pgl also takes on Mankiw's recent (subscriber only) New Republic article. For the record, Mankiw does not claim there is a free lunch on Social Security reform in his Wall Street Journal article.
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March 05, 2005
Not that he needs it from me, and there have already been multiple comments about Brad DeLong's rant on Greg Mankiw and Phillip Swagel's Thursday Wall Street Journal commentary -- at Angry Bear, at MaxSpeaks, at New Economist, at Dead Parrot Society, at EconLog-- but I feel compelled to put in my two cents.
Apparently, IT'S THE HYPOCRISY that got Brad's dander up.
This morning he writes, giving free advice to Democrats like me:
Mankiw and Swagel: Stop railing about the budget impact [of the Bush Social Security plan]. The introduction of personal accounts will involve some transition financing, but this increase in the budget deficit won't place a new burden on future generations. These deficits are just an acknowledgment of promises that were made long ago. And if you think that complaining about budget deficits will advance your career, just ask President Mondale.
Back in 1998 he wrote:
...the most basic lesson about budget deficits follows directly from their effects on the supply and demand for loanable funds: When the government reduces national saving by running a budget deficit, the interest rate rises, and investment falls. Because investment is important for long-run economic growth, government budget deficits reduce the economy's growth rate. (N. Gregory Mankiw (1998), Principles of Economics (New York: The Dryden Press/Harcourt Brace), p. 557.
If you read carefully, you will detect that DeLong knows these two statements are not necessarily inconsistent. It is entirely reasonable to believe that deficit spending leads to lower national saving in general, while at the same time acknowledging that there some types of transactions that have Ricardian properties. I have said it so many times before that I won't even bother to link to previous posts, but if there was ever a policy-driven transaction without consequences for national saving, it would have to be issuing explicit debt for already promised benefit payments. (OK, I lied -- here's the link.)
It's bad enough that DeLong confused the issue with his largely irrelevant juxtaposition. What's worse is that he ignores a real inconsistency in the debate. Roland Patrick at Let's Fly Under the Bridge nails it:
With his pajamas down [DeLong] admits that Social Security's 'Trust Fund Bonds' aren't real assets and future generations will not collect their promised benefits.
At least that is the only logical argument that can be drawn from criticizing Greg Mankiw for saying transitioning to private accounts will simply be a matter of replacing implicit debt with explicit debt.
Right. DeLong goes on:
I am cranky, and annoyed. And I am not asking for very much. All I want is:
- No more claims that we know that carving-out Social Security revenues to fund private accounts will have no damaging effect on national saving. It might work. It might not.
Fine. But if your answer is "not" then you should also drop the argument that the trust fund is meaningful.
PROPHYLACTIC COMMENT: I have already conceded that the trust fund should be treated as a meaningful promise to pay future benefits.
SIDE NOTE: For some reason, thinking about the difficulty of pegging a particular policy as Ricardian or not reminded me of the results from this long-ago paper by Jim Poterba and Larry Summers:
Using a lifecycle simulation model, we show that even though deficit policies shift sizable tax burdens to future generations, individuals live long enough to make the assumption of an infinite horizon a good approximation for analyzing the short—run savings effects. In practice, periods of debt accumulation such as that in the United States during World War II are reversed sufficiently rapidly to make their short—run effects on consumption and national savings relatively small.
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» What will privatization do to national saving? from William J. Polley
Let's start with a quote from macroblog. I won't even bother to link to previous posts, but if there was ever a policy-driven transaction without consequences for national saving, it would have to be issuing explicit debt for already promised... [Read More]
Tracked on Mar 7, 2005 1:59:36 AM
February 21, 2005
The World Bank On Public Pension Reform
In 1994, the World Bank set out its thinking on pensions in developing countries in a landmark report. “Averting the Old Age Crisis” became the reference point for the Bank's approach—one given clout by its lending power. It advocated a move away from pay-as-you-go financing, under which contributions from workers pay for today's pensions... The report backed, where possible, a much bigger role for compulsory funded pensions, paid for by workers saving part of their earnings in retirement accounts.
Eleven years on, the Bank has taken stock, reviewing how reforms have worked and taking account of criticism and new ideas. The result is a new report, to be released on February 21st. “Old-Age Income Support in the 21st Century”, a copy of which The Economist has seen, is intended to be the definitive guide to the Bank's current thinking...
The new report says that the case for the Bank to support pension reform has grown stronger in the past decade. Existing systems are not good enough. “Most pension systems in the world,” it argues, “do not deliver on their social objectives, they contribute to significant distortions in the operation of market economies, and they are not financially sustainable when faced with an ageing population.”
... In Latin America, for example, reforms to expensive pay-as-you-go schemes have improved governments' long-term fiscal positions. The new funded individual accounts have been costly to run but have generally delivered impressive returns. Nevertheless the number of future pensioners who will benefit looks set to be disappointingly low, because many workers are not covered by the new arrangements...
Since “Averting the Old Age Crisis”, there has been fresh thinking about reforming existing pension systems. Sweden pioneered the idea of “notional accounts”. These maintain pay-as-you-go financing, but treat workers' contributions as if they were paid into individual accounts, which then form the basis of their pension benefits. Poland and Latvia have also adopted the system. At first, the Bank was sceptical about this idea. However, it has since recognised the potential of notional accounts, which establish a tight link between payroll contributions and eventual pension benefits. They are, says the report, a “promising approach to reform or to implement an unfunded first pillar”.
The report did not appear to be available at the time of this post.
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February 20, 2005
From John Berry, writing for Bloomberg:
Federal Reserve Chairman Alan Greenspan's testimony yesterday before the Senate Banking Committee undermined virtually all of the Bush administration's arguments for diverting some Social Security tax payments to fund private retirement accounts.
From Amity Shales, in the Financial Times (access may require subscription):
Things were looking especially good in midweek, when Alan Greenspan, the Federal Reserve Board chairman, blessed the main components of the Bush plan.
Hmm. Any thoughts on which opinion is "most right"?
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Are Federal Reserve Notes And Treasury Debt The Same Thing?
2042 is the fictional date for the fictional bankruptcy of a fictional trust fund. Let's start with basics. The Social Security system has no trust fund. No lock box. When you pay your payroll tax every year, the money is not converted into gold bars and shipped to some desert island, ready for retrieval when you turn 65... These pieces of paper might be useful for rolling cigars. They will not fund your retirement. Your Leisure World greens fees will be coming from the payroll taxes of young people during the years you grow old. That is why 2042 is a fiction. The really important date is 2018.
pgl trots out a pretty clever argument.
If there are Federal Reserve notes in your wallet, I’ll gladly buy you a cup of coffee if you give them to me.
If you really believe piece of paper called financial assets are worth nothing, I’ll gladly take all of your cash, funds in your bank accounts, and other financial assets. In turn, I’ll even buy a week’s worth of groceries.
Clever, but not apt, I think, because modern institutions really do imply different expectations about the liability represented by a Federal Reserve note compared to that represented by a Treasury security.
Here's what I mean. I think it useful (and appropriate) to think of my economic relationship with the government in terms of the totality of our financial interactions. In other words, my net tax burden does not just consist of my social security taxes, or my income-tax payments, or what I remit in Medicare "premiums", etc., etc., etc, but the present value of all my payments to the government less all the payments they make to me. (This is the fundamental idea behind the concept of generational accounting, of which I am a very big fan.)
Suppose I hold a Treasury security. That, of course, is a payment the government owes to me, and I have every expectation that it will be made. But if, for some reason, there has been a miscalculation, a change in economic circumstances, a change in policy, the government may find that it has to raise my taxes to obtain the revenues to honor those payments. In doing so, it has effectively reduced the return on that security. Distortionary price effects aside -- granted, a major qualification -- why should it matter to me how it happens? Lower my social security benefits, raise my income taxes, whatever. It all amounts to a haircut on that Treasury payment to me.
Because the distributional aspects of these things can matter, blanket haircuts are probably a pretty bad idea -- foreigners, for example, finance a good chunk of our collective borrowing, and they aren't likely to appreciate the opportunity to finance our fiscal imbalances on an ongoing basis. Changes in tax and transfer policies are the way we go because they can be targeted (which gets us to positive versus normative questions, which I'll address below.) But the basic economic distinction is one without a difference.
Why are Federal Reserve notes different? At some level, they aren't, as pgl has reminded me on numerous occasions. One way to truly implement a haircut on government debt is to reduce the purchasing power of the currency in which the debt is paid -- by employing, in other words, the so-called inflation tax. But the United States, and almost all developed countries, have worked hard to ensure people that this won't happen. This is why the Fed is largely independent of the Treasury. In essence, we have guaranteed that fiscal imbalances won't be addressed by reducing the value of Federal Reserve notes. Despite protests to the contrary, no such promise is made for the return to Treasury notes, as the ever-changing tax rate on interest income makes abundantly clear.
Now to Krauthammer's point. Here we, again, we have the unfortunate confluence of positive and normative assertions. I think Krauthammer is making the positive point that private debt and equity supports investment. In many cases, public debt supports consumption, and there is a big difference between these two situations. Of course, you may want to argue that, at the margin, the bulk of public expenditure is actually investment (and more productive than private investment). That is an assertion that can be adjudicated by evidence, and I'll listen But there is no fallacy in Krauthammer's assertion.
Then there is the normative question -- whether is right to renege on the government payments promised (and planned for) by retirees and near-retirees. On this, pgl and I (and President Bush) agree that the answer is "no."
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» What does it mean to default? from William J. Polley
PGL at Angry Bear critiqued a recent Charles Krauthammer article for essentially calling the IOUs in the Social Security trustfund worthless. Specifically, Krauthammer says, Let's start with basics. The Social Security system has no trust fund. No lock... [Read More]
Tracked on Feb 20, 2005 11:06:31 PM
February 19, 2005
Indexing Social Security Benefits The Progressive Way
Victor at The Dead Parrot Society offers his variation on a plan to restore actuarial balance in the social security system by adjusting the indexation provisions of benefit formulas. A riff on a proposal by Robert Pozen, the essential idea is to maintain wage indexation at the lower end of the benefit-income distribution, while shifting toward CPI-indexation-only for everyone else (on a sliding scale).
What Progressive CPI-Indexing does is to let the current system of benefits work for the lower income classes. In Pozen's version, the bottom 30% of the wage earners in 2012 (and beyond if the wage distribution doesn't change) will get the exact same scheduled benefits that they get now. The very, very top of the income distribution will have their benefits frozen at a constant real level. People in between will fall, well, somewhere in between.
Mechanically, Pozen suggests that a new "bend point" should be created between the two that already exist. To the left of the "bend point", the formula wouldn't change at all. To the right of the new "bend point", the increase in benefits associated with additional income would be reduced by a proportion designed to freeze the benefit levels of a "steady maximum earner" at a constant real level.
That's really all there is too it. For workers just above the 30th percentile (and therefore just above the new bend point), little would change. For workers at the highest income levels, their benefits would be frozen. Over time, the shape of the benefit curve will change.
If you haven't been following reform proposals based on adjustments in benefit-indexation, Victor's post is a great place to start.
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February 13, 2005
An Entirely Different Type Of Social Security Reform
Most young households simultaneously hold both unsecured debt on which they pay an average of 10 percent interest and social security wealth on which they earn less than 2 percent. We document this fact using data from the Panel Study of Income Dynamics. We then consider a life‐cycle model with “tempted” households, who find it impossible to commit to an optimal consumption plan and “disciplined” households who have no such problem, and we explore ways to reduce this inefficiency. We show that allowing households to use social security wealth to pay off debt while exempting young households from social security contributions (but in both cases requiring higher contributions later) leads to increases in welfare for both types of households and, for disciplined households, to significant increases in consumption and saving and reductions in debt.
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February 10, 2005
Max And I Agree
Unless I'm reading this wrong, Max Sawicky and I agree.
Preemptive response to critics of SS: yes 1.3 or worse is a lousy rate of return. But in my reading of the social insurance lit, the implicit debt of SS is a fait accompli. There is no way on God's green Earth to avoid this result in a pay-as-you-go system where the economy grows more slowly than the rate of interest. That's not a great affirmation of the program, but if it's true, no privatization/reform scheme can avoid hammering somebody with the implicit debt of the system.
That was exactly my point here. But I've yet to hear an answer to the question I posed in that post: Given that a hammerin' is inevitable "in a pay-as-you-go system where the economy grows more slowly than the rate of interest," why the insistence on clinging to this hybrid forced-saving/redistributive system we inherited from the Great Depression?
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February 06, 2005
Social Security Once More
Speaking of Vox Baby, Andrew's most recent entry (as of the time I write) has his take on the Social Security part of the State of the Union address. It is characteristically thoughtful, and I commend it to you. But there are a few points on which I differ, or am not fully convinced. But first, the points that I agree with (which make up the bulk of the post):
[The President] excluded the possibility of raising the payroll tax to restore solvency. That will make it more difficult...
I did not like the statement, "By the year 2042, the entire system would be exhausted and bankrupt."...
The President was clear that everyone 55 and over is in the traditional system with benefits as specified by current law. Good. He was also clear about a gradual phase-in. Good. He explicitly mentions the Federal Thrift Savings Program as a guide for the sort of investment options available. Very good...
An item not discussed--exactly how progressive the reductions in future benefits from the current system would be. I expect this to be another area for compromise--make the traditional system that continues even more progressive, to make sure that the lowest-income people, who are less able to bear financial risk, are depending less on the personal accounts than other workers.
So what are my quibbles? They are minor, but here they are. Andrew writes:
There is a vagueness about the "greater than anything the current system can deliver" phrase that is troubling. It doesn't mention the risk associated with obtaining those returns.
The whole issue of risk seems, to me, vastly overblown. First, I've yet to see any compelling case made against Jeremy Siegel's observation that, for the long-run investor, equity does not look like a particularly risky bet. (Although Professor Siegel concedes the possibility of lower-than-historical equity returns going forward, that would presumably go a long with lower-than-historical bond returns. This was pointed out in the comment section of this Vox Baby entry.) The option for moving to a "safe" fixed-income account should, of course, be made available in a private account system -- maybe even mandatory at some point near retirement. But most of the people I know under the age of, say 55, have the great bulk of their saving in equity funds. I think revealed preference counts for something.
There is certainly the question of what happens if their is a gigantic market meltdown of the magnitude that eventually led to the creation of our current social insurance system. It could happen, I guess. But if it does, nothing like the revisions contemplated by those who favor the status quo would be sufficient. In that case, the solution is a set of intergenerational transfers that look like the picture in this post. Nothing on the table comes even close to that (nor should it).
Which brings me to the second point. In what sense is the present social security system riskless? I'd say right now I'm pretty uncertain about what my true returns are likely to be. If I was 20, I'd be even more uncertain. Commentary in the blogosphere is chock full of discussions about productivity trends, demographic assumptions, and the like, all of which are highly uncertain. There seems to me very little probability that, twenty years from now, the fixes we might put on the current system today will reveal themselves to have been exactly the right medicine.
This has led some to suggest that we implement reforms that include some set of automatic adjustments -- in retirement ages, benefit formulas, and the like -- to guarantee the program is always in actuarial balance. In other words, they would make the net returns in the system explicitly state-contingent -- which they already implicitly are. Which exactly makes my point. It would be appropriate for the opponents of private accounts to at least acknowledge this uncertainty whenever they invoke the dreaded "risk" dragon.
I'd make a related point regarding this comment from Andrew:
It is a stretch to say that the government "cannot take these accounts away." I agree that it would (probably) be more difficult for the government to impose a surtax on the accounts than it would be to cut benefits coming from the pay-as-you-go system, but "cannot" is too strong.
The point is, there is substantially less reason to "take these accounts away" in a defined contribution system. The problems inherent in the pay-as-you-go, defined benefit scheme are the reason we are talking about "take aways" today.
And finally, Andrew says:
The issue of bequests is completely unnecessary. Social Security exists to provide insurance against outliving one's means. Nothing prevents people from leaving bequests currently if they so desire. I am not aware of any failures in the life insurance market that need government attention.
I disagree. Even if I don't plan to leave a bequest, I can still receive residual utility from unintended bequests. And that possibility may cause me to provide more "self insurance" against outliving my means than I might otherwise, potentially (at least) "bringing new money into the system," as Andrew desires.
Other than that, I completely agree with him.
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