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Why Does the Fed Say Current Debt Levels Are not Sustainable?

A few months ago US national debt exceeded $28 trillion. This number is certainly the one economists usually work with, but does this figure capture a long-term perspective?
In March 2021, the Department of the Treasury published the 2020 Financial Report

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A few months ago US national debt exceeded $28 trillion. This number is certainly the one economists usually work with, but does this figure capture a long-term perspective?

In March 2021, the Department of the Treasury published the 2020 Financial Report of the United States Government. In the initial message, Secretary Janet L. Yellen writes: “This Financial Report discusses not only current financial results but also important, long-term trends affecting our critical social insurance programs and fiscal health.” The report not only discloses the current debt level, but also projects the cost of the government’s future obligations to its citizens. It notes that citizens will have the right to demand benefits from the state in the future.

The United States is one of the few countries whose treasury, in an act of transparency and with rigorous analysis, has warned its government of the unsustainability of the country’s public finances.

The US Department of the Treasury anticipates that unless there are substantial changes, the system will not be sustainable: “If changes in policy are not so abrupt as to slow economic growth, then the sooner policy changes are adopted, the smaller the changes to revenue and/or spending [that] will be required to return the government to a sustainable fiscal path.”

Government reports on macroeconomic matters tend to be ambivalent. Nevertheless, this one’s conclusion is decisive: the US government’s fiscal policy is unsustainable.

The Primary Deficit

The report usefully distinguishes between the primary deficit and the total deficit. Generally speaking, the primary deficit does not include the cost of servicing the debt (i.e., interest) while the total deficit does.

To conduct a rigorous analysis of public finance sustainability, it is appropriate to consider the primary deficit, because if there is a structural primary deficit, it is difficult for a country to achieve long-term sustainability no matter the interest rate. The Fed could help the government lower the total deficit with a rate decrease, but major structural changes are needed to lower the primary deficit.

The following graph, which appears in the report, compares total fiscal receipts, represented by the black line, with total structural expenditure. When the line representing total receipts (the thick black line) is below the sum of the various budget expenditure items, there is a primary deficit. During the years of the financial crisis (2009–12), the deficit-to-GDP ratio spiked, and it skyrocketed again in 2020 due to increased spending to address covid-19.

Chart 1: Comparison of Each Major Category’s Weight with Respect to Tax Revenues

Source: US Department of the Treasury, Financial Report of the United States Government, FY 2020, Mar. 25, 2021.

The Department of the Treasury assumes there will be a structural primary deficit and that total deficit (represented by the difference between the blue line and the thick black line), which includes the cost of servicing the debt, will increase with time.

The report continues with a graph that illustrates how, if the trend continues, the government’s debt could reach 300 percent of GDP in less than forty years.

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It is important to clarify that the above graph only considers “debt held by the public,” currently around 100 percent of GDP; however, if debt held by Federal Reserve Banks were included, the total debt would be 130 percent of GDP. The Fed argues that this  additional $6 trillion debt should not be considered because “Federal Reserve Banks remit their profits to the Treasury, [and] any interest earned on their federal debt is rebated to the federal government.” But if the Fed continues to increase its position relative to US debt, this consideration might need to be reviewed.

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In any case, the Department of the Treasury projects the future debt of the government and calculates that it could triple GDP within forty years. If the Federal Reserve Banks’ debt were consolidated, this threshold would be reached in much less time.

A country with a welfare state commits to offering its citizens future benefits (principally pensions and health services) using taxes collected in the present. While tax revenues are accounted for upon collection, government’s future obligations are not. What would happen if we accounted for the obligations in present value terms? This is exactly what the Department of the Treasury does in its analysis.

US companies that agree to provide their employees with future pensions (which the companies have to finance) have to budget annually to satisfy their future payment obligations in accordance with US Generally Accepted Accounting Principles (GAAP). But the government is not required to make provisions to cover future benefits, currently doing so only for federal employees and veterans.

What Would the Debt Figure Be If the United States Calculated the Present Value of Future Obligations?

The Department of the Treasury declares that “[t]he long-term fiscal projections indicate that the government’s debt-to-GDP ratio will rise to 623 percent over the 75-year projection period, and will continue to rise thereafter, if current policy is kept in place.” Just to give an idea of how fast the debt-to-GDP forecasts are increasing, the same report two years ago estimated that same ratio would rise to 530 percent in that period.

Let’s see why the debt is projected to become more than six times GDP.

First, considering a seventy-five-year projection period, the net present value of future tax revenues is estimated to be $295.4 trillion. From this the present value of future noninterest spending—$374.9 trillion—must be subtracted. The main projected expenditures are on social insurance—that is, healthcare and pensions.

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The Statements of Long-Term Fiscal Projections (SLTFP) shows that the present value of total noninterest spending, including Social Security, Medicare, Medicaid, defense, education, etc., over the next seventy-five years under current policy is projected to exceed the present value of total receipts by $79.5 trillion. Social insurance net expenditures (Social Security and Medicare) account for $65.5 trillion of this noninterest spending.

However, these projections fix variables that the calculation of payment obligations is very sensitive to, such as the fertility rate, life expectancy, and average annual growth in health costs. Much like in the majority of developed countries, the fertility rate (defined as number of children per woman) in the United States showed a downward trend. In 2007 this ratio was 2.1 percent while in 2020 it reached 1.64 percent, a record low. Is it realistic to assume that fertility rate will return to 2.0 and remain stable for the next seventy-five years, as the Treasury’s projections assume? Using an assumed fertility rate of 1.8 percent (closer to the current one) instead of 2.0 percent increases the financing shortfall by $2.5 trillion. The same is true for average annual growth in health costs: if 4.7 percent is used instead of 3.7 percent, $14 trillion more in debt are added.

The Department of the Treasury also assumes the country will not disintegrate. Therefore, it calculates the present value of future revenues and obligations into the indefinite future (valuations by companies similarly assume they will operate indefinitely):

Experts have noted that limiting the projections to 75 years understates the magnitude of the long-range unfunded obligations because summary measures reflect the full amount of taxes paid by the next two or three generations of workers, but not the full amount of their benefits … [E]xtending the calculations beyond 2094, captures the full lifetime benefits, plus taxes and premiums of all current and future participants. The shorter horizon understates the total financial needs by capturing relatively more of the revenues from current and future workers and not capturing all the benefits that are scheduled to be paid to them.

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With these adjustments, the present value of future costs less the present value of future income rises to $154 trillion, and let’s recall that this figure does not include interest expenses nor the debt held by the Fed in their books.

What Is the Situation in Other Countries?

Unfortunately, the same analysis applies to other countries. In fact, some years ago Citigroup calculated what the debt would be if future government pension liabilities were accounted for in present value terms. Note that the report only includes expenditures on pensions.

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As can be seen in the graph, the majority contingent government pension liabilities in most European countries reached a present value of three times their GDP.

Conclusion

Economists need to warn the public of the unsustainable nature of our governments’ public finances. Only then will our political leaders be able to debate measures that might reverse the undesirable trends.

Not much can be added to what has been exposed in the US government’s financial report, and its conclusions speak for themselves:

The continuous rise of the debt-to-GDP ratio indicates that current policy is unsustainable…. The projections in this Financial Report indicate that if policy remains unchanged, the debt-to-GDP ratio will steadily increase throughout the projection period and beyond based on this report’s assumptions, which implies current policy is not sustainable and must ultimately change. Subject to the important caveat that policy changes are not so abrupt that they slow economic growth, the sooner policies are put in place to avert these trends, the smaller are the adjustments necessary to return the nation to a sustainable fiscal path, and the lower the burden of the debt will be to future generations.

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A popular vacation destination is about to get much more expensive

The entry fee to this destination known for its fauna has been unchanged since 1998.

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When visiting certain islands and other remote parts of the world, travelers need to be prepared to pay more than just the plane ticket and accommodation costs.

Particularly for smaller places grappling with overtourism, local governments will often introduce "tourist taxes" to go toward things like reversing ecological degradation and keeping popular attractions clean and safe.

Related: A popular European city is introducing the highest 'tourist tax' yet

Located 900 kilometers off the coast of Ecuador and often associated with the many species of giant turtles who call it home, the Galápagos Islands are not easy to get to (visitors from the U.S. often pass through Quito and then get on a charter flight to the islands) but are often a dream destination for those interested in seeing rare animal species in an unspoiled environment.

The Galápagos Islands are home to many animal species that exist nowhere else in the world.

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This is how much you'll have to pay to visit the Galápagos Islands

While local authorities have been charging a $100 USD entry fee for all visitors to the islands since 1998, Ecuador's Ministry of Tourism announced that this number would rise to $200 for adults starting from August 1, 2024. 

More Travel:

According to the local tourism board, the increase has been prompted by the fact that record numbers of visitors since the pandemic have started taking a toll on the local environment. The islands are home to just 30,000 people but have been seeing nearly 300,000 visitors each year.

"It is our collective responsibility to protect and preserve this unparalleled ecosystem for future generations," Ecuador's Minister of Tourism Niels Olsen said in a statement. "The adjustment in the entry fee, the first in 26 years, is a necessary measure to ensure that tourism in the Galápagos remains sustainable and mutually beneficial to both the environment and our local communities."

These are the other countries which are raising (or adding) their tourist taxes

While the $200 applies to most international adult arrivals, there are some exceptions that can make one eligible for a lower rate. Adult citizens of the countries that make up the South American treaty bloc Mercosur will pay a $100 fee while children from any country will also get a discounted rate that is currently set at $50. Children under the age of two will continue to get free access.

In recent years, multiple countries and destinations have either raised or introduced new taxes for visitors. Thailand recently started charging all international visitors between 150 and 300 baht (up to $9 USD) that are put toward a sustainability budget while the Italian city of Venice is running a test in which it charges those coming into the city during the most popular summer weekends five euros.

Places such as Bali, the Maldives and New Zealand have been charging international arrivals a fee for years while Iceland's Prime Minister Katrín Jakobsdóttir hinted at plans to introduce something similar at the United Nations Climate Ambition Summit in 2023.

"Tourism has really grown exponentially in Iceland in the last decade and that obviously is not just creating effects on the climate," Jakobsdóttir told a Bloomberg reporter. "Most of our guests visit our unspoiled nature and obviously that creates a pressure."

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Merck’s six-year deal strategy could deliver a blockbuster if hypertension drug is OK’d this month

With an FDA decision expected next week for its blood pressure drug sotatercept, Merck is hoping that its bundle of acquisitions in recent years will lead…

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With an FDA decision expected next week for its blood pressure drug sotatercept, Merck is hoping that its bundle of acquisitions in recent years will lead to multiple approvals and late-stage clinical wins.

The regulator is set to decide whether to approve the pulmonary arterial hypertension drug known as sotatercept by March 26. If approved, the drug could generate $1.9 billion in sales in 2025, according to Leerink Partners analyst Daina Graybosch.

The subcutaneous treatment came to Merck by way of its $11.5 billion acquisition of Acceleron in 2021.

Sunil Patel

“We viewed [Acceleron] as a great Merck-type company to own, especially with their legacy of R&D,” Sunil Patel, Merck’s head of corporate development and business development & licensing, said in an interview.

For the past few years, the pharma giant has been amassing help from external biotechs to broaden its pipeline and prepare for the looming patent deadline for Keytruda, the cancer immunotherapy that had $25 billion in sales last year. It’s Merck’s most notable treatment to come from external innovation; Organon made the drug, known then as pembrolizumab, and was bought by Schering-Plough, which merged with Merck in 2009.

Now, Merck is once again hoping a drug that it bet billions of dollars on will lead a spate of approvals out of its promising late-stage pipeline. The company has put at least $50 billion toward business development since 2018. Aside from Covid-19 treatment Lagevrio, which was authorized in late 2021 and developed with Ridgeback Biotherapeutics, Merck’s dealmaking over the past few years has not produced another blockbuster medicine.

In three months, Merck could have another approval in patritumab deruxtecan, an antibody-drug conjugate it’s developing with Daiichi Sankyo, in certain forms of non-small cell lung cancer. The FDA set a decision date of June 26. As part of the $4 billion upfront deal, Merck is co-developing and co-commercializing three antibody-drug conjugates with the ADC powerhouse.

Merck also expects a late-stage race with Roche in the inflammatory market, stemming from its $10.8 billion acquisition of Prometheus Biosciences last year. It began a Phase III of Prometheus’ lead drug, now called tulisokibart or MK-7240, in ulcerative colitis last fall. Meanwhile, the company also bagged a Phase I/II cancer drug via its more relatively modest $680 million acquisition of Harpoon Therapeutics earlier this year.

The acquisitions are likely to keep coming. Merck CEO Rob Davis said earlier this year the pharma is willing to spend as much as $15 billion on M&A.

It’s made more than 20 biotech acquisitions in the past 10 years, and that has led to at least 17 compounds that have been approved or are in mid- and late-stage development, Patel said.

“This current management team is deeply rooted in the legacy of this company. They understand the importance of building a long-term sustainable future, and they’re just not afraid to make the bold scientific bets,” he said.

Last year, Merck adjusted the way it calculates R&D spending to factor in M&A and licensing costs, and doing so catapulted the company to the top of Endpoints News 2023 pharma R&D expenditure list.

But not all deals have been smooth. Merck discontinued a Covid-19 treatment candidate from its 2020 acquisition of OncoImmune. And a chronic cough drug that it gained through its 2016 acquisition of Afferent Pharmaceuticals has twice been rejected by the FDA. The drug has been approved in Europe, Switzerland and Japan.

All told, Merck inks about 80 to 100 business development transactions per year, Patel said. That includes licensing pacts and early-stage collaborations, like a $1 billion biobuck-loaded deal for new biologics with Pearl Bio that it announced last week.

“Once we get through the science, we act decisively and very rapidly to bring the right type of BD structure,” said Patel, who’s been at Merck Research Laboratories for 25 years.

Dean Li

About 80 employees search and evaluate potential transactions, which are then presented to a committee led by Dean Li, president of Merck Research Laboratories. Li joined Merck in 2017 from the University of Utah Health, where he co-founded biotechs such as Recursion and Hydra Biosciences.

“It’s seamless between Merck Research Labs and the BD unit. We’re just one simple group that operates with the one pipeline mentality,” Patel said.

About 60% of the Acceleron team remains at Merck.

“That’s a testament to how we can integrate these teams and how we embrace the science that we’re acquiring,” he said.

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Key Events This Week: Central Banks Galore Including A Historic Rate Hike By The BOJ

Key Events This Week: Central Banks Galore Including A Historic Rate Hike By The BOJ

According to DB’s Jim Reid, "this could be a landmark…

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Key Events This Week: Central Banks Galore Including A Historic Rate Hike By The BOJ

According to DB's Jim Reid, "this could be a landmark week in markets as the last global holdout on negative rates looks set to be removed as the BoJ likely hikes rates from -0.1% tomorrow." That will likely overshadow the FOMC that concludes on Wednesday that will have its own signalling intrigue given recent strong inflation. We also have the RBA meeting tomorrow and the SNB and BoE meetings on Thursday to close out a big week for global central bankers with many EM countries also deciding on policy. We’ll preview the main meetings in more depth below but outside of this we have the global flash PMIs on Thursday as well as inflation reports in Japan (Thursday) and the UK (Wednesday). US housing data also permeates through the week as you'll see in the full global day-by-day week ahead at the end as usual.

Let’s go into detail now, starting with the BoJ tomorrow. We’ve had negative base rates now for 8 years which if is the longest run ever seen for any country in the history of mankind. In fact it is doubtful that pre-historic man was as generous as to charge negative interest rates on lending money prior to this! It also might be one of the longest global runs without any interest rate hikes given the 17 year run that could end tomorrow. So, as Reid puts it, a landmark event.

DB's Chief Japan economist expects the central bank to revise its policy and abandon both NIRP and the multi-tiered current account structure and set rates on all excess reserves at 0.1%. He also sees both the yield curve control (YCC) and the inflation-overshooting commitment ending, replaced by a benchmark for the pace of the bank’s JGB purchasing activity. The house view forecast of 50bps of hikes through 2025 is more hawkish than the market but risks are still tilted to the upside. On Friday, the Japan Trade Union Confederation (Rengo) announced the first tally of the results of this year's shunto spring wage negotiation. The wage increase rate, including the seniority-based wage hike, is 5.28%, which was significantly higher than expected. This year will probably see the highest wage settlements since 1991 which given Japan’s recent history is an incredible turnaround. This wage data news has firmed up expectations for tomorrow.

With regards to the FOMC which concludes on Wednesday, DB economists expect only minor revisions to the meeting statement that saw an overhaul last meeting. With regards to the SEP, the growth and unemployment forecasts are unlikely to change but the 2024 inflation forecasts potentially could; elsewhere, expect the Fed to revise up their 2024 core PCE inflation forecast by a tenth to 2.5%, although they see meaningful risks that it gets revised up even higher to 2.6%. In our economists' view, a 2.5% core PCE reading would allow just enough wiggle room to keep the 2024 fed funds rate at 4.6% (75bps of cuts). However, if core PCE inflation were revised up to 2.6%, it would likely entail the Fed moving their base case back to 50bps of cuts, as this would essentially reflect the same forecasts as the September 2023 SEP.

Beyond 2024, DB expect officials to build in less policy easing due to a higher r-star. If two of the eight officials currently at 2.5% move up by 25bps, then the long-run median forecast would edge up to 2.6%. This could be justified by a one-tenth upgrade to the long-run growth forecast. After all this information is released the presser from Powell will of course be heavily scrutinised, especially on how Powell sees recent inflation data. Powell should also provide an update on discussions around QT but it is unlikely they are ready yet to release updated guidance.

One additional global highlight this week might be a big fall in UK inflation on Wednesday, suggesting that headline CPI will slow to 3.4% (vs 4% in January) and core to 4.5% (5.1%). Elsewhere there is plenty of ECB speaker appearances including President Lagarde on Wednesday. They are all highlighted in the day-by-day guide at the end.

Courtesy of DB, here is a day-by-day calendar of events

Monday March 18

  • Data: US March New York Fed services business activity, NAHB housing market index, China February retail sales, industrial production, property investment, Eurozone January trade balance, Canada February raw materials, industrial product price index, existing home sales

Tuesday March 19

  • Data: US January total net TIC flows, February housing starts, building permits, Japan January capacity utilization, Germany and Eurozone March Zew survey, Eurozone Q4 labour costs, Canada February CPI
  • Central banks: BoJ decision, ECB's Guindos speaks, RBA decision
  • Auctions: US 20-yr Bond ($13bn, reopening)

Wednesday March 20

  • Data: UK February CPI, PPI, RPI, January house price index, China 1-yr and 5-yr loan prime rates, Japan February trade balance, Italy January industrial production, Germany February PPI, Eurozone March consumer confidence, January construction output
  • Central banks: Fed's decision, ECB's Lagarde, Lane, De Cos, Schnabel, Nagel and Holzmann speak, BoC summary of deliberations
  • Earnings: Tencent, Micron

Thursday March 21

  • Data: US, UK, Japan, Germany, France and Eurozone March PMIs, US March Philadelphia Fed business outlook, February leading index, existing home sales, Q4 current account balance, initial jobless claims, UK February public finances, Japan February national CPI, Italy January current account balance, France March manufacturing confidence, February retail sales, ECB January current account, EU27 February new car registrations
  • Central banks: BoE decision, SNB decision
  • Earnings: Nike, FedEx, Lululemon, BMW, Enel
  • Auctions: US 10-yr TIPS ($16bn, reopening)
  • Other: European Union summit, through March 22

Friday March 22

  • Data: UK March GfK consumer confidence, February retail sales, Germany March Ifo survey, January import price index, Canada January retail sales

* * *

Finally, looking at just the US, Goldman notes that the key economic data releases this week are the Philadelphia Fed manufacturing index and existing home sales reports on Thursday. The March FOMC meeting is on Wednesday. The post-meeting statement will be released at 2:00 PM ET, followed by Chair Powell’s press conference at 2:30 PM. There are several speaking engagements from Fed officials this week, including Chair Powell, Vice Chair for Supervision Barr, and President Bostic.

Monday, March 18

  • There are no major economic data releases scheduled.

Tuesday, March 19

  • 08:30 AM Housing starts, February (GS +9.4%, consensus +7.4%, last -14.8%); Building permits, February (consensus +2.0%, last -0.3%)

Wednesday, March 20

  • 02:00 PM FOMC statement, March 19 – March 20 meeting: As discussed in our FOMC preview, we continue to expect the committee to target a first cut in June, but we now expect 3 cuts in 2024 in June, September, and December (vs. 4 previously) given the slightly higher inflation path. We continue to expect 4 cuts in 2025 and now expect 1 final cut in 2026 to an unchanged terminal rate forecast of 3.25-3.5%. The main risk to our expectation is that FOMC participants might be more concerned about the recent inflation data and less convinced that inflation will resume its earlier soft trend. In that case, they might bump up their 2024 core PCE inflation forecast to 2.5% and show a 2-cut median.

Thursday, March 21

  • 08:30 AM Current account balance, Q4 (consensus -$209.5bn, last -$200.3bn)
  • 08:30 AM Philadelphia Fed manufacturing index, March (GS 3.2, consensus -1.3, last 5.2): We estimate that the Philadelphia Fed manufacturing index fell 2pt to 3.2 in March. While the measure is elevated relative to other surveys, we expect a boost from the rebound in foreign manufacturing activity and the pickup in US production and freight activity.
  • 08:30 AM Initial jobless claims, week ended March 16 (GS 210k, consensus 215k, last 209k): Continuing jobless claims, week ended March 9 (consensus 1,815k, last 1,811k)
  • 09:45 AM S&P Global US manufacturing PMI, March preliminary (consensus 51.8, last 52.2): S&P Global US services PMI, March preliminary (consensus 52.0, last 52.3)
  • 10:00 AM Existing home sales, February (GS +1.2%, consensus -1.6%, last +3.1%)
  • 02:00 PM Federal Reserve Vice Chair for Supervision Barr speaks: Federal Reserve Vice Chair Michael for Supervision Barr will participate in a fireside chat in Ann Arbor, MI with students and faculty. A moderated Q&A is expected. On February 14, Barr said the Fed is “confident we are on a path to 2% inflation,” but the recent report showing prices rose faster than anticipated in January “is a reminder that the path back to 2% inflation may be a bumpy one.” Barr also noted that “we need to see continued good data before we can begin the process of reducing the federal funds rate.”

Friday, March 22

  • 09:00 AM Fed Reserve Chair Powell speaks: The Federal Reserve Board will host a Fed Listens event in Washington D.C. on “Transitioning to the Post-Pandemic Economy.” Chair Powell will deliver opening remarks. Vice Chair Phillip Jefferson and Fed Governor Michelle Bowman will moderate conversations with leaders from various organizations. On March 6, Chair Powell noted in his congressional testimony that if the economy evolves broadly as expected, it will likely be appropriate to begin dialing back policy restraint at some point this year.
  • 12:00 PM Federal Reserve Vice Chair for Supervision Barr speaks: Federal Reserve Vice Chair for Supervision Michael Barr will participate in a virtual event on “International Economic and Monetary Design.” A moderated Q&A is expected.
  • 04:00 PM Atlanta Fed President Bostic (FOMC voter) speaks: Atlanta Fed President Raphael Bostic will participate in a moderated conversation at the 2024 Household Finance Conference in Atlanta. On March 4, Bostic said, “I need to see more progress to feel fully confident that inflation is on a sure path to averaging 2% over time.” Bostic also noted, “I expect the first interest rate cut, which I have penciled in for the third quarter, will be followed by a pause in the following meeting.”

Source: DB, Goldman, BofA

Tyler Durden Mon, 03/18/2024 - 09:59

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