Unit 5

Reluctant Leader of the World and Ideological Challenges to American Capitalism:

The dawning of the 20th century brought a general optimism in both the U.S. and the rest of the industrialized, developed world.  Technology and inventions were improving life. Public health improvements such as sanitation were lengthening life. Although the benefits of economic growth and development were not evenly distributed, there was still a general increase in welfare.  With the benefit of 20-20 hindsight, a close examination of society and the economy in 1900-1914 shows the underlying conflicts that would eventually  explode into World War, Great Depression, and more World War. But at the time, the general view of businesspeople, politicians, and the general populace was one of optimism and hope.  The future looked bright and promising.

The view in the U.S. was particularly bright and promising. The dawn of new century had arguably actually begun in 1893 with the World Columbian Exposition (Chicago World’s Fair) that brought the U.S.’s economic development to the world’s attention. By 1900, the U.S. was the largest industrial producer in the world.  And, as we learned in the last unit, the period 1895 – 1905 brought massive waves of mergers and consolidations that created U.S. corporations as large or larger than any in the world.

The world economy was growing and thriving as well as the U.S.  Europe in particular was experiencing widespread prosperity and peace. International trade hit a peak.  American advances in transportation and cars were matched by German advances in chemicals and drugs. [an excellent reading suggestion that makes a great vacation book:  Barbara Tuchman’s The Proud Tower: A Portrait of the World Before the War, 1890-1914]

The optimism was short-lived. Hope collapsed in Europe in 1914 as a series of political miscalculations rapidly evolved into the Great War (later to be called World War I).  Initially, the U.S. stayed officially neutral. It was “Europe’s war”.  But the U.S. was by no means uninvolved. As all of the major powers of Europe mobilized for the war, they needed help. They needed food, war munitions, equipment, and most of all, they needed money The U.S. supplied it all.  Eventually, Europe would need soldiers too, and eventually in 1917 the U.S. would supply that too.

By the end of the war, the U.S. would be the undisputed leading power of the world. But it was a role America seemed reluctant to assume. The U.S. tried to politically and financially separate itself from Europe in the 1920’s. But events of the following two decades would force the issue as first the world devolved into a Great Depression. Then, the Great Depression set the stage for a return to World War.  During this 30-year period of 1914 to 1945 theU.S. and its own version of capitalism would be tested and challenged.  We sub-divide this period into 4 parts, World War I, the 1920’s, the Great Depression, and World War II.

The  First World War

Of course, the war was not called “world war I” until twenty years later.  At the time, it was simply the “The Great War”.  The scale and scope of the tragedy of this war cannot be understated. It was horrendous. And it changed the world. Permanently. It was not the first “total war”. Starting with General Sherman’s “March to the Sea” in the American Civil War where civilian property and infrastructure was completely laid to waste and casualties run high, the world had seen total war before. But now the doctrine of “total war” was fully exposed. Before examining the impact on the U.S. economy of the war, it is important that we attempt to come to grips with the dimensions of the war first.

The war began as a series of stupid miscalculations by most of the political leaders. The gravest of miscalculations was that any war that happened would be short, victorious, and glorious. A full and fascinating recounting of the many miscalculations, and a good lesson for advocates of future wars is available in Barbara Tuchman’s The Guns of August. The trigger was the assassination of the heir to the throne of Austria-Hungary in June 1914 in territory Austria had occupied since 1878. The assassination brought tensions between Austria-Hungary and occupied Serbia to a head. Russia, a leading power, sought to increase its influence in the Balkans and sided with Serbia. Austria sought to punish and “teach Serbia a lesson”. A state of war was declared. Russia enters to aid Serbia. Fighting has not yet occurred. Then Germany declares war and mobilizes in an attempt to aid Austria by intimidating Russia. Unfortunately, the German military had no plans prepared for how to fight a war in eastern Europe. The German staff is only prepared to fight a war with France (a thousand miles to other direction) and to only do that by invading via Belgium. So they did. France was eager to fight too, having promised Russia to join in its defense and to “even the score” for territory lost to Germany in 1871. Britain immediately enters the war to aid Belgium. Within days, actually hours, all of Europe is involved in war.

This war, though, is different from the old wars of Napoleon or of imperial conquest. It is not the few months’ glorious and quick engagement that the leaders promised. This is total war with machinery, specifically machine guns, chemical gas, and eventually tanks. This war resembles the total destruction of farms and cities pioneered by General Sherman of the US Union armies during the US Civil War.  It grinds all into submission.  Soon the war settled into a war of attrition and near stalemate. Human waves of soldiers were sent to attack entrenched soldiers of the other side.  Machine guns and poison gas mercilessly destroyed soldiers on both sides.  The war did not last a few months as promised. Instead, it lasted 51 months – over 4 years.  During this period, the war becomes a giant meat-grinder destroying humans, machinery, and resources on both sides. By the time it is finished, the European powers (both sides) will find 1 of every 10 of their adult males dead and 1 of every 10 adult males permanently maimed. France will see 1 in 7 adult males dead. The losses are not limited to armies. Starvation kills millions of civilians. British and German naval blockades reduce food imports.  Men become soldiers at the front instead of farmers. The French/Belgian countryside and farms become a war zone.  And finally, exports of grain from the Russian “breadbasket” disappear with the Russian Revolution,  Then, to cap it off, the influenza epidemic of 1918 sweeps through the trenches and weakened civilian populations killing an additional millions of people.

The US Economy and the War: Banking, Profits, and Central Planning

As horrible as the war was for Europe, it proved to be a boon for the U.S. economy. The outbreak of war in 1914 initially brought a quick recession brought on by war fears on Wall Street.  Soon, however, it became clear that the war was a benefit for the U.S.  Both sides in the war needed industrial output, food, and money.  The U.S. supplied all three.  U.S. exports boomed.  Prices of exports, particularly grain, rose. Profits grew significantly.  Initially, the U.S. supplied both sides of the war (Allied: Great Britain, France, Italy, Russia;  Central Powers: Germany, Austria-Hungary, Ottoman Empire).  By 1916, though, Britain and France had gained the edge.

The combatants needed more than exports, though.  They also needed money to pay for their war efforts.  Prior to the war, most major nations were on a gold standard.  The gold standard means that a nation that imports more than it exports (a trade deficit) must experience an outflow of gold to pay for the imports.  This reduces the supply of gold in the country (gold reserves), which in turn reduces the amount of money in circulation with the public, which in turn produces deflation and recessions/depressions.  The U.S. prior to World War I had frequently experienced such crises in part because it was a heavy importer of capital goods and capital investments.  At the outbreak of World War I, the U.S. was a leading “debtor nation”, meaning US governments and businesses had borrowed extensively from foreigners.  This was a natural consequence of the investment opportunities posed by US growth in the 19th century.  So, when the war starts, the U.S. (in aggregate, not just the government) owes foreigners significant amounts, primarily to British, French, and German banks and investors, while the U.S. holds slim gold reserves.

The war reverses this completely.  Initially gold flows into the US as Europeans begin buying US exports. Soon, European gold reserves are depleted and the Europeans abandon the gold standard. Next, as Europeans need to pay for their imports (U.S. exports), they desperately need to sell their bonds and shares in US firms to get the cash.  American banks, businesses, and investors buy up (or buy-back) these shares and bonds at fire sale prices, turning a nice profit in the process. In 3 years of the war for example, the British liquidated 70% of all their shares and investments in U.S. firms – investments the British spent 125 years accumulating. By 1916, the European powers are essentially unable to continue to pay for their imports – they have liquidated their investments in the U.S. and depleted their gold reserves.  At this point, the U.S. government and U.S. banks, who now have plentiful gold reserves, begin to make loans to the Europeans so that they may continue buying U.S. exports.  Inter-governmental debt (debt owed to one government by another) was non-existent before the war.  After the war, the victorious allied governments owed the U.S. government  total of $9.6 billion.  By the end of the war, the U.S. is the leading creditor nation in the world.  The war shifted the world’s financial and banking center from London to New York’s Wall Street.

The U.S. also became a propaganda battleground. As the war evolved and it become evident to both sides that there would be no quick victory, it also became evident that with the U.S. on the sidelines as a non-combatant, the two sides were evenly matched. It was a war of attrition. Both sides, the British-French Allied powers and the German-led Central Powers began to posture and propagandize the U.S. in an attempt to get the U.S. to join the war on their side. Eventually, the British-French side won out when the RMS Lusitania, a British passenger cruise ship carrying 1,959 people and supplies of ammunition to Britain from New York was sunk by a German submarine off Ireland. There were 139 Americans on board. The U.S. declared war on Germany in April 1917 although it would take months to get troops to the front.

As the U.S. prepared to enter the war as an active combatant, it faced a new task: mobilization of an industrial economy.  Jeremy Atack and Peter Passell explain in A New View of American Economic History:

American democracy and the free enterprise system,though, were ill-suited to the needs of modern warfare, which required the massive mobilization of resources for public, rather than private, benefit. The sudden, unexpected increase in demand and the competing priorities of government and the private sector wreaked havoc on the system. The solution was “a totally planned economy run largely by big-business interests through the instrumentality of the central government which served as the model … for state corporate capitalism for the remainder of the twentieth century.” To this end the federal government seized control of vital sectors of the economy. Some preliminary planning had been done before America’s formal entry into the war through the public-private Council for National Defense, which included cabinet officers and corporate executives. The first director, for example, was Walter Gifford, the chief statistician for AT&T. Other members included the president of Sears, Roebuck, and Company and the president of the B&O Railroad. The council discussed such issues as conscription, price controls, and the government take-over fo private industry and formed the nucleus of the command mechanism that emerged after war was declared. 

Shortly after war was declared, the council created the War Industries Board. It was charged with determining priorities, fixing prices, converting plants to meet war needs, and purchasing – requisitioning if and when necessary — supplies for the United States and the Allies.

The mobilization under central planning combined with Wall Street’s rise as the financier of the war had a few other side effects.  First, the size of the federal government mushroomed. Before 1915 federal expenditures had never exceeded $760 million per year, yet during the last year of the war monthly expenditures exceeded that level. Even after the de-mobilization and return to “normalcy” of the 1920’s, the federal government was at least 3 times as large as it had been before the war.  With such an increase in spending comes a need for government revenues.  To pay for it, the government created the income tax. By the mid-1920’s the income tax (corporate + individual) had become the primary means of financing the enlarged government.

A second effect was that the power of Wall Street was greatly enhanced.  The trend towards concentration and consolidation that had started in 1895 had gained momentum.  The largest corporations became even larger and more powerful.  Wall Street had become a world financing  and banking power.

A third effect of the war involved the newly created Federal Reserve System (created in 1913 to end currency crises and banking panics).  The Fed gained control over U.S. currency during the war, although it stayed with a gold standard.  To facilitate government borrowing for the war, The Fed kept interest rates low during the war and for a while afterwards.  Low interest rates combined with an influx of gold meant significant price inflation during the war.  The Fed maintained these policies until 1921 after the war.  Then, in an effort to slow inflation, The Fed raised interest rates and tightened the money supply.  The economy sank into a serious, albeit relatively short depression.  Unemployment rose to between 8.7 and 11% (estimates vary), but GNP dropped sharply.  Prices also dropped as a severe bout of deflation reversed many of the price increases of the war.  But by 1922, the stage is set for the “roaring twenties”.

The Roaring Twenties – Not Unlike Today

In many ways, the 1920’s were much like our own era of the 1990’s to 2008. To all outward appearances, as well as the popular image, the economy was booming and growing. Aggregate economic data showed a strong growth trend in GNP (now called GDP). Government policy featured several cuts in income taxes targeted toward upper-income households. It featured a tech boom. Electricity and fractional horsepower motors revolutionized manufacturing and business in much the same way that computers and the Internet have changed business in more recent times. The tech boom extended to households as well. Radio swept the nation and found its way into most households the same way the Internet and Web have penetrated households recently.  The growth of the auto industry put consumers and the whole country on wheels.  Movies and entertainment took off and became a major industry.

At the same time, there were less visible parallels to our own recent era.  While the national economy was growing, the growth was not equally shared. Income distribution became more unequal.  The rich, especially the ultra-rich, became even more rich. Meanwhile, some poor segments of the economy suffered.  In the 1920’s, the decline of export markets for foodstuffs (Europe began to grow food again) combined with the explosion in farm productivity brought on by tractors and trucks rapidly displacing horses on farms meant that farm prices collapsed.  Farmers, especially in the Great Plains and deep South suffered greatly.  Workers in the “high-tech” manufacturing industries such as autos, radio, and electrical equipment benefitted but were subject to intense, even violent union-busting activities. Employment in these new industries expanded rapidly but wages did not always follow suit. Workers in older manufacturing industries such as textiles and older manufacturing centers such as the Northeast lost their jobs as the new electrical motors enabled entire factories to abandon the water power of the Northeast for the lower-wage, non-union South.

Like more recent times, the 1920’s also featured a heightened sensitivity toward internal national security issues. In the aftermath of the First World War, American business and political leaders were afraid that the Communist Revolution that had just happened in Russia in 1917 would spread to America.  The result was the First Red Scare, a high-profile pursuit of “terrorists” and “anarchists”, and the suspension of constitutional liberties for some. The 1920’s even featured a “war on drugs” as the Federal government attempted to enforce the recently enacted prohibition on alcoholic beverages.

The popular mood was tired from the War and any involvement with Europe’s or the World’s problems.  The popular focus was on what could be done with the new technologies: what could be heard with radio, where people could go and what they could see in their new cars, and whatever fantasy was showing at the movie theater.  Although very few people were actually becoming very rich, it became a popular idea and image. America had emerged from the War with a powerful “anything is possible” self-image.  In the relatively peaceful 1920’s, Big Business became the epitome of American might and success.  President Calvin Coolidge even pronounced that “The business of America is Business.”  Indeed, Big Business was successful.  In the period 1923-1929, corporate profits grew by a total of 62 percent.  And the profits of the biggest corporations grew even faster.  The largest 1,346 corporations, only 0.26% of all corporations, saw their share of all corporate profits grow from 48% to over 60%.  Not only were businesses growing and becoming more profitable, the biggest of the big were growing even faster and becoming even more powerful.

But while politicians and the news in the 1920’s focused on the growth and success of big business, this profitability and success was not evenly shared.  Average workers and households had not kept up with the rich. Average households were able to afford the new consumer products of radios and cars largely by going into debt and borrowing. Businesses, too, began to borrow extensively in the 1920’s.  The late 1920’s featured an explosion of credit and debt. Much of the debt among businesses and banks was used to finance speculative stock purchases on the rising stock market.

By 1929, the stage was set for a correction. In early 1929, The Federal Reserve attempted to raise interest rates modestly to begin to slow the obviously overheating business and investment economy.  The economy began to slide into a mild recession by the summer of 1929.  The stock market began to weaken in September. Banks and investors became nervous. Yet, when the market firmed in early October 1929, one of the leading economists of the age, Irving Fisher, pronounced that “stocks had reached a new, permanently high plateau.”  Fisher attributed the high level of stock prices to the increased productivity of the economy due to the successful prohibition of alcohol reducing drunkenness and improving “morals”.  It was believed the new technologies heralded a new era of permanent prosperity. Fisher was wrong.

The Great Depression

In late October 1929 the stock market resumed it’s decline and accelerated into the Great Crash of 1929.  The decline accelerated on “Black Thursday”, October 24, when a record number of shares were sold.  Leading bankers met at  1pm that day and tried to visibly express confidence in the market just as they had in 1907.  The move failed.  The market fell 25% on the following Monday and Tuesday amid panic selling.  The speculative bubble of 1928-1929 was bursting. Despite some interim short rallies, the stock market continued to decline for 4 years.  By July 1932 it had lost 89% of its peak 1929 value. The recession became a Great Depression.

The scale of the Great Depression is difficult to fully communicate.  For 4 years, the economy contracted, production shrank, employment dropped, prices dropped, and banks failed.  At the time, there was inadequate or non-existent federal regulation of banks and no national bank deposit insurance.  Banks had speculated in the stock market with depositor’s funds. Even those supposedly “sound” banks that avoided lending for the stock market were still hurt as people lost confidence, business borrowers went bankrupt, and losses in some banks rippled throughout the banking system.  I have an article in my blog that recounts the severity of the bank losses.  You are encouraged to read it at econproph.com.

The economy was spiraling downward. Businesses began to lay off workers and shutdown production because sales were declining. But as unemployment rose, spending and sales decreased even more, precipitating new rounds of layoffs.  Banks continued to fail in increasing numbers until 4000 banks failed in the first 3 months of 1933.  Prices plunged. The money supply shrank as bank credit declined.

At its worst, unemployment rose to 25% in the nation. That statistic still understates the severity of the crisis.  At the time, there was no unemployment compensation system.  So people who lost their job lost all income immediately.  Often unemployed working people had no access to credit or any savings. They became dependent upon family, charity and soup kitchens for food.  Many lost their homes or could not pay rent and became homeless. Unemployment was also likely to be a very long-term experience.  Lose your job and it was likely you might not get another for years. In Chicago, the largest manufacturing center in the nation, unemployment reached 40%.  “Hobos”, homeless men catching rides on freight trains from town to town in search of jobs, became common.

During the period of 1929-March 1933, Herbert Hoover was President.  His Treasury Secretary, Andrew Mellon, felt the government should do nothing. That way the depression would  squeeze the “excesses” out of the economy faster and “purge the rottenness” so that growth could be re-established. Mellon argued for a balanced federal budget and against any deficit spending for the economy. The policy did not work. The Depression continued to decline. It spread also.  Virtually every major developed nation experienced the Great Depression also. In Germany, the Depression led to 33% unemployment and election of the Nazi Party to power.

In March 1933, Franklin Roosevelt became President of the U.S.  He immediately began a blitz of new policies and programs intended to alleviate the suffering and to correct the Depression.  At first there was little coherent theory or guiding policy behind the programs.  It was mostly ‘try everything and keep what works’. The first step was a bank holiday closing all banks until they could be audited, restructured and re-opened. New banking and Wall Street regulation was created to limit the speculative and banking excesses of the 1920’s. Jobs programs such as the Civilian Conservation Corps and Works Progress Administration were started. Social security was started. Government deficits soared (relative to previous amounts, but small in comparison to World War II deficits).  The programs began to work.  The economy began to recover in 1934-36. It still wasn’t anywhere near the levels of 1929, but it was headed in the proper direction.  Roosevelt won a landslide re-election in 1936.

Then in 1937, Roosevelt, who was personally a fiscal conservative, sided with advisors who began to worry about the government’s budget deficits. In 1937 Roosevelt attempted to balance the government budget by cutting back on spending and many of the jobs programs. It was too soon.  The economy plunged again and returned to the depths of 1933, although with a stronger banking sector this time.

During this period, economists, led by John Maynard Keynes, began to formulate theories and an understanding of the crisis.  Government policy, however, was not directed by such policy at the time.  Theory called for massive deficit government spending to stimulate the economy and for an easy money (low interest rates) policy by The Federal Reserve until the economy began to grow of its own accord.  The theory then called for gradual transition away from deficit spending and easy money. “Keynesian” policy wasn’t really embraced by governments. Both the U.S. and the U.K. continued modest hit-and-miss programs directed at the Depression until 1939.  Then political events in Europe and the Pacific began to overwhelm government economic policy and government leaders began to dramatically increase government spending. Essentially, both the U.S. and U.K. began a massive deficit-spending economic stimulus program called World War II. Full employment rapidly returned.

World War II

War breaks out in Europe in September 1939. But the U.S., following the pattern of the earlier World War, doesn’t engage in hostilities.  Instead, it ramps up production and exports. The increased demand for exports of war materials, food, machinery, and vehicles boosts the U.S. economy. By 1941, the U.S. has reversed The Great Depression and is approaching full employment.  However, in December 1941, the Japanese government responds to a U.S. embargo on oil shipments to Japan by attacking a U.S. base at Pearl Harbor, Hawaii.  The next day, the U.S. declares war on both Japan and Germany. The U.S. is involved in world war again, only 23 years after the last war.

Economically, the Second World War brings a much larger federal government involvement in the economy than we have ever had (before or since).  At the peak, government expenditures account for 45% of total GDP in the U.S.  In other words, 45% of everything produced was sold to the U.S. government. For comparison purposes, just prior to World War I, the U.S. government had accounted for approximately 7-8% of GDP. During WWI, this rose to 21% and dropped back to 7-8% afterward. The Great Depression and the “New Deal” saw government spending reach just under 15% of GDP. For the period from the 1960’s through the present, federal government expenditures have typically run 20-22% of GDP.

The government’s involvement in the economy extended well beyond simply purchasing the output. During the war the prices of many critical goods were fixed and controlled by authorities in Washington. The intent was to prevent price inflation since the demand for goods exceeded the economy’s ability to produce.  To further prevent inflation and to ensure “fair” distribution of critical resources, many essential goods were rationed.

In purely numeric terms, the economy boomed during the Second World War. Full employment returned. Real GNP grew 56% in the short time from 1940 to 1945.  Of course, people’s well-being did not increase with the economy. Much of the output produced in the economy went to fight the war. War destroys economic resources and kills people.  The Second World War was even more a war of economic attrition than the First World War.  When the U.S. with its allies emerged victorious in 1945 the U.S. was in a very fortunate position relative to other nations. While the U.S. had indeed lost a significant number of men and women (although a smaller percentage than other nations), the U.S. had the good fortunate to have the war fought elsewhere.  This set the stage for a long post-war boom as the U.S. emerges from World War II as  the only major industrialized nation with all of its industries and factories intact and untouched by the war.

Ideology & Conflict

Earlier eras in American history featured conflict between the specific interests of different groups: New England manufacturers vs. Southern Cotton growers; Western farmers vs. Eastern bankers; etc.  In the period from 1914 through 1945, the dominant struggle behind the scenes becomes ideological for the first time.  Ideology in the form of economic theories and  political party platforms was, of course, common throughout American History.  But in this time period, the struggle between competing ideologies begins to take center stage.  The First World War did not explicitly begin as an ideological struggle. However, it ended with strong ideological implications.  One of the world’s powers was removed from the war by a communist revolution (Russia).  The U.S. President, Woodrow Wilson, tried to make ideological issues of representative democracy and human rights the centerpiece of the peace treaty (largely failing to do so).

Most of the competing ideologies took power in countries other than the U.S.  Russia became communist. In England the Labour Party (socialist) rose to power and to compete with the Conservatives (Tories).  In Germany, Social Democrats gave way to National Socialists (Nazis). In Italy, Fascists rose to power.  Throughout Europe, Socialists, Communists and fascist parties were serious competitors at the ballot box in nearly all nations.

In the U.S., government fears of socialism and communism combined with Big Business’s dislike of unions in the 1920’s Unions and strikes were often violently disrupted with the support of the government.  The rising economy of the 1920’s masked a severe and growing income inequality. The popular image that “anyone who works hard can succeed and become rich in America”, the idea of America as a special land of opportunity helped to keep working class resentment quiet during the 1920’s.

But the Great Depression of the 1930’s changed things.  With literally massive “armies” of unemployed people, both the wealthy owners of the large corporations and the politicians began to fear the consequences. In 1932, a “Bonus Army” of 43,000 World War I (and other) veterans, most of them unemployed for years, marched on Washington to demand payment of bonuses the government had promise them in the future.  Some in Congress wanted to pay the bonus. Hoover and the Republicans in Congress opposed it, saying it would worsen the government’s deficit.  The marchers stayed and camped in Washington in “Hoovervilles” of shacks. In July, the U.S. Army under the command of Douglas MacArthur was ordered to evict them.  MacArthur, fearing that the veterans represented a threat of communist coup attacked with infantry, tanks, and gas.  Hundreds were injured. Several were killed.

The Great Depression was seen by many as a struggle to maintain capitalism itself.  Indeed, both Roosevelt and Keynes would repeat this idea as they searched for policies to fix the Great Depression.  It was widely seen that capitalism was caught between communism on the left and fascism/national socialism on the right.  Without some form of government  management or regulation or balance, unregulated big-business industrial capitalism (as opposed to a free competitive market of many little businesses) would collapse due to financial crises. It was feared that rising unemployment would inevitably lead to revolution.  The challenge was to find policies that would enable a capitalist economy to continue yet ensure full employment and share at least some of the benefits of growth with all groups of the population, not just the wealthy financiers and corporation owners.  The ultimate expression of this struggle comes in World War II when the enemy is explicitly the fascists of Italy, Nazi’s of Germany, and corporate-militarists of Japan.  With the defeat of fascists/Nazis in World War II, the fear of threat to the system shifts to Russia and Communism. But it was not just the fascists, national socialists, and corporate-militarists that appeared to have lost WWII ideologically. By the end of the war, it appeared that the doctrines of laissez-faire capitalism with large corporations, an unregulated finance sector, and increasing inequality of income were also dead. At the end of the war, few wanted to return that earlier era. They feared a return to the Great Depression.

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