Glass Steagall: The Real History

by on September 19, 2008 at 7:24 am in Economics, History, Law | Permalink

Many wise people are now recognizing that the repeal of Glass-Steagall was one of the few saving graces of the current crisis.  Let’s thank President Clinton (and Phil Gramm) for that wise bit of deregulation.  The following potted history of the law, however, is all too typical:

Glass-Steagall was one of the many necessary measures taken by Franklin Delano Roosevelt and the Democratic Congress to deal with the Great Depression. Crudely speaking, in the 1920s commercial banks (the types that took deposits, made construction loans, etc.) recklessly plunged into the bull market, making margin loans, underwriting new issues and investment pools, and trading stocks. When the bubble popped in 1929, exposure to Wall Street helped drag down the commercial banks….The policy response was to erect a wall between investment banking and commercial banking.

Given a history like this people wonder how repealing the law could have been a good thing.  But a significant academic literature has investigated these claims and rejected them.  Eugene White, for example, found that national banks with security affiliates were much less likely to fail than banks without affiliates.  Randall Kroszner (now at the Fed.) and Raghuram Rajan found that (jstor) securities issued by unified banks were (ex-post) of higher quality that those issued by investment banks.  A powerful book by George Benston went through the entire Pecora hearings which supposedly revealed the problems with unified banking and found them to be a complete sham.  My colleague, Carlos Ramirez later showed that the separation of commercial and investment banking increased the cost of external finance (jstor).  Finally, my own work (pdf) unearthed the real reasons for the separation in a titanic battle between the Morgans and Rockefellers.

Thus, the history of banking before Glass-Steagall and now our recent experience after is consistent, generally speaking unified banking is safer and repeal was a good idea.

IWantCookieNow September 19, 2008 at 7:44 am

I think Glass-Steagall protected institutions that were – for whatever reasons -separated, basically because there was no alternative to using their services. So, the repeal of Glass-Steagall made them somewhat less stable and now they are combining with commercial banks like Bank of America, at least those who can (and aren’t as reputable as Goldman Sachs).

Also the repeal created some huge and unmanageable institutions like Citigroup, which probably never should have existed in this form.

So, I think that, while, as such, a world without Glass-Steagall would probably be better, the repeal (as in: change) did probably cause problems.

J Thomas September 19, 2008 at 8:50 am

Eugene White, for example, found that national banks with security affiliates were much less likely to fail than banks without affiliates.

How well did he control for confounding variables?

If for example banks that didn’t gamble on the markets were banks that were too weak to take the risk, you might get that result.

Or if for one reason or another the banks that gambled were more likely to get bailed out.

Randall Krozner (now at the Fed.) and Raghuram Rajan found that (jstor) securities issued by unified banks were (ex-post) of higher quality that those issued by investment banks.

Again, which is the cause and which is the effect?

Carlos Ramirez later showed that the separation of commercial and investment banking increased the cost of external finance (jstor).

That sounds like it would be a hard fact. But was cheaper external finance worth the Great Depression?

A powerful book by George Benston went through the entire Pecora hearings which supposedly revealed the problems with unified banking and found them to be a complete sham.

That isn’t surprising. Of all the economics done in 1932, how much of it would stand up today? But their wrong analysis doesn’t say whether their conclusions were wrong.

Finally, my own work (pdf) unearthed the real reasons for the separation in a titanic battle between the Morgans and Rockefellers.

That’s fascinating. But it doesn’t address whether the result was an improvement or not. Probably every law that strongly affects financial giants has involved a titanic battle between financial giants. Maybe one side wins. Was it the right side? It depends.

What we have now is unacceptable. We need some sort of regulatory change that will make sure it never happens again.

I would prefer that the changes cost us less than 1%/year growth in GDP, but I’d accept up to 2%/year reduction in growth. Because the result of the travesty will certainly be a wealth transfer from taxpayers to thieves. What good does it do us to grow the economy and give more than we grow to them?

If as seems plausible Glass/Steagal was not the best legislation to prevent this theft, what would work better?

If you’re a professional economist with expertise in this area, the ball is in your court to propose legislation that will keep this from ever happening again, with minimal bad effects.

whosonfirst September 19, 2008 at 9:07 am

First of all, at the top of page 2 of the PDF the author says “bares” when he means ‘bears”. Doesn’t inspire confidence in the whole thing.

It is long on assertion and short on explanation. My knowledge of the topic is minimal to say the least but, doesn’t asserting that unified banking is safer run counter to common sense? And don’t current circumstances bear this out?

Rich Berger September 19, 2008 at 9:34 am

Alex-

Ouch!

josh September 19, 2008 at 9:40 am

Smack down; hurt feelings; must demonstrate dominance; flame war in 3….2….1….

IWantCookieNow September 19, 2008 at 9:56 am

I don’t think it’s the absence but the change from have to have-not.

And yes, this is completely unempirical and unscientific and stuff, but that’s no reason to insult me. I did read the post but not all links, especially not the gated.

IWantCookieNow September 19, 2008 at 9:59 am

And in the long term, America will IMHO benefit from the absence of Glass Steagall.

IWantCookieNow September 19, 2008 at 10:04 am

From what I understand, all these papers say “universal banking works, so repealing GS is fine”. I think that’s slightly flawed (remember, I’m being unscientific, but I do use my head) because not having something in the first place is not the same as repealing it.

luke September 19, 2008 at 10:06 am

“Eugene White, for example, found that national banks with security affiliates were much less likely to fail than banks without affiliates.”

Even if this is true there are problems with this thinking. It is likely that while bigger entities are less likely to fail (according to the paper), once they do fail it is a major catastrophe. Maybe if entities fail more often when smaller in scope, the problem would not affect the entire financial system.

David J September 19, 2008 at 10:09 am

Whos’: “And don’t current circumstances bear this out?” Unified banking, by its very presence in the sector, is only one influence – AMONGST MANY – on our current economy. Maybe things would be worse if Glass-Steagall was still in effect. I seriously question any empirical study of economics as being able to accurately predict or explain cause and effect. There are too many issues of degree that cannot be readily controlled even if a perfect understanding of all possible influences were possible. We are not trying to prove physical facts in economics but trying to understand the push/pull of differing influences (both in type and degree) on human behavior/interactions, by extension, societal trends. In the end what has happened is to be expected; we missed something, felt its consequences, and reacted to the best of our ability. Think of it as being a global game of bash-a-mole.

J Thomas: “If you’re a professional economist with expertise in this area, the ball is in your court to propose legislation that will keep this from ever happening again, with minimal bad effects.” You give too much credit to economists. Even if they did put together a visionary long-term model the fact the government leadership changes too quickly and that external conditions will inevitably change make those models useless. Additionally, fundamental beliefs about what is good for society varies greatly and the reality is that what is good for those that hold power and influence is often detrimental to those who are living paycheck-to-paycheck.

Our society is too big to fail and too diverse to achieve utopia; and thus is stuck gyrating between the good times and the bad.

engineer September 19, 2008 at 10:13 am

“A few (but only a few) of the comments on both of our G-S posts today are very off. They show just how widespread is the presumption that the absence of Glass-Steagall is at fault. But a look at the evidence (and indeed not even a “close look”) shows that the burden of proof is exactly on the other foot. There simply isn’t a good argument that the absence of Glass-Steagall caused major problems, either before or after G-S. Some people are simply reiterating that G-S absence is at fault and asking us to prove the contrary. Alex and I are saying that putting the blame on G-S absence simply “isn’t there” in terms of being a serious argument. Alex and I are right.”

I think what is at issue here is that pre-deregulation the markets didn’t melt down. Post-de-regulation, the markets did melt down. I would say the burden of proof is on YOU as professional economists to make it clear to the layperson why that deregulation wasn’t a problem, or the millions of people whose lives have gone to shit because of this problem have every right to call for draconian restrictions on the markets and tie the hands of the people who clearly are at least partially at fault in this issue.

Tyler Cowen September 19, 2008 at 10:20 am

“Engineer” is just piling on top of the mistakes. There have been several different kinds of (partial) deregulation. The repeal of Glass-Steagall is one of them but not the only one. The main claim is that there is no good argument linking G-S repeal to the recent problems. You still might hold a presumption against the other forms of deregulation (and I’ll try to cover those soon), but that doesn’t justify a presumption against G-S repeal. You’ve actually got to make an argument as to how it caused things to go wrong. The data suggest that it helped, not hurt.

eccdogg September 19, 2008 at 10:38 am

I knew someone would question Citi in the list, and I agree that they have had problems. But they have not gone bankrupt

Relative to the others I would rather hold equity (or bonds) in Citi than Morgan Stanley or WaMu.

As to the Ponzi scheme. How did GLB help create it? It is stupid to say that well we had no crisis before it and now we have one so it had to have an effect.

Why do you think it created the situation? I can’t find the path. Most of the problems seem to have been created by investment banks not unified banks.

If anything GLB seems to have been a stabilizing factor in this crisis.

J Thomas September 19, 2008 at 10:53 am

Eccdog, I do not understand the details of how this crisis has happened. No doubt over the next 80 years we will get detailed studies that will throw a lot of light onto it.

I do not understand it and I have some doubts that others understand it either, particularly when they state their evidence and their evidence does not apply to the question at hand.

If anything GLB seems to have been a stabilizing factor in this crisis.

I will take your opinion into account.

It is stupid to say that well we had no crisis before it and now we have one so it had to have an effect.

Agreed. I don’t yet have an opinion whether GLB helped or hurt the economy. I’ve so far seen no link to any evidence about that.

Furthermore, even if it happens to be true that GLB hurt the economy, there could have been a better GLB that would have been a great blessing. If it turns out that in reality the bill the politicians put through was deeply flawed, that doesn’t prove it couldn’t have been done well.

Engineer September 19, 2008 at 10:58 am

My comment is not necessarily saying that the repeal of glass-steagall was the root cause, but that in order to avoid the backlash that is coming you’re going to need more than what appears to be an ivory-tower “it’s so complicated you can’t understand it but take my word for it” argument.

If you truly believe that the deregulation was a good thing, explain it in such a manner that the people with the power to change the system (right now, the common voter) can understand it. Otherwise your main-man Phil Gramm and his show-pony McCain are going to lose the blue ribbon at the state fair to Obama and woe be unto you and your kind then.

My point is that the prevailing common wisdom is that it is you as a conservative academician and your buddies the conservative politicians and investment bank managers that caused this mess. In many circles right now you don’t have a leg to stand on anymore when it comes to a position of authority, and therefore any argument you make that relies on an appeal to that authority without CLEARLY STATING the underlying reasons you’re right is going to be automatically dismissed by the majority of people.

Please note that I’m not saying that you’re wrong, but your argument that “complex statistics” proves you right doesn’t carry a whole lot of weight when some very simple statistics (hundreds of billions of dollars of taxpayer money) at first glance demonstrate you to be wrong.

I understand this is an economics blog for economists who shouldn’t be afraid of an academic paper, but this is a very serious matter on a much bigger scale and if you want to influence the public discourse and change the minds of those who call you out, you’re going to need more than a list of obscure citations that rely on complex statistical manipulations and which can’t be easily fact-checked.

The argument opposed to yours appears straightforward and is (seemingly) easily understood. You need to match that or be happy with the knowledge that you’re right even if nobody else believes you anymore. If your argument can’t be boiled down like that, I think your side is going to come out behind in this particular round of debate.

Dave September 19, 2008 at 11:22 am

I hope that the repeal was good, but I’d say it’s a little early to declare victory just yet. Perhaps we should wait until the end of this crisis and then revisit your conclusion.

eccdogg September 19, 2008 at 11:58 am

I am just trying to understand.

Prior to the repeal of GS there were comercial banks and investment banks and no overlap.

Then with the repeal of GS comercial banks were allowed to get into investment banking.

This caused LESS? competition in the investment banking area and thus allowed pure investment banks to grow too big?

This does not initally make sense to me. But maybe I am missing something.

Also I don’t see how GS protects investment banks, the fact that someone relys on someone else does not mean that that person makes sound investments. Many (including banks) relied on AIG as one of the only insurers of some products yet they still failed.

A plausible argument could be that the repeal of GS created competition in the traditional investment banking business of advising and facilitating transactins and that in order to remain profitable IB had to take more and more risk and thus it indirectly created the risk taking of investment banks. I don’t really buy this argument, but at least it could fit the facts.

joe September 19, 2008 at 12:35 pm

IWantCookieNow:
//Also the repeal created some huge and unmanageable institutions like Citigroup, which probably never should have existed in this form.//

Be careful with verbage; the repeal created nothing, it made it possible for Citigroup to create itself. And Citigroup is doing fine in this crisis, unlike other entities, so why should it not exist in its current form?

On a different note, Alex’s paper is very concise and thorough. Very interesting account of the private interest perspective on the origins of GS. Always have to be suspicious when policy helps or hurts essentially one entity or group of entities…

IWantCookieNow September 19, 2008 at 12:43 pm

@joe:

Citi is doing fine? We must live on different planets.

And please forgive my potential language abuses and mistakes, English is not my native language.

joe September 19, 2008 at 1:02 pm

I say “fine” in relative terms. Citi is weathering the crisis better than others, and even though it was in crisis a few months ago (and it not completely out of it), it raised capital and has decent funding sources available, as evidenced by its recent posturing.

Forgive my callous remark, it was not intended to offend.

In any case, we do agree that Glass Steagall is no good: //DON’T REENACT GLASS STEAGALL//

J Thomas September 19, 2008 at 6:26 pm

A law, a regulation, that will MAKE SURE IT NEVER HAPPENS AGAIN!

I thought that would amuse somebody.

But it’s what we face, politically, isn’t it? GS was created with the intention of keeping it from ever happening again. After GS we went 60+ years and it didn’t happen. Then GS was revoked and we went 9 years and it happened. That’s suggestive to a lot of people. Not proof, but suggestive.

When people get upset they demand the government do something. Like, when people get upset about crime some of them demand gun control and others demand harsh sentences for convicted felons. Sometimes the government does both. Do either one reduce crime? Probably not, but the voters demand that local and state governments do something and they do something.

If you don’t want GS brought back, propose a better method to make sure it never happens again. Argue why it will work better than GS.

To me the problem looks like gambler’s ruin. it reminds me of the way they used to do hurricane insurance.

There would be a hurricane that did a lot of property damage and the insurers would be in serious trouble. Since the same companies that made the bad hurricane policies were responsible for lots of other insurance, the government would bail them out as part of the hurricane relief. Then for some years it would be impossible to get hurricane insurance. Not available at any price. But we’d go some time without hurricane damage, and some people wanted hurricane insurance very much indeed. They’d pay high for hurricane insurance in areas that were unlikely to get hurricane damage. Very profitable business. Insurers competed for that business. They loaned to more people, and at cheaper rates. “You can’t win if you don’t play.” And when the hurricane hit they were in so deep they had to be bailed out. Then for some years it would be impossible to get hurricane insurance.

FEMA “solved” that by building pools of properties to insure that were widely separated so they would not suffer hurricane damage at the same time. They could market these averaged-risk groups to insurance companies that should not accept lots of policies from one place. Sounds familiar?

So once again we have entities that get nice profits by taking a small risk of large losses, and lots of them wind up with lots of large losses all at the same time, and there’s an added question of just who is at risk. But to my way of thinking any real regulatory solution would need to encourage the economy as a whole not to put too many resources into gambler’s ruin. I don’t have any idea how to do that.

But if nobody comes up with a solution that *looks* better than GS, we might easily get GS back, or a new variant GS, or some random sort of regulation that has the promise it will MAKE SURE THIS NEVER HAPPENS AGAIN.

Gadfly September 20, 2008 at 12:01 am

PBS has a good timeline on the demise of glass-steagall. Those who forget the past are condemned to repeat it

J Thomas September 20, 2008 at 9:22 am

RW Rogers, you have badly misinterpreted my comments.

I do not know whether GS has been on net good or bad. I have seen no credible evidence about that question. Alex Tabarrok has described a series of studies which do not speak to that question.

I don’t claim that GS had good effects or that its repeal had bad effects. I claim that the people who say they know that GS had bad effects and its repeal had good effects have presented nothing that particularly supports their position.

Further, I suggest that GS was popular once because it purported to solve an important problem. It is becoming popular again because of a similar problem. If you are a professional economist who dislikes GS, it isn’t very useful to argue that GS won’t do the job.

Much better to present a better proposal to compete with GS.

assman September 20, 2008 at 1:57 pm

“I thought that would amuse somebody.

But it’s what we face, politically, isn’t it? GS was created with the intention of keeping it from ever happening again. After GS we went 60+ years and it didn’t happen. Then GS was revoked and we went 9 years and it happened. That’s suggestive to a lot of people. Not proof, but suggestive.”

Except that Europe never had GS. They had the opposite: universal banking. Over the last 60 years the American model has not proved itself more resilient than the European model. That is proof that GS is not effective in preventing crises. Indeed I could argue the opposite: countries which never had GS and therefore never separated their commercial and investment banks did not have a large number of banking failure like the US.

J Thomas September 20, 2008 at 8:00 pm

How about universal banking, Type A. Securities underwriting, insurance and commercial banking under one roof with a single pool of capital. No walls.

My prejudices tell me that wouldn’t make a whole lot of difference, and that it wouldn’t do much harm.

I believe the fundamental problem comes when somebody leverages a whole lot of risk that somehow gets revealed all at once.

Like, insurance companies have insured all of the Gulf coast including New Orleans against flood insurance and then there’s a big hurricane.

Or they make a whole bunch of bad housing loans that show up all at once.

Or they pay for a whole lot of construction and it turns out there are no buyers.

Lots and lots of ways it can happen. The guys who did it were highly leveraged and they can’t possibly pay off what they’re obligated to pay off. A lot of people don’t get their money or a lot of people owe a lot of money who didn’t expect they were actually liable for it.

The problem is the leveraged risk that shouldn’t have been created in the first place, that doesn’t let us write it off a little bit at a time.

Once you have that, a whole lot of people are going to be hurting. And all you can do about it is choose who it will be.

Better to be cautious about allowing leveraged risk transactions that might come due too clumpy. I’m not clear how to do that, although the clearer I am at asking the question the more ideas come up about answering it.

ideogenetic September 21, 2008 at 10:51 pm

There is not enough transparency in the system to say Glass-Steagall helped mitigate disaster. If I am reading the newspapers properly, just allowing an irresponsible player or two to fail seems to be impossible due to invisible ties bringing down everyone. It is sooo risky to the FINANCIAL SYSTEM to allow any creative destruction that we are having to socialize large swaths of Wall Street. Obviously, the reckless financial activity that binds all the players prevents the bankruptcy of a single player.

I was watching someone today say this financial recklessness wasn’t a conspiracy. It then occurred to me that the whole thing could be the first financial conspiracy resulting from the inherent rules of a flawed game- finance capitalism.

How did repeal of Glass-Steagall mitigate systemic risk?

Dick King September 23, 2008 at 1:39 pm

J Thomas is willing to pay 2% growth to prevent the current situation.

Are you really willing to pay 2% growth, compounded annually, forever, to avoid what just may turn out to be a 5% hit, 10% at the outside, in the nine years since the repeal?

-dk

Hacky-sac September 29, 2008 at 5:35 am

What we have now is the reverse of what happened in the market crash of 1929. Back then banks that speculated in the stock market, through investment banking, lost the deposits of their Main Street customers who used the banks for their personal banking services. This happened because they used their customers personal banking deposits to speculate on the market. Today the banks have sold mortgages to Main Street customers and then sold the mortgage notes to the investment banking firms who packaged them and resold them to themselves and the banks. Then they used those investments as collateral to loan themselves more money to create more cheap loans for the main street customer to go out and buy a second or third house. They again packaged those loans and sold them as more interest bearing investments. This leveraging process was repeated and repeated creating a market bubble in real estate, this time, instead of stocks as in 1929.

Today the Glass-Stegall Act would have protected the investment bankers. They were the ones to get caught first (this time around). Their pain will make its way to main street by creating a lack of liquidity in the marketplace (every marketplace), just as the crash of 1929 started on Main Street and spread to Wall Street. This crisis is starting on Wall Street and will spread to Main Street unless extraordinary measures are taken.

Payday Loan Advocate October 1, 2008 at 2:44 am

If there are no problems, no solution is necessary. When it comes to the payday loan industry and the valuable assistance that they provide, there aren’t very many problems, if any at all. Many customers have nothing but good things to say, due to the fact that, if used properly, these loans provide a valuable service, and help a person out when they are in trouble. However, many of the people in high places don’t see the value behind short term loans, and want to fix what isn’t broken. Some bipartisan fronts have outlawed the industry outright in several states, and even candidate Barack Obama wants to take a shot as well. We aren’t going to tell you how to vote, but remember that you have to make the right choice for the people’s right to financial independence.

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Payday Loan Advocate October 1, 2008 at 2:45 am

If there are no problems, no solution is necessary. When it comes to the payday loan industry and the valuable assistance that they provide, there aren’t very many problems, if any at all. Many customers have nothing but good things to say, due to the fact that, if used properly, these loans provide a valuable service, and help a person out when they are in trouble. However, many of the people in high places don’t see the value behind short term loans, and want to fix what isn’t broken. Some bipartisan fronts have outlawed the industry outright in several states, and even candidate Barack Obama wants to take a shot as well. We aren’t going to tell you how to vote, but remember that you have to make the right choice for the people’s right to financial independence.

Post Courtesy of Personal Money Store
Professional Blogging Team
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accute October 2, 2008 at 12:50 am

My 2 cents on this fiasco is simple. The deregulate crowd misses a very important caveat; their “universal bank† framework operates with the benefit of a massive CDO written by the taxpayers of this country; unfortunately the taxpayer never gets paid for this insurance. If they had to pay for that CDO, they would not be nearly as profitable or risk aggressive. It is fairly clear that Goldman and Morgan want this free CDO in tough times.

I also find hypocrisy with the position of the “deregulators†. This crowd seems to draw the line of deregulation at a very awkward place. If they were truly free market intelligentsias they would balk at the government backing them at all; clearly the government is giving banks an advantage over the rest of the market in terms of cheaper capital than the market in general. This cozy situation imposes unfair advantages to the government-sponsored entities, as was the case with Fannie Mae and Freddie Mac. We now know all too well the consequences of such arrangements.

The financial system, in my view, is every bit as important as the power and transportation infrastructure; it needs to function in good times and bad. Although in general I am a market advocate, I would say that there are elements of our civilization that everyone can agree need to exist at all times. The current situation is proof that some regulation and axioms are necessary.

In a nutshell I would say that any institution that gets government backing should be a solid entity that is not going to make a wildly profitable endeavors, but will always function; that is where they earn the free CDO.

Payday Loan Advocate October 18, 2008 at 7:18 am

The current presidential candidates, Barack Obama and John McCain, supported an anti-payday loan bill in 2006. The bill, which took effect in October 2007, put a 36 percent cap on the interest rates that payday loan stores charge military personnel. The basis behind the bill was the increasing number of American soldiers that found out that loans had been taken out in their names without their consent. Many of these loans were either given to identity thieves or to their spouses. More often than not, the loan recipients borrowed money, but did not repay the loans. A majority of the loans should never have been approved in the first place because the applicants didn’t meet the qualifications. Military personnel as a whole are generally considered low-income and sometimes, unfortunately, considered to possess very little financial knowledge. The government wanted to prevent identity theft of military members because it would also prevent security breaches. Therefore, the government ruled in favor of the measure. Barack Obama would like to employ the measure nationwide. If the same interest cap is imposed throughout the U.S., the payday loan industry will be wiped out. Take time to think about who you’re voting for because your financial liberties are at risk in this election.
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Keith Klingeman March 10, 2009 at 12:31 pm

so you are telling me that the repeal of the Glass-Steagall act was good, eh?

just look at CITI bank, BofA, and tell me that they (and the American tax payer) are better off with the repeal of this act……….. and the creation of new Grahm-Leach-Billy Act of 1999……

this act is the direct result of companies lobbying and becoming one with the government…..

WHAT A SHAMEFUL TIME THAT WE LIVE IN….

GREEEEEEEED.

althea April 22, 2009 at 8:03 am

I think this crisis is a direct result of repealing Glass-Steagall. The reason It was enacted in the first place was to allow investment banks the freedom to do as they pleased in investment bank while protecting citizens deposits in regulated banks. The subprime market is about 600 billion. The credit default swap market is 15 trillion just in America. If all the CDS transactions took place in seperate investment banks we could have let them go bankrupt instead of bailing out AIG and CITI to protect peoples deposits, insurance and anuity investments. There will now need to be strict regulation of all mixed financial institutions . The free market proponents missed the boat here as Glass-Steagall allowed an unfettered free market for investment banks as long as they were not playing with the public’s money.
now that is ruined.

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