Justin Fox http://blogs.reuters.com/justinfox Fri, 29 Oct 2010 21:28:00 +0000 en-US hourly 1 http://wordpress.org/?v=4.2.5 Economists respond to incentives http://blogs.reuters.com/justinfox/2010/10/29/economists-respond-to-incentives/ http://blogs.reuters.com/justinfox/2010/10/29/economists-respond-to-incentives/#comments Fri, 29 Oct 2010 21:28:00 +0000 http://blogs.reuters.com/justinfox/?p=50 Here’s my short take, following on Barbara’s post Wednesday, on economists:

1. The single most valuable and durable lesson of economics is that incentives matter. Monetary incentives don’t always matter more than other motivations, and sometimes people’s behavior regarding money is a little nutty. But as an organizing principle for a social science, incentives matter is pretty good.

2. Economists respond to incentives, too. Real and potential financial awards affect what they choose to study, how they go about it, and what conclusions they draw. This doesn’t mean all economists are evil sellouts. It means they’re human beings.

3. For people who purport to believe that incentives matter, economists can be strangely touchy when anyone brings up point No. 2.

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Is all quantitative financial risk management bunk? http://blogs.reuters.com/justinfox/2010/10/28/is-all-quantitative-financial-risk-management-bunk/ http://blogs.reuters.com/justinfox/2010/10/28/is-all-quantitative-financial-risk-management-bunk/#comments Thu, 28 Oct 2010 15:43:38 +0000 http://blogs.reuters.com/justinfox/?p=45 The comments to my post here last week on Benoit Mandelbrot were for the most part significantly more sophisticated than the post itself. So, since my days at Chez Felix are numbered, I thought I should avail myself of the brilliance of his commenters while I still can to ask a very basic question: Is the practice of quantitative financial risk management one big con job?

That’s one of the key arguments in Amar Bhidé’s new book A Call for Judgment: Sensible Finance for a Dynamic Economy. He says in the book that the approach to risk management that grew out of Harry Markowitz’s portfolio theory, Bill Sharpe’s Capital Asset Pricing Model (yes, I know it wasn’t just his, but he was the first to publish) and Fischer Black, Myron Scholes, and Robert Merton’s option-pricing model—all of which netted Nobels for their (still-living) creators—is fatally flawed because it depends on predictions about future volatility, and no one knows how to predict future volatility.

The funny thing is that the Markowitz/Sharpe/Black/Scholes/Merton approach arose in part out of the realization that it’s really hard to predict the trajectory of an individual stock—and that even if you did figure it out, others would start to imitate you, eventually affecting the the trajectory of the stock and rendering your predictions invalid. A stock’s future volatility might not be easy to predict, they reasoned, but it was much easier to predict than the stock’s future return. Bhidé turns that argument on its head:

Forming reasonable, subjective estimates of a stock’s return can be a challenging exercise. Predicting whether and by how much IBM’s price will appreciate requires researching and thinking about several factors such as its project plans, relationships with customers, existing and potential competitors, exchange rates, and the strength of the economy. With volatility, because there is no sensible way to think about what it should be, there is almost no choice but to take the “easy way out”: Calculate historical volatility. Shade to taste.

Now the objection one often hears from those in the financial world is that practitioners have moved on from the simple volatility models of the 1960s and 1970s. And that they have. But the models they use still assume that they know how to predict volatility, right? Is there evidence that anybody actually knows how to do that—not just short-term but through an entire market cycle? Or is everybody just shading to taste?

Another issue with quantitative risk models that even many of their creators acknowledge is that when a particular method of modeling risk becomes popular enough, it begins to affect market behavior and creates new risks that the model cannot see. I think this may have been a major contributing factor to every financial panic of the past 25 years, starting with the 1987 crash. (Well, except maybe the dot-com bubble and crash. I can’t really blame that on risk models. Although it is perhaps telling that the dot-com collapse wasn’t really a panic.)

You can’t prove the cause-and-effect, but it is clear that financial risk models have repeatedly broken down after years of seeming success. Which shouldn’t be all that surprising: It is in the nature of financial markets that every good (that is, money-making) idea eventually becomes a bad one. The difference between a momentum-investing formula and a risk-management model is that a risk-management model is supposed to, um, manage risk. And so I guess the question remains: Are all financial risk-management models ultimately a joke?

I really don’t know the answer. That’s why I’m asking you folks.

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What Gretchen Morgenson is good for http://blogs.reuters.com/justinfox/2010/10/27/what-gretchen-morgenson-is-good-for/ http://blogs.reuters.com/justinfox/2010/10/27/what-gretchen-morgenson-is-good-for/#comments Wed, 27 Oct 2010 20:12:23 +0000 http://blogs.reuters.com/justinfox/?p=41 New York Times business columnist Gretchen Morgenson is Terry Gross’s guest on Fresh Air today. I caught about ten minutes of the conversation while out driving this afternoon, and it reminded me of why I’m not a big fan of Gretchen Morgenson’s work. She’s just not very interesting to listen to, or read: Too flat, too broad-brush, too predictable, lacking in cleverness and nuance and curiosity. That’s why I’d take a Joe Nocera column (or a Felix Salmon blog post) any day over a Morgenson offering.

But then talk on Fresh Air turned to the ongoing brouhaha over foreclosures of homes where it’s not clear that the foreclosing bank can actually prove that it owns the mortgage. Morgenson pointed out that this is a problem she’s been writing about since 2007. Has she been writing about it well? Not necessarily. Morgenson’s columns and articles on this and other topics have been a favorite Felix target through the years. And remember how Tanta, Calculated Risk’s late, lamented mortgage-banker co-blogger, used to get absolutely apoplectic over Morgenson’s real-estate-related work. The anger comes about because Morgenson so often gets basic facts wrong, seemingly misunderstands the businesses she covers, offers assertions that she fails to back up with evidence—that kind of stuff.

Which makes it only more aggravating when she so often eventually turns out to have been far closer to right than her critics were. For example, Morgenson claimed in March 2007 that the mortgage market was headed for a big crisis. What a wild assertion! As one Felix Salmon wrote immediately afterward: “Morgenson adduces no evidence whatsoever that any crisis is looming at all.” (I figure it’s okay to pick on Felix for this because I came very close to writing exactly the same thing at the time but was just too lazy to actually do it.)

If this had just happened once, okay. But Morgenson was also among the first and most persistent on the case of the Wall Street scandals of the early 2000s. She also really spotlighted aspects of the financial crisis of the past few years that the rest of the media only got around to months later. Forget Nouriel Roubini or Bob Shiller; Gretchen Morgenson may be the most reliable early warning device around.

How does she accomplish this? I think it’s partly that the same bullheadedness and simplistic approach that drives readers like me and Felix crazy actually enables Morgenson to zero in on targets that those more interested in nuance totally miss. It’s also that Morgenson suffuses her work with a sort of high moral dudgeon—and disgust for the evil ways of Wall Street—that more “sophisticated” journalists won’t allow themselves. The results speak for themselves: Sometimes battering rams work better than X-Acto knives. And I say that as someone who vastly prefers X-Acto knives (stylistically speaking).

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What’s really behind that $1.3 trillion deficit? http://blogs.reuters.com/justinfox/2010/10/25/whats-really-behind-that-1-3-trillion-deficit/ http://blogs.reuters.com/justinfox/2010/10/25/whats-really-behind-that-1-3-trillion-deficit/#comments Mon, 25 Oct 2010 17:51:03 +0000 http://blogs.reuters.com/justinfox/?p=37 The Treasury Department reported on Oct. 15 that the deficit in fiscal 2010, which ended Sept. 30, was $1.294 trillion. That’s less than FY 2009’s $1.416 trillion, but it’s still really really big. Why is it so big, though? Is it because of all that stimulus and bailout spending? Or is something else going on?

To find out, I created a fantasy world. I figured out how fast federal spending and revenue grew over the last business cycle, from 2000 through 2007, and calculated where we’d be today if those growth rates had continued through 2010. I was originally motivated to do this for a commentary that’s supposed to air tomorrow night on Nightly Business Report. But I’m thinking there’s not a huge overlap between Felix Salmon readers and Nightly Business Report viewers, so I’ll go ahead and share what I learned.

In my no-financial-crisis, no-bailout, no-recession, no-stimulus scenario, spending kept growing at 6.22% a year, and revenue kept growing at 3.45%. You can see from the difference between the two numbers that this was an unsustainable path. But it clearly could have been sustained for a few more years.

Where would it have left us in fiscal 2010? With $2.843 trillion in federal revenue and $3.270 trillion in spending, leaving a deficit of $427 billion. The actual revenue and spending totals for 2010 were $2.162 trillion and $3.456 trillion. So spending was $186 billion higher than if we’d stuck to the trend, and revenue was $681 billion lower. In other words, the giant deficit is mainly the result of the collapse in tax receipts brought on by the recession, not the increase in spending. Nice to know, huh?

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Tim Geithner’s poor imitation of John Maynard Keynes http://blogs.reuters.com/justinfox/2010/10/22/tim-geithners-poor-imitation-of-john-maynard-keynes/ http://blogs.reuters.com/justinfox/2010/10/22/tim-geithners-poor-imitation-of-john-maynard-keynes/#comments Fri, 22 Oct 2010 13:11:08 +0000 http://blogs.reuters.com/justinfox/?p=30 Tim Geithner has proposed to his fellow G-20 finance ministers that trade surpluses and deficits be capped at 4% of GDP. The idea is already running into criticism from countries that run big trade surpluses. German Economy Minister Rainer Brüderle warned against “planned economy thinking,” according to Reuters, and  “makroökonomische Feinsteuerung und quantitative Zielsetzungen” (macro-economic fine-tuning and quantitative target-setting), according to Reuters Deutschland. “We doubt whether rigid numerical targets should be set,” said Japanese Finance Minister Yoshiko Noda.

The sad irony in all this is that some other guy proposed limits on trade surpluses and deficits 66 years ago, and did it in a far more elegant and thought-through manner than Geithner has. And it was the U.S. that torpedoed the plan. To borrow from George Monbiot’s lucid summary of John Maynard Keynes’ proposal:

He proposed a global bank, which he called the International Clearing Union. The bank would issue its own currency – the bancor – which was exchangeable with national currencies at fixed rates of exchange. The bancor would become the unit of account between nations, which means it would be used to measure a country’s trade deficit or trade surplus.

Every country would have an overdraft facility in its bancor account at the International Clearing Union, equivalent to half the average value of its trade over a five-year period. To make the system work, the members of the union would need a powerful incentive to clear their bancor accounts by the end of the year: to end up with neither a trade deficit nor a trade surplus. But what would the incentive be?

Keynes proposed that any country racking up a large trade deficit (equating to more than half of its bancor overdraft allowance) would be charged interest on its account. It would also be obliged to reduce the value of its currency and to prevent the export of capital. But – and this was the key to his system – he insisted that the nations with a trade surplus would be subject to similar pressures. Any country with a bancor credit balance that was more than half the size of its overdraft facility would be charged interest, at a rate of 10%. It would also be obliged to increase the value of its currency and to permit the export of capital. If, by the end of the year, its credit balance exceeded the total value of its permitted overdraft, the surplus would be confiscated. The nations with a surplus would have a powerful incentive to get rid of it. In doing so, they would automatically clear other nations’ deficits.

Brilliant, right? Not impossible-to-enforce targets, but a system with incentives built in that would have made big trade imbalances unattractive to both sides. There’s that little matter of creating a new global currency and getting everybody to accept it, but this was at the tail end of World War II. If the U.S. had decreed that the International Clearing Union was a go, the International Clearing Union would have been a go. But at the time, the U.S. ran big trade surpluses and assumed it would do so forever. Its delegates at the Bretton Woods meetings were vehemently opposed. So the idea went nowhere. Now Tim Geithner is pushing for clunky trade-surplus caps. It might be better if he just asked for a do-over.

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Tax incentives: Boeing 707 edition http://blogs.reuters.com/justinfox/2010/10/21/tax-incentives-boeing-707-edition/ http://blogs.reuters.com/justinfox/2010/10/21/tax-incentives-boeing-707-edition/#comments Thu, 21 Oct 2010 19:29:44 +0000 http://blogs.reuters.com/justinfox/?p=22 I’m going to a book party at a bar in Newton, Mass. tonight (yes, life here in metropolitan Boston is unspeakably glamorous) for Sam Howe Verhovek’s Jet Age: The Comet, the 707, and the Race to Shrink the World. It’s a great little book—and I don’t think the fact that Verhovek’s brother is a friend of one my wife’s best friends from high school (the reason I was invited to the book party) invalidates my positive opinion. I brought a galley along on a flight West a couple months ago and, despite being alarmed by Verhovek’s accounts of exploding jet airplanes, couldn’t stop reading. I had finished it by the time I landed in Reno.

The reason I’m bringing all this up (other than to impress you with the facts that I know Sam Howe Verhovek’s brother and have been to the Biggest Little City in the World), is because there’s a really fascinating tale in the book involving tax incentives. During the Korean War, Congress enacted an excess profits tax meant to keep military contractors from, well, profiteering. In its infinite wisdom, Congress defined excess profits as anything above what a company had been making during the peacetime years 1946-1949.

Boeing was mostly a military contractor in those days (Lockheed and Douglas dominated the passenger-plane business), and had made hardly any money at all from 1946 to 1949. So pretty much any profits it earned during the Korean conflict were by definition excess, and its effective tax rate in 1951 was going to be 82%. This was unfair and anti-business. If similar legislation were enacted today, you could expect U.S. Chamber of Commerce members to march on Washington and overturn cars on the streets.

It being 1951, Boeing instead sucked it up and let the tax incentives inadvertently devised by Congress steer it toward a bold and fateful decision. CEO Bill Allen decided, and was able to persuade Boeing’s board, to plow all those profits and more into developing what became the 707, a company-defining and world-changing innovation. Writes Verhovek:

Yes, it was a huge gamble, but for every dollar of the dice roll, only eighteen cents of it would have been Boeing’s to keep anyway. For Douglas and Lockheed, both in a much lower tax bracket, that was not so easy a call.

So that’s it! High tax rates—confiscatory tax rates—spur innovation! Well, at least once in a blue moon they do. Which is an indication that there might be some important stuff missing from the classic economists’ view of taxation, as summed up by Greg Mankiw a few weeks ago:

Economists understand that, absent externalities, the undistorted situation reflects an optimal allocation of resources. It is crucial to know how far we are from that optimum.  To be somewhat nerdy about it, the deadweight loss of a tax rises with the square of the tax rate.

Somehow I don’t think that formula held true in Boeing’s case.

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Some people really need organizations. Like Marty Peretz, for example http://blogs.reuters.com/justinfox/2010/10/19/some-people-really-need-organizations-like-marty-peretz-for-example/ http://blogs.reuters.com/justinfox/2010/10/19/some-people-really-need-organizations-like-marty-peretz-for-example/#comments Tue, 19 Oct 2010 21:33:31 +0000 http://blogs.reuters.com/justinfox/?p=15 The Boston Globe has a Local-Boy-Made-Controversial story about Marty Peretz (it was in yesterday’s paper, but I just got around to reading it today). There’s nothing much new in it, but it got me thinking about the changing division of labor in journalism and how it hasn’t worked out equally well for everybody.

Peretz is in trouble for making some sweeping and denigratory generalizations about Muslims in his blog, and then not-quite-apologizing for it. I would imagine that Peretz has held similar opinions for decades. But he’s only started getting himself into big trouble for them in the past four years: that is, since he launched his blog, The Spine. Until then, Peretz was mostly judged in the context of the institution that he bought in 1974 and has been editor-in-chief of ever since (even while selling his majority stake in 2000 and then repurchasing it in 2009), The New Republic. In that context, he came off pretty well. As Eric Alterman wrote a few  years ago in an otherwise critical account of the Peretz era at TNR:

I think any honest reader would be forced to admit that for many if not most of these years, The New Republic was, despite everything, a truly terrific little magazine.

The main reason: Peretz knew how to hire, and keep, talented people. Here’s Alterman again:

“Try, try very hard not to hire anybody who isn’t smarter than you, and wiser,” Peretz says he promised himself. In this, he notes, he succeeded. He might have added “and more liberal.” For in the days when the neoliberal Kinsley and old-fashioned social democrat Hertzberg traded off the magazine’s editorship, literary and political giants did indeed walk the TNR hallways. Just 28 and still in law school when he initially took over the magazine, Kinsley’s contrarian nature and inimitable example would prod not only The New Republic but an entire generation of pundits in the direction of Mickey Kaus/Jacob Weisberg–style smart-ass neoliberalism.

So as the head of an institution, Peretz was (at least until recently) undeniably successful—even if, like Alterman, you didn’t like the direction in which he pushed that institution. As a writer and thinker, though, he was always something of a dud. I was an enthusiastic reader of TNR in the 1980s and early 1990s, but I learned to skip the magazine’s “Diarist” page whenever Peretz wrote it. In a magazine characterized by intellectual sparkle and surprise, Peretz’s dispatches, mostly devoted to Middle Eastern affairs, were leaden and predictable. But so what? They were just a few pages a year in an otherwise great magazine. And look at all the brilliant people Peretz hired!

Since 2006, though, Peretz has had a blog. This allows him to share his opinions as often as he wants, without the intervention of smarter, wiser TNR editors who in past years might have protected him from his most intemperate and infelicitous phrasings. It also allows him to reach readers who probably aren’t interested in the rest of TNR’s content. That is, Peretz has to a certain extent been allowed to break free from his organization. Similar new freedoms have been granted in recent years to lots of journalists, myself included, and many of us have found it wonderfully liberating. Heck, Peretz probably finds it liberating too. But it’s done permanent damage to his reputation. For 90% of the people who’ve ever heard of him, he’s now that anti-Muslim fanatic, not the guy who hired Hertzberg and Kinsley and did what he could to promote the career of the young Al Gore. He was far better off and more valuable as part of an organization—an organization that he happened to own—than as a mostly independent pundit.

Why do I go on and on about this? Not to defend Marty Peretz, but to observe that institutions have been getting short shrift lately, especially in the world of journalism. And for sure, a lot of existing journalistic institutions are deserving of no shrift at all. But the idea of journalistic organizations in which people specialize, in which editors keep writers from making fools of themselves, in which cranks have a place as long as they’re good at something, isn’t entirely archaic. We’re not all cut out to be freestanding journalistic brands.

Update: Jack Shafer e-mails to point out that Marty Peretz was writing loopy stuff, and occasionally getting called a racist, back in the 1980s and early 1990s too. But he has  definitely taken it up a notch or three since he started blogging, and he never got into the amount of trouble then that he finds himself in now. Also, I failed to mention my favorite Peretz controversy of the past year, when he approvingly quoted from a Tunku Varadarajan Daily Beast column that compared John McCain to Liza Minnelli in a way that reflected poorly on both, then issued a bizarre apology the next day for “slighting … her and her gifts.”

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Apple’s day of earnings glory, iPad disappointment http://blogs.reuters.com/justinfox/2010/10/19/apples-day-of-earnings-glory-ipad-disappointment/ http://blogs.reuters.com/justinfox/2010/10/19/apples-day-of-earnings-glory-ipad-disappointment/#comments Tue, 19 Oct 2010 02:04:18 +0000 http://blogs.reuters.com/justinfox/?p=12 Apple’s earnings announcement this afternoon was something of an epic event. First, the company reported making a staggering amount of money: $4.3 billion in profit for the quarter. Second, Steve Jobs got on the phone and was even more obstreperously entertaining than usual. Third, iPad sales for the quarter were a bit lower than hoped and Apple’s stock price dropped 6% in after-hours trading.

That sort of sensitivity to the slightest bit of disappointment is to be expected when a company has been doing as well as Apple has for as long as Apple has. Everybody’s looking for the moment when the company’s spectacular growth trajectory over the past half decade finally plateaus. As somebody who bought Apple at $14 and sold at around $40 early in the 2000s (I don’t own any Apple stock now, except indirectly through mutual funds), I’m certainly not the one to predict when that moment will arrive. But I doubt that the iPad disappointment is any kind of lasting setback.

Why’s that? Because I want an iPad, I really do. And I will buy one soon. But Apple has trained me by now to wait for at least the second generation of any new product—it’s inevitably so much better than the first. I’m going with the rumors that a new-look iPad will be out by Christmas. If and when that happens, I’ll buy. For now, I’m waiting. I’m betting I’m not the only one.

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Why didn’t people in finance pay attention to Benoit Mandelbrot? http://blogs.reuters.com/justinfox/2010/10/18/why-didn%e2%80%99t-people-in-finance-pay-attention-to-benoit-mandelbrot/ http://blogs.reuters.com/justinfox/2010/10/18/why-didn%e2%80%99t-people-in-finance-pay-attention-to-benoit-mandelbrot/#comments Mon, 18 Oct 2010 15:49:32 +0000 http://blogs.reuters.com/justinfox/?p=5 Mathematician Benoit Mandelbrot was not one of those great thinkers who was ignored in his own time. He won lots of prestigious prizes. He wrote acclaimed books. He even gave two TED talks.

But it’s curious how little of the acclaim and attention Mandelbrot received over the years, and after his death last week, came from the world of finance. Mandelbrot was, believe it or not, one of the founding fathers of modern quantitative finance. In the early 1960s, he and scholars at Harvard, MIT, Chicago and a couple other places began to explore the meanings of random walks in stock prices. (I spent several years immersing myself in this history for a book; hence my obsessive interest. Here’s an excerpt from it related to Mandelbrot.)

In the early days, Mandelbrot was very much one of the random walk gang. He considered Eugene Fama, then a grad student at the University of Chicago, to be his student and protégé. A 1965 article by Mandelbrot in the Chicago B-school’s Journal of Business proved that a rational financial market would be an unpredictable one, providing an essential building block for what soon came to be known as the efficient market hypothesis.

Before long, though, Mandelbrot and the finance crowd drifted apart. It was partly just that Mandelbrot was a curious guy, and got interested in other sources of the fractal patterns that he saw in stock prices. But he also felt that “an ominous cloud” was developing in his relationship with the other random walkers. As long as quantitative finance was mostly exploratory in nature, Mandelbrot and the economists and finance professors got along fine. But as soon as the latter groups started trying to develop tools for understanding and managing risk in financial markets, there were tensions. The tool builders wanted to shoehorn market-price behavior into a bell-curve statistical model. That is, they wanted to believe that while price movements couldn’t be predicted, price volatility could. Mandelbrot thought volatility was far harder to capture than that. As Paul Cootner, a random walker from MIT’s Sloan School, wrote in 1964:

Mandelbrot, like Prime Minister Churchill before him, promises us not utopia but blood, sweat, toil and tears. If he is right, almost all of our statistical tools are obsolete . . . Surely, before consigning centuries of work to the ash pile, we should like to have some assurance that all our work is truly useless.

And so it went. For Mandelbrot, the crucial turning point came with the development—and widespread acceptance—of the Black-Scholes options pricing model in the early 1970s. Black-Scholes and the many financial risk models that have evolved from it (including Felix’s friend the Gaussian copula) are all about volatility being measurable and predictable. “When Black-Scholes came out, I said, ‘Well, it won’t last,'” he told me in 2005. “‘I’ll come back when it’s gone.'”

After the 1987 stock market crash, brought on in part by portfolio insurance strategies built upon Black-Scholes, Mandelbrot began paying attention to finance again, and some financial practitioners actually began paying attention to him. So he made a partial comeback. But the reliance on risk-management systems based on the belief that price volatility can be easily measured and predicted has continued, and it has continued to lead the financial system to the brink of disaster every few years.

So why haven’t finance academics and practitioners paid more attention to Mandelbrot’s warnings? I think it’s mainly that he didn’t provide them a handy alternative to Black-Scholes. I can’t pretend to fully understand the practical implications of his fractal view of markets (and yes, I’ve read his book for lay readers on the subject), but it does seem more useful as a critique than as a positive model of market behavior. You can’t haul in big consulting fees or create giant new securitization markets with a critique. So the natural tendency of both scholars and bankers has been to hold on for dear life to the Black-Scholes approach to modeling market risk. They get paid well for doing so, after all.

Finally, to switch topics entirely: Thanks to Felix for inviting Barbara and me to procrastinate blog at his place for the next couple of weeks. It should be fun. And it won’t normally be quite this wonky.

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