The Myth of Fractional Reserve Banking

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Three Busi­ness Spec­ta­tor read­ers con­tacted me directly about one topic last week – bank money cre­ation, and how bank reserves work. Fol­low­ing an old jour­nal­ism adage that three direct enquiries about a topic from the pub­lic means that everybody’s inter­ested in it, I’m div­ing into wonkdom to answer their queries in detail here. Ignore this post if the adage isn’t true for you, but if it is and you haven’t yet had your morn­ing Java, now’s the time for that stroll to the barista.

To read the rest of this post, click here

About Steve Keen

I am a professional economist and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous debts accumulated in Australia, and our very low rate of inflation.
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23 Responses to The Myth of Fractional Reserve Banking

  1. mikeh1980 says:

    Until eco­nom­ics stu­dents start demand­ing a refund of tuition fees I’d expect that the teach­ing this myth will continue.

  2. TruthIsThereIsNoTruth says:

    Cer­tainly a big step adding the extra bank in there.

    The part about look­ing for reserves later high­lights how banks are incen­tivised not to do that and we have the credit crunch as a con­tem­po­rary example.

    If you’re bal­ance sheet posi­tion is so weak that you are des­per­ately look­ing for funds to fill your reserves, the mar­ket knows this and either makes you pay or not give you money at all, i.e. credit crunch. Well funded banks in Aus­tralia could sit on their hands for months dur­ing the worst of the credit cri­sis, while their Amer­i­can coun­ter­parts needed mas­sive res­cu­ing from the fed­eral reser­val. So how does it really hap­pen? Depends on when and where you look.

    The two main direc­tions in terms of increas­ing com­plex­ity, is defin­ing dif­fer­ent cap­i­tal tiers to be con­sis­tent with the cur­rent reserve regime, and adding more banks cre­at­ing com­pe­ti­tion for both deposits and loans.

  3. Steve Hummel says:

    Regard­ing: http://krugman.blogs.nytimes.com/2012/10/23/theory-and-the-thirties/?smid=tw-NytimesKrugman&seid=auto

    Econ­o­mists sound so eru­dite and con­fi­dent. And yet there is so much un-examined ortho­doxy lay­ing around all over the place and so much at stake that they should be much more hum­ble and open to new think­ing. The kind of think­ing which con­sid­ers fac­tors that are not abstract, but as real as com­merce itself. One such REALITY is the enforce­ments of cost account­ing which inval­i­date veloc­ity THEORY, and make incomes inevitably less in com­par­i­son to prices. Another factor/REALITY that econ­o­mists are fail­ing to con­sider is the increas­ing effect of tech­no­log­i­cal inno­va­tion on unem­ploy­ment. The inex­orable march of Tech­no­log­i­cal effi­ciency wed to profit mak­ing sys­tems where there is an equally inex­orable drive to reduce costs and hence increase prof­its is like the irre­sistible force meet­ing the immov­able object. Tech­nol­ogy reduces the RATIONAL need for human employ­ment and the pur­suit of profit is happy to accel­er­ate their col­li­sion. The ques­tion is only whether the result­ing impact will explode into a rev­o­lu­tion­ary social­ism, a reac­tionary neo-feudalism or result in an evo­lu­tion of profit mak­ing sys­tems via a change in the con­sumer finan­cial par­a­digm from loan only to citizen’s div­i­dend and loan if desired and cred­itable. And the fac­tor that will mon­i­tor which one of these results occurs is whether we choose to to think as homo eco­nom­i­cus or homo sapi­ens, that is, wise and dis­cern­ing man. Con­sider it.

  4. peteryogman says:

    The cen­tral bank must accom­mo­date these trans­ac­tions. But the cen­tral bank also can cre­ate or destroy money in sep­a­rate money mar­ket oper­a­tions and for an over­all look at credit in the econ­omy these oper­a­tions must be com­bined with sup­port of the pri­vate bank­ing sys­tem. There­fore is money totally endoge­nous or is there room for cen­tral bank activ­ity that is truly exoge­nous and is this large enough to effect the econ­omy beyond pri­vate bank activity?

  5. TruthIsThereIsNoTruth says:

    Cen­tral bank influ­ences the price at which money exchanges by set­ting the overnight rate. I think there is a nat­ural mis­con­cep­tion that endoge­nous money means explicit con­trol by pri­vate banks. Endoge­nous money is a mech­a­nism via which money vol­ume is cre­ated, how­ever it can be con­trolled or influ­enced by a wide vari­ety of fac­tors, includ­ing the cen­tral bank. Banks behav­iour is mainly influ­enced by price and risk (still miss­ing from the par­si­mo­nous model), both in turn influ­enced by many things, depend­ing on when and where you look.

  6. TruthIsThereIsNoTruth says:

    Just think­ing there is a nat­ural exten­sion of the model to vec­tor space. So instead of hav­ing a buyer and seller bank, you have a vec­tor of banks which are both buy­ers and sellers.

  7. alainton says:

    Well done in start­ing to model intra bank transactions.

    These are cru­cial of course in under­stand­ing how mon­eys ‘flows the other way’ and why reserves arnt drained by credit creation.

    It also exposes a flaw in the ‘chicago plan’ — full reserve bank­ing — recently pro­moted by the IMF in that loans cre­ated from term deposits (which would be allowed) would cre­ate reserves of equal value in other banks which could then be lent out. From an email from Dirk Beze­mer im sure he wouldnt mind sharing

    ’ Here is another prob­lem, Andrew:

    Sup­pose an alpha­bet of banks A,B,C,…Z. Sup­pose bank A can lend while
    banks B,C,…, Z are all ‘loaned up’ — they have lent just so much to
    the pub­lic as their reserves allow.

    What if bank A, with enough reserves to lend mil­lions, does so, to the
    point where also bank A reaches its limit? And what if the bor­row­ers
    draw down the loan and spend the money? All very likely to happen.

    Now mil­lions in deposits find their ways through the econ­omy and onto
    bank bal­ances of banks B,C, …Z, all in excess of reserves.

    Mean­while bank A still has the same capac­ity to lend — all its deposits
    have been trans­ferred to other banks, after all.

    So it does the same thing again. And again.

    What will the cen­tral bank do to stop this? I can­not stop bank A — bank
    A is oper­at­ing by the rules. It can­not destroy deposits in banks
    B,C,…Z. The deposit are not theirs.

    Ergo, their will de deposit=money cre­ation in excess of reserves and
    loans will be funded by deposits — all the dis­as­ters that full-reserve
    money was try­ing to avoid.

    Dirk’

    So per­haps a bet­ter title would have been ‘The Myth of Full Reserve Banking’

  8. cyrusp says:

    Isn’t frac­tional reserve bank­ing sim­ply the oppo­site of 100% reserve banking?

    I don’t get why debunk­ing the money mul­ti­plier the­ory means that FRB is a myth. As far as I can tell there is no con­flict between endoge­nous money and FRB. When a layper­son talks about FRB they sim­ply mean bank money cre­ation (which I agree with some Aus­tri­ans is a form of fraud).

  9. Ian Wentworth says:

    Dear Steve

    Thank you for the detailed account of ‘The myth of the money mul­ti­plier’.
    I fol­low the rea­son­ing down to the descrip­tion accom­pa­ny­ing Table 3, where the inter­bank trans­ac­tions are inter­me­di­ated by the Reserve Bank, how­ever when a bank has insuf­fi­cient Reserves to cover a spe­cific trans­ac­tion it become less clear.

    If in the first instance, a bank has insuf­fi­cient liq­uid reserves to com­plete an inter­bank set­tle­ment, it pre­sum­ably bor­rows against or sells other assets in the short and/or longer term to meet its oblig­a­tion. How­ever, you pose the sit­u­a­tion where an indi­vid­ual bank is already at the limit of its reserves — either as deter­mined by the cap­i­tal ade­quacy require­ments, or sim­ply has no reserves at all (?).

    You sug­gest that in such sit­u­a­tions the RBA is bound, in the inter­est of main­tain­ing order or pre­vent­ing col­lapse of the sys­tem, to pro­vide fur­ther loans or make pur­chases in open mar­ket oper­a­tions using addi­tional issues of base money. In which case the cap­i­tal reserves of indi­vid­ual banks are increased allow­ing the extended lend­ing to continue.

    What I don’t under­stand is the dif­fer­ence between this sit­u­a­tion, and a bank with no deposits or reserves what­ever, loan­ing out any amount it choses, only to have this sup­plied by the Reserve Bank on request — in the name of sys­tem sta­bil­ity. Pre­sum­ably not the same thing, but what is the difference?

    Also, this ‘money cre­ation’ process result­ing from com­mer­cial bank loans, in the absence of addi­tional base money cre­ation by the Reserve Bank, is actu­ally credit cre­ation, and you have spo­ken of this before as the cre­ation of ‘credit money’. This com­bi­na­tion of credit and the money base as the ‘money sup­ply’ is con­fus­ing. For an indi­vid­ual, the poten­tial spend­ing power of his cash and bank credit would appear to be the same — he can spend both imme­di­ately. How­ever, the sum of all credit bal­ances in a sys­tem which also includes debt, appears to rep­re­sent not just present spend­ing power, but promised future spend­ing power — realised only when out­stand­ing debts are repaid by con­tin­u­ing eco­nomic activ­ity. Thus the ‘money sup­ply’ is largely a pro­jec­tion of poten­tial future spend­ing power, as only the mon­e­tary base is avail­able to spend in the present — a small frac­tion of the com­pos­ite ‘money sup­ply’. Is this cor­rect, and is this an alter­na­tive way of describ­ing why the Reserve Bank issues more base money — in essence to meet ‘with­drawals’ of future spend­ing power before its due time?

  10. mahaish says:

    If you’re bal­ance sheet posi­tion is so weak that you are des­per­ately look­ing for funds to fill your reserves, the mar­ket knows this and either makes you pay or not give you money at all, i.e. credit crunch”

    think this whole thing started because it was the other way round titint,

    remem­ber , the crash hap­pened because there was a pay­ments cri­sis in the sec­ondary mar­ket, which most cen­tral banks dont supervise.

    the sec­ondary mar­ket exists to by pass the bal­ance sheet con­straints within the bank­ing system.

    the level of reserves is pretty mean­ing less, when we look at the size of the deriv­a­tives mar­ket, and thats where the crap happened.

    reme­ber the first rule of bank­ing , the greater the lever­age the greater the profit in a ris­ing market.

    off course , it all goes to hell in hand bas­ket, when some­one cant pay or has insuf­fi­cient col­la­toral to buy or swap there way out of stife.

    which is exactly what happened

    it would have been inter­est­ing to see how things would have turned out had lehman broth­ers kept their mouths shut, not called in the fed, and just went to the dis­count window

  11. mahaish says:

    The cen­tral bank must accom­mo­date these trans­ac­tions. But the cen­tral bank also can cre­ate or destroy money in sep­a­rate money mar­ket operations”

    cen­tral banks cant cre­ate money, or net finan­cial assetts.

    the trea­sury can cre­ate reserv­able deposits or money(i hate this term)

    the cen­tral bank just adjusts the port­fo­lio com­po­si­tion within the bank­ing sys­tem through var­i­ous unwind­able credit/liquidity swap oper­a­tions once trea­sury does the reserve add.

    even under a sce­nario of cen­tral bank credit, it still means there is no net finan­cial assett being created

    it cant alter net worth either in or out of the bank­ing sys­tem, just the com­po­si­tion of the assett base

  12. TruthIsThereIsNoTruth says:

    pay­ments cri­sis in the sec­ondary market?

    Mahaish, thanks for the reply. I’m not going to engage in a debate on text­book seman­tics. Pri­mary mar­ket, sec­ondary mar­ket… what­ever. Maybe look up what they mean first.

    Any­way, banks like lehmans had credit risk posi­tions which they were not eval­u­at­ing prop­erly, mak­ing their book look fic­ti­tiously bal­anced. When that unwound they were des­per­ate for fund­ing, as was every other US bank, they all hit the mar­ket at the same time as no one was will­ing to give them a penny (not even the Fed in case of Lehmans). If by dis­count win­dow, you mean the whole­sale fund­ing mar­ket, there was no mar­ket big enough for them at the time.

    At the same time aussie banks could sit back and weather down the worst of the storm from a fund­ing per­spec­tive. This is a con­tem­po­rary exam­ple of how fund­ing works. The lat­est ver­sion of Steve’s model is a really good tool to under­stand this as it pro­vides a the­o­ret­i­cal frame­work for how money flows around (gets cre­ated if you want). What I’m still not com­fort­able with is the attempt to infer some con­clu­sions regard­ing actual banks behav­iour from the frame­work. It is bet­ter used as tool to study the vari­ety of ever evolv­ing bank­ing behav­iour instead.

  13. F. Beard says:

    We’d have an inter­est­ing social sys­tem the instant after the Cen­tral Bank did such a thing, but it wouldn’t be called cap­i­tal­ism. Steve Keen

    I don’t see why not. Why should the money lenders have gov­ern­ment to stand behind their check kit­ing? That’s more akin to fas­cism than a free market.

    The mon­e­tary sov­er­eign (e.g. US Trea­sury) itself should pro­vided a risk-free fiat stor­age and trans­ac­tion ser­vice that makes no loans and pays no inter­est. And after that ser­vice is pro­vided then gov­ern­ment deposit insur­ance and the legal ten­der lender of last resort should be abol­ished. Peo­ple could still choose to deposit with the banks but with the firm under­stand­ing that they might lose those deposits.

    As for endoge­nous pri­vate money cre­ation, com­mon stock and other pri­vate money forms (futures con­tracts, store coupons, etc) could fill the need but in an eth­i­cal man­ner and those money forms, like lim­ited credit cre­ation, do NOT require gov­ern­ment priviledge.

  14. Steve Hummel says:

    Regard­ing IMF paper and Coppola’s critique:

    The prob­lem is not frac­tional reserve it is the monop­oly (actu­ally tri­opoly) on credit. ONLY the CONSUMER finan­cial par­a­digm need be changed from loan ONLY to Div­i­dend and loan if desired and cred­itable, the business/commercial one remains the same and sim­ply requires the few reg­u­la­tory mech­a­nisms like lim­it­ing the per­cent­age of lever­age on spec­u­la­tive activ­ity and then also the insti­tu­tion­al­iza­tion of a com­pen­sated retail dis­count to to deal with any cost push/demand pull infla­tion. Shadow bank­ing sys­tem of course being the utter­est of eco­nomic desta­bi­liza­tion needs to be unwound in a sane and equi­table man­ner and then banned or straight­jack­eted because its just unwork­able stu­pid­ity and invi­ta­tion to mon­e­tary deadly sin. C. H. Dou­glas had the solu­tion nailed 90 years ago. Econ­o­mists and the finan­cial sys­tem just need to get over it.

  15. Steve Hummel says:

    If the con­sumer econ­omy is 70% of the total econ­omy how much less debt and more sta­bil­ity would be accom­plished by chang­ing the con­sumer finan­cial par­a­digm to Div­i­dend? Lots and lots is the answer. Com­bine this with the rapidly accel­er­at­ing fact of the inex­orable march of tech­no­log­i­cal inno­va­tion which is mak­ing human input into pro­duc­tion RATIONALLY unnecessary.…if you want to main­tain a profit mak­ing eco­nomic system.…and the Citizen’s Div­i­dend and Gen­eral com­pen­sated Dis­count are the LOGICAL SOLUTIONS. MESST (Monetary/Economic/Spiritual Syn­the­sis The­ory) can be found and derided by econ­o­mists and financiers, but rec­og­nized as the obvi­ous solu­tion by any­one with a truly open mind…here:

    http://www.amazon.com/dp/B009QGFX6U/ref=rdr_kindle_ext_tmb

  16. vk says:

    A bit of trivia: not every cen­tral bank is as san­guine as RBA or the FED when it comes to the bal­ances of the com­mer­cial banks. 20 years ago I spent (wasted?) some time work­ing in the Bul­gar­ian bank­ing sys­tem. Each inter­bank trans­fer had to be con­firmed by the cen­tral bank. Occa­sion­ally the sys­tem would “clog up” and banks would receive mes­sages about incom­ing trans­fers but with­out the con­fir­ma­tion mes­sage from the cen­tral bank no account­ing entries could take place. The sit­u­a­tion is still pretty much the same as per http://www.ecb.int/pub/pdf/other/ecbbluebooknea200708en.pdf , page 27:
    “A pay­ment in RINGS can be set­tled indi­vid­u­ally in accor­dance with the FIFO prin­ci­ple within its pri­or­ity level, pro­vided that there are suf­fi­cient funds on the account of the payer’s bank. Pay­ments are placed in a queue and remain pend­ing until suf­fi­cient funds are received to cover the out­stand­ing pay­ments.“
    Cus­tomers nat­u­rally hate it when their funds aren’t been received because a dealer in the pay­ees bank couldn’t project the cash­flow accu­rately enough but the cen­tral bank there main­tains tight grip and does not allow over­drafts on the com­mer­cial banks’ accounts.

  17. Steve Keen says:

    Not trivia at all vk–quite inter­est­ing in fact. Yes of course that is an option for a clear­ance set­tle­ment sys­tem, and it would require banks to hold much more sub­stan­tial reserves to min­i­mize the odds of a payee not hav­ing his trans­fer settled.

  18. csr says:

    Hi Steve,
    In the last table 7, even though the Buyer Bank has bor­rowed reserves from another bank & lent (LendB) it to a non-bank entity, new bank money equal to LendB is cre­ated, isn’t it? If this under­stand­ing is cor­rect, I’m won­der­ing why then prior to 2008 finan­cial cri­sis did the US cen­tral bank even have to cre­ate $20B of reserves & not lower. Is it because of a his­tory of inter­ven­tions dur­ing pre­vi­ous finan­cial crises when the num­ber of banks look­ing for reserves was higher than the num­ber of banks who are capa­ble of lend­ing them (only the scale of prob­lem is lot big­ger in 2008)?

    Also is the lend­ing of reserves between banks occur through some spe­cial types of bonds?

    Thanks.

  19. vk says:

    Hi Steve,
    I am glad you found the Bul­gar­ian case inter­est­ing.
    Actu­ally the com­mer­cial banks there did not need to hold sub­stan­tial reserves. In fact if a bank was a net recip­i­ent of trans­fers it wouldn’t need any reserves at all because the incom­ing trans­fer would be more than suf­fi­cient to cover the out­go­ings. How­ever it would be pru­dent to keep some reserves as one never knows how much trans­fers the bank would receive.
    The cen­tral bank there intro­duced this sys­tem soon after the fall of the Berlin wall. There were all sorts of prob­lems, includ­ing infla­tion, and the cen­tral bank fig­ured out that infla­tion could be caused by a com­mer­cial bank send­ing lots of trans­fers to other banks.
    Amus­ingly even with such a restricted sys­tem in place Bul­garia went through a hyper­in­fla­tion in 1996–1997. I am curi­ous to see how your endoge­nous the­ory of money would explain that lit­tle fact.

  20. Stamatis Kavvadias says:

    @alainton

    Regard­ing the IMF paper, a full-reserve bank­ing sys­tem may have 2 types of banks (or banks can have 2 types of accounts). One for deposits-only, that are fully backed by reserves. Depos­i­tors may have to pay some fee to the bank, in this case.

    ?n the dis­cre­tion of depos­i­tors to use their money oth­er­wise, there may be another type of bank (or another type of account) that give(s) inter­est (or div­i­dend –that’s orthog­o­nal), and “deposits” in this case are used for lend­ing by the bank. In these banks (or type of accounts), money of “deposits” are not safe, and they may also suf­fer losses. In fact, in this case “depos­i­tors” are actu­ally *lenders* of the bank, as is the implic­itly and com­pul­sory case today with main-stream bank­ing. This means that “depos­i­tors” carry risk.

    For a con­tem­po­rary pro­posal on full-reserve bank­ing, see http://www.positivemoney.org.uk/

  21. Tel says:

    Steve Hum­mel, you might want to take a look at “Lend­ing Club” which is indeed an alter­na­tive to the banks, and also works on a div­i­dend basis.

    So if you want a mort­gage, they set you up very sim­i­lar to a com­pany IPO where you offer a prospec­tus and float your propo­si­tion for investors to buy into. The investors own shares in your mort­gage and they can­not have their money at all but they get div­i­dends when you make your pay­ments. The facil­i­ta­tor com­pany take a small per­cent­age and the investors accept most of the risk (but they can choose exactly who they decide to invest in).

    Ulti­mately it’s a much more sta­ble busi­ness model that FRB and because the investors are in effect buy­ing shares in your loan, they don’t need to even worry about money cre­ation or that other reserve bank­ing crap. Many peo­ple for­get the fact that issu­ing share cer­tifi­cates is (secretly) exactly equiv­a­lent to money cre­ation, but per­haps as this cri­sis gets worse new ideas will float to the sur­face (that’s a good thing, even if the new ideas are just old ideas rediscovered).

  22. cliffy says:

    VK,

    If we regard money as no dif­fer­ent to any­thing else, which I do, then hyper­in­fla­tion is sim­ply a mea­sure­ment of prices at shops that is chang­ing rapidly when com­pared to other peri­ods of examination.

    If per­ceived value of thing A reduces in rela­tion to thing B, then if the price tags [to the extent their are price tags] we are mea­sur­ing to con­clude ‘yes their is infla­tion” are those of thing B then we might con­clude there is infla­tion when in fact all is square.

    Lets how­ever restrict our­selves to the case where “hyper­in­fla­tion” means peo­ple hand­ing money back­wards and for­wards amongst them hand­ing over stuff back­wards and forwards.

    In that case their are only two options for prices to increase:

    A. The amount of money able to spent grows

    B. The range of goods that all indi­vid­u­als buy reduces and the value of par­tic­u­lar goods in the eyes of indi­vid­u­als increases, those par­tic­u­lar goods being dif­fer­ent for each indi­vid­ual, result­ing in lower trans­ac­tion vol­umes and higher prices.

    Did the vol­ume of sales in the hyper-inflationary period reduce?

    If that all be true then you might hypoth­e­size that the larger the range of goods reg­u­larly sold in an econ­omy the less likely for hyper­in­fla­tion to occur given the occur­rence of an event that could lead to hyperinflation?

  23. Aaron Smith says:

    I think it is impor­tant not to toss out the baby with the bathwater.

    Yes, FRB doesn’t per­fectly match our mod­ern soci­ety because the mon­e­tary base is not sta­tic and can be induced indi­rectly into creation/destruction from pri­vate banks through open mar­ket mech­a­nisms. How­ever, if say the Fed were to freeze MB, then FRB would hold true. The one way around this would be for banks to move more deposits into ‘near-deposits’ or mar­ket their short term assets/long term debt to the pub­lic and let them bear the short/long liq­uid­ity imbalance.

    To say how­ever that FRB is a myth how­ever, implies that (even if not intended) that banks don’t cre­ate money which they do. The use of the St Louis Fed graphs is decep­tive because of course M1/M2 don’t include bank reserves. So yeah, M1/M2 can look smaller than MB because MB actu­ally includes the reserves. If you were to count cash out­side of the banks + reserves + deposits made in excess of reserves at indi­vid­ual banks) than it would be pos­i­tive. The rea­son the Fed doesn’t do that of course is where are the reserves applied? To M1 deposits? M2? M3? It’s just eas­ier to exclude reserves even though it cre­ates con­fus­ing graphs.

    Lastly, I don’t like the idea of con­sid­er­ing the reserve ratio use­less just because banks can move deposits into ‘near-deposits’ or they bor­row the reserves they need indi­rectly from the Fed to cover their reserve ratios. Sure they can do that, but that is not the whole story. With the lat­ter, the money mar­ket can indeed shut­down dur­ing scares and we’re back to FRB basics. As a pub­lic pol­icy con­sid­er­a­tion, demand deposits should be con­sid­ered sep­a­rate and more secure than inter­est and time deposits. And gov­ern­ment should be more apt to pro­tect check­ing deposits over time/interest deposits because the lat­ter is more implicit in its risk. With a higher RR (our ‘myth’), bail­ing out demand deposits becomes much eas­ier to do.

    I mean you can take the reserve ratio logic to it’s extreme and argue that 100% reserves wouldn’t mat­ter. This is false of course…yes, banks would increase inter­est rates to induce peo­ple into near-deposits, but your reg­u­lar Joe who deposits 1000 dol­lars in a reg­u­lar bank account will absolutely be guar­enteed his money (unless the bank com­mits fraud) and he will not need one penny of bailouts (indi­rect or direct) from the gov­ern­ment should there be a bank­ing cri­sis. From a pub­lic pol­icy stand­point, that is a very pos­i­tive thing.

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