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Open Mouth Operations



April 06, 2012 – Comments (12)

Fantastic post by Ramanan discussing the central bank operations and its lack of control over the money supply. Central banks defend/maintain interest rates (price) not the money supply (quantity). This is in direct opposition to what many mainstream economists say occurs with central bank operations.


Open Mouth Operations
by Ramanan, Thursday, 5 April 2012

In the previous post Is Paul Krugman A Verticalist?, I discussed the confusions economists and market commentators have on open market operations. Even top economists such as Krugman suffer from confusions on central banking and monetary matters.

I also mentioned the work of Alfred Eichner on bringing out more clarity on the defensive nature of open market operations. Let’s look at these matters more closely.

Before this let’s look at what people in general think. Most people think of open market operations as some kind of extra activity on the part of the central bank in collaboration with the bureau of engraving and printing and think of it as operational implementation of Milton Friedman’s helicopter drops! So when a central bank such as the Federal Reserve changes its target on interest rates – such as lowering the “Fed Funds target rate”, people start commenting as if the Federal Reserve is undertaking a mystical operation.

This is Monetarist or Verticalist intuition. It is easy to show that open market operations have nothing to do with fiscal policy and as we saw in the previous blog – very little with monetary policy itself. The open market operation of the central bank is not an income/expenditure flow such as government expenditure flows or tax flows and the former does not affect the net worth of the change the net worth of either the domestic private or the foreign sector. Hence it is hardly fiscal. Yet commentators and economists keep arguing that the central bank is “injecting money” into the economy!

Even Paul Krugman erred on some of these matters and was shown how to do good economics by Scott Fullwiler in his post Krugman’s Flashing Neon Sign. Missing everything Fullwiler was saying, Krugman wrote another post A Teachable Money Moment which has the following diagram:

Below we will see how Krugman’s Neoclassical/New Keynesian (whichever) intuition is flawed.

Setting Interest Rates

These matters (the public understanding) have become worse ever since the Federal Reserve and other central banks around the world started purchasing government debt in the open markets on a large scale – in programs called Large Scale Asset Purchases (also called “QE”). In the following I will consider cases when there is no “asset purchase program” by the central bank and tackle this issue later in another post.

A simple case to highlight how a central bank defends an interest rate (as opposed to changing it) is considering the corridor system. There target for overnight rates is usually at the midpoint of this “corridor”. At the lower end of the corridor banks get paid interest on their settlement balances they keep at the central bank while at the upper end it is the rate at which the central bank lends.

Because banks settle among each other on the books of the central bank, this gives the latter to fix the short-term rates and indirectly influence long term rates.

Why do banks need to settle with each other?

One of the first economists to understand the endogenous nature of money was Sir Dennis Holme Roberston who used to work for the Bank of England. In 1922, he wrote a nice book simply titled Money.

 From page 52:

. . . If A who banks at bank X pays a cheque for £10 to B who banks at bank Y, then Bank Y, when it gets the cheque from B, will present it for payment to Bank X: and bank X will meet its obligation by drawing a cheque for £10 on its chequery at the Bank of England. As a matter of fact, the stream of transactions of this nature between big banks is so large and steady in all directions that the banks are enabled to cancel most of them out by an institution called the clearing-house:  but the existence of these chequeries at the Bank of England facilitates the payment of any balance which it may not be possible at the moment to deal with in this way …

Because banks finally settle at the central bank finally, central banks have learned since their creation that they can set interest rates. This is strongest at the short end of the “yield curve” but directly or indirectly central banks also influence long term rates.

At the end of each day, some banks will be left with excess of settlement balances (if they see more inflows than outflows) and some banks will face the opposite situation. Because they need to satisfy a reserve requirement at the central bank (which can be zero as well), some banks would need to borrow funds from others. Borrowing means paying back with interest and this is where the central bank’s ability to target rates comes enters the picture.

For suppose some bank X needs funds and other banks wish to lend bank X at a very high interest rate. In this scenario bank X can simply borrow from the central bank, while other banks who demanded higher interest will see themselves with excess settlement balances earning less than the target rate. So it would have been better for the latter to have lent than keep excess balances. (Of course the qualifier is that these things are valid under scenarios when there is less stress on the financial system). Also with the same logic, the rate at which banks lend each other will not fall below the corridor because it will be foolish of a bank to have lent settlement balances to another bank when it could have earned higher by just keeping excess settlement balances at the central bank.

Here is a diagram from the post Corridors And Floors In Monetary Policy from FRBNY’s blog which explains central bank’s operations:

The other system as per this post is the floor system – in which the central bank’s target is the interest paid on settlement balances itself, rather than the midpoint of any corridor. This is what has been followed by the US Federal Reserve in recent times.

Back to the corridor system, an important question arises. Hopefully the reader is convinced that the overnight rate at which banks lend each other is between the corridor. However it is still unclear how and why the central bank can keep it at the midpoint.

If the central bank and the bankers understand the system well, it is possible for the central bank to be quite perfect in this. This happens for example in the case of Canada, where the bank is quite accurate in its objective.

The reason is that the central bank can easily add and subtract settlement balances by various means.

Take an example. Suppose the interest on reserves is 2.25%, the target is 3.00% and the discount rate – the rate at which the central bank lends overnight – 3.75%. If the central bank observes that banks are lending each other at 3.25% – slightly away from the target of 3.00%, it can simply create excess balances. Among the many ways, there are two -

-- purchase/sale of government securities and/or repurchase/reverse repurchase agreements.
-- shifts of government deposits from the central bank account into the Treasury’s account at banks or the opposite.

So the central bank knows how the curve in the figure above looks like and adds/subtracts settlement balances by the above methods (mainly). So banks are lending each other at 3.25%, the central bank will add settlement balances; if they are lending each other at 2.75% – the central bank will drain settlement balances.

More generally the “threat” by the central bank is reasonably sufficient to make banks lend at the target!

Open Mouth Operations

Let us suppose the central bank had been targeting 3.00% for three months now and decides to decrease rates.

What does it do?

Almost nothing!

The announcement itself will make banks gravitate toward the new target!

In his paper Monetary Base Endogeneity And The New Features Of The Asset-Based Canadian And American Monetary Systems, Marc Lavoie says:

When they [central banks] are not accommodating—that is, when they are pursuing “dynamic” operations as Victoria Chick (1977, p. 89) calls them—central banks will increase (or decrease) interest rates. As shown above, to do so, they now need to simply announce a new higher target overnight rate. The actual overnight rate will gravitate toward this new anchor within the day of the announcement. No open-market operation and no change whatsoever in the supply of high-powered money are required.

Hence the term “open mouth operations” which was coined by Julian Wright and Greame Guthrie in their paper Market-Implemented Monetary Policy with Open Mouth Operations.

Open Market Operations

The above paper by Marc Lavoie is an excellent source for open market operations and looking at central banking from an endogenous money viewpoint.

I mentioned in the previous post that the open market operations are defensive. In my analysis in this post till now, I ignored the factors which cause settlement balances of the banking sector as a whole to change. Let us bring in this complication.

Apart from banks, the Treasury – the domestic government’s fiscal arm – and other institutions such as foreign central banks, governments and international official institutions (such as the IMF) also keep an account at the (domestic) central bank. When these institutions transact, there is an addition/subtraction of banks’ settlement balances at the central banks.

Here’s one example. Suppose the Treasury transfers funds of $1m to a contractor for settlement of a project done by the latter. When the funds are transferred, the contractor’s bank account increases by $1m and the bank in which he banks sees its deposits and settlement balances rise by $1m while the central bank will reduce the Treasury’s deposits by $1m.

This may lead to a deviation of banks’ lending rate to each other and the central bank needs to drain reserves. The central bank can achieve this by shifting government funds at a bank into the central bank account. If the central bank transfers $1m of funds, banks’ deposits and settlement balances reduce by $1m and the Treasury’s account at the central bank will increase by $1m.

This is not an “open market operation” but another way of adding/draining reserves. In general, depending on institutional setups, the central bank may also do purchase/sale of government securities and/or repurchase agreements.

But this has nothing to do with policy itself – rather it is to maintain status quo. (Of course “large scale asset purchases” is a slightly different matter – first one needs to understand the corridor system).

In other words, this is a defensive behaviour on part of the central bank.

Alfred Eichner

In the previous post and in Alfred Eichner And Federal Reserve Operating Procedures, I mentioned about the contribution of Eichner. In an essay in honour, Alfred Eichner, Post Keynesians, And Money’s Endogeneity – Filling In The Horizontalist Black Box, (from the book Money And Macrodynamics – Alfred Eichner And Post-Keynesian Economics) Louis-Philippe Rochon says:

For Eichner, the overall or “primary objective [of the central bank], in conducting its open market operations, is to ensure the liquidity of the banking system,” which applies to either the accommodating or defensive roles. In either case, Eichner argues that “the Fed’s open market operations are largely an endogenous response to . . . the need both to offset the flows into and out of the domestic monetary-financial system and to provide banks with the reserves they require”; that is, resulting from the demand for money and the demand for credit respectively (1987, 847, 851).

And while the accommodating argument has been debated at length by post-Keynesians, the defensive role has been virtually ignored and only recently rediscovered (see Rochon 1999). Yet it is certainly Eichner’s greatest contribution to the post-Keynesian theory of endogenous money. . .

. . . The “defensive” behavior is defined by Eichner as the “component of the Fed’s open market operations [consisting] of buying or selling government securities so that, on net balance, it offsets these flows into or out of the monetary-financial system,” leaving the overall amount of reserves unchanged. This is the result of changes in portfolio decisions and increases or decreases in bank (demand) deposits. As a result of an increase in the nonbank’s desire to hold currency, for instance, “in order to maintain bank reserves at the same level, the Fed will need to purchase in the open market government securities equal in value to whatever additional currency the nonbank public has decided to hold” (Eichner 1987, 847).

In making the distinction between temporary and permanent open market operations, Rochon also quotes Scott Fullwiler:

Outright or permanent open market operations are primarily undertaken to offset the drain to Fed balances due to currency withdrawals by bank depositors. . . . Temporary open market operations are aimed at keeping the federal funds rate at its target on average through temporary additions to or subtractions from the quantity of Fed balances. Temporary operations attempt to offset changes in Fed balances due to daily or otherwise temporary fluctuations in the Treasury’s account, float, currency, and other parts of the Fed’s balance sheet, in as much as is necessary to meet bank’s demand for Fed balances. (2003, 857)

Paul Krugman

All this is completely opposite of Paul Krugman’s position that

. . . And currency is in limited supply — with the limit set by Fed decisions.

And Krugman’s mistake is not minor – it seems he is completely unaware of the huge difference money endogeneity makes.

So what is the difference between Krugman’s diagram and the one from FRBNY blog – even though they look similar? The difference is that the latter is descriptive of behaviour when policy is unchanged and is useful for describing open market operations etc while Krugman uses the same to describe policy changes – which in reality happen via open mouth operations. Paul Krugman confuses open market operations and open mouth operations. So much for a “teachable money moment”.

Krugman also shows his Monetarist intuition by claiming:

And which point on that curve it chooses has large implications for the economy as a whole. In particular, the Fed can always choke off a private-sector credit boom by moving up and to the left.

implying that the central bank in reality controls the monetary base and thence the money stock.

Some Post Keynesians argued since long ago that the central bank cannot control the money stock:

Here’s on Wynne Godley from from The Times, 16 June 1978:

(click to enlarge)

12 Comments – Post Your Own

#1) On April 07, 2012 at 8:00 PM, leohaas (30.12) wrote:

OK, maybe I don't really get all this. So help me out here. Let me start quoting you near the end:

 "Krugman also shows his Monetarist intuition by claiming:

And which point on that curve it chooses has large implications for the economy as a whole. In particular, the Fed can always choke off a private-sector credit boom by moving up and to the left.

implying that the central bank in reality controls the monetary base and thence the money stock.

I am no fan of Krugman's, so I am quite happy to see someone point out his errors. But this totally confuses me. Here is my understanding of how this works. Now tell me where I go wrong:

 1) Fed increases the overnight rate from X to Y% (pick whatever number you like here). As you explain, all they do is announce it, nothing else. In Krugman's terms, that is "moving up and to the left."

 2) Banks follow. They will lend each other at about Y% instead of X% before the announcement, and to their clients at Y+Z% (they are in business to make money; the Z represents that) instead of the X+Z% they charged before the announcement.

 3) Businesses (and individuals) now pay Y+Z% instead of the X+Z% they paid before the announcement. In other words, borrowing money has become more expensive.

 4) Because borrowing is more expensive, businesses and individuals have a smaller incentive to borrow and thus borrow less.

And isn't "businesses and individuals borrow less" the exact same as "choking off a private-sector credit boom"?

So where do I go wrong? Because if I don't go wrong here, neither does Krugman.

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#2) On April 08, 2012 at 10:29 AM, binve (< 20) wrote:


OK, maybe I don't really get all this. So help me out here.

It isn't that it is hard to get, per se. It's just that the standard economic thinking which is pervasive is hard to break though. And I fully inlclude myself in this, because 2-3 years ago I would have had the same inclinations that you are describing. But they are (I was) incorrect. And to understand why, you have to understand what the Fed's role is in the banking system, and it is very different than most people think.

Let me start quoting you near the end:

You are not quoting me, you are quoting Ramanan, whose post is reposted above (and I give attribution to). But seeing as how I agree with his post completely, I will engage in the discussion.

"Krugman also shows his Monetarist intuition by claiming: 'And which point on that curve it chooses has large implications for the economy as a whole. In particular, the Fed can always choke off a private-sector credit boom by moving up and to the left.' implying that the central bank in reality controls the monetary base and thence the money stock."

The statement by Krugman 'And which point on that curve it chooses has large implications for the economy as a whole. In particular, the Fed can always choke off a private-sector credit boom by moving up and to the left.' is wrong and here is why:

The 'moving' up and to the left is referring to the first chart above, this one

And what it implies is that there is some fixed relationship between intrest rates and the monetary base. That when the Fed defends an intrest rate, they also limit the amount of reserves in the system (the base) controlling both price (interest rates) and reserves (quantity) at the same time, which implies that the banking system is reserve constrained.

This is patently false.

(continued in next comment)

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#3) On April 08, 2012 at 10:30 AM, binve (< 20) wrote:

Consider this point that I bring up in this post from last May:

"What policies like QE and interest rate targeting assume is that monetary policy can drive behavior in the banking system (i.e. that the behavior is driven by the supply side of the equation). And we have seen time and again that this assumption is invalid, that the primary driver of activity in the banking system is from the demand side.

Were low interest rates the primary cause of the housing bubble? Or were lax lending standards? I believe that it is incontrovertible that it was the latter. If someone has a $30,000 income and can buy a $400,000 mortgage (based on no down payment, and either dubious paperwork or loan officers that are very aggressive) on the belief that they can flip the house for a quick profit, would it have mattered if the interest rate was at 8%? Conversely, if interest rates were at 0%, but a 20% down payment was required would people be buying able to buy houses to flip as we saw during the bubble?

My point of discussing all of this in the context of this section of the post is to disabuse you of the notion that Monetary Policy is 'all-powerful' or that it is the primary driver of what happens in the economy. It is a popular theory, and I also believe that it is incorrect."

And what do we see today?

We see a massive increase in the level of bank reserves (monetary base) and lowering of the interest rate, which by all accounts should induce a private sector credit boom. But the base does not 'contstrain' bank lending at all. Consider this FRED graph looking at the Monetary Base and M2 and the Fed Funds Rate ( You see that the correlation between the Monetary Base and M2 is weak, meaning that the change of reserves in the system has nothing to go with loans and deposits being made in the broader economy. However the change in the Monetary base has a *very tight* inverse relationship with the Federal Funds rate.

And to fully explain both observations you need to understand that role of the Fed, bank reserves, under what conditions banks lend (which has nothing to do with reserves), stability in the payment/settlement system.

(continued in next comment)

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#4) On April 08, 2012 at 10:33 AM, binve (< 20) wrote:

(stupid comment system)


As loans increase, deposits increase. This is described here and many other places. Loans create deposits. So in order for the Fed to maintain control of the Federal Funds Rate, it must create reserves for the banking system. This is where proper understanding of the banking / monetary system is needed so you see how these pieces fit together.

(continued in next comment)

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#5) On April 08, 2012 at 10:34 AM, binve (< 20) wrote:

As banks create loans, some portion of those loans move though the economy and becomes spending (income) which is eventually saved and deposited at banks. As the transactions settle and new deposits are made the reserves shift from the banks which made the loans to the banks that receive the deposits. If in aggregate more loans were created than were paid-off over a given time period (say one day), then there would be a system-wide deficit of reserves needed to meet reserve requirements. Banks by themeselves cannot make reserves or change the amount of reserves in the system, it only shuffles them amongst themselves. The only entity that can alter the net reserve position in the banking system is the Federal Reserve.

When the banking system is short of reserves as in the above example, this manifests as upward pressue on the overnight lending rate (the iterbank rate that banks pays to borrow reserves). Some banks have more reserves than they need to meet requirements and some banks have less. The banks that do have more want to lend their reserves to make a profit to the banks that need them. That level of supply/demand puts upward pressure on the overnight rate. If that rate goes above the Fed Funds rate (the Fed's policy rate target) then it responds by injecting reserves into the banking system (which it does by buying Treasury bonds). The opposite happens if the overnight lending rate drops below the Feds target rate. It sells Treasury bonds, which soaks up reserves (banks use the excess reserves to buy the bonds from the Treasury, thereby returning the reserves back to the Feds balance sheet where they promptly disappear into the ether).

This is the cause and effect:

1) Customers want loans, bank lending is determined from the demand side
2) Banks extend loans to any credit-worthy borrows when it feels it can make profit on the transaction, and if the loan does not violate capital requirements
3) Banks make the loan independent of their reserve positions and finds reserves after the fact
4) The demand / supply of reserves manifests as movement in the overnight lending rate which the Fed responds to by adding or soaking up reserves such that the overnight lending rate meets the Fed Funds policy rate.

Once you understand this cause and effect then your 'monetary base against loans' chart becomes crystal clear: the Fed does *NOT* 'lead' credit cycles by increasing the monetary base, it *FOLLOWS* credits cycles and increases the monetary base based on loan demand.

And once you understand the above points, this last sentence makes perfect sense.

The Fed has a mandate to promote stability in the banking system. It also has a mandate to maintain control of its policy interest rate. The only way for both to happen is for the Fed to guarantee that there are sufficient reserves in the system such that demand (the overnight lending rate) equals the Fed Funds target policy rate. In short, the Fed controls PRICE. And in doing so CANNOT control QUANTITY. It can't do both at the same time and to suggest otherwise means one is talking out of the side of their face (or doesn't undestand the system).


Because if the Fed really wanted to 'limit the size of the monetary base' directly, i.e. to target the amount of reserves (quantity), then what would happen is that banks would still makes loans to customers. These loans would create deposits. And because the deposits do not have enough reserves to back them system-wide without a reserve injection by the Fed would find that the competion for reserves from banks that have more than they need vs the banks that need them would receive fierce competition on the overnight market such that the overnight rate would skyrocket, deviating significantly from the Fed Funds rate. The interbank settlement system would grind to a halt as banks hoarded reserves.

Which is direct opposition to the Feds mandate of ensuring a smooth settlement system at it target policy rate.

In short, banks are not reserve constrained because it's the FED's JOB to ensure they are not. And to suggest otherwise means that someone is describing a banking system that we do not have and does not exist.

(continued in next comment)

There is no direct / unique relationship between the monetary based and the Fed Funds rate as Krugman and Monetarists suggest in the fist chart in the post, for all the reasons I just explained and for the observable trends we see between the the Monetary Base and M2 and the Fed Funds rate. They money multiplier is a myth. Which is what Krugman's banking theory (as are most mainstream economists banking theories) are built upon. Banks are not reserve constrained. To hammer this point home consider Canada's banking system which is virtually identical to ours except they do not have reserve requirements and our banks have 10% resever requirements. If the money multiplier model was accurate, then when the Bank of Canada increased the monetary base by $1 than this 'injection' (which is a false way to look at Central bank OMO operations) would result in an infinite leverage as it is 'lent' infinitely (nevermind that banks don't lend reserves) which could result in a infinite money multipler or something equally absurd.

The money mulitplier model is a myth and a complete and utter failure and desribing how our banking / monetary system works and providing any predicitve guidance as to how things will work in the future. It is time for mainstream ecnomists to think critically about these flawed models and update them accordingly.

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#6) On April 08, 2012 at 11:02 AM, scruffy4life (82.27) wrote:

Scruffy understands... Hmm Hrmmm!

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#7) On April 09, 2012 at 1:47 PM, leohaas (30.12) wrote:

Thanks very much for all the effort you put into this. I still disagree (or I just don't get it--please, keep the discussion civil: do not imply I talk from the side of my face).

We agree that the FED determines the price of money and that demand for money is the driver. I contend that if they increase the price when demand is strong demand will go down. That is econ 101. With demand down, supply will also have to go down. The FED takes care of that per the mechanism you explained. In a strong-demand environment, the opposite is also true.

However, this mechanism does not work as well in a weak-demand environmnet. I already mentioned several reasons for this: banks may have tough lending standards, and consumers and businesses may have little appetite for taking on risk when the economy is weak.

So the FED determines indirectly (thourgh thre price) the quantity to some extent. The stronger the ecoomy, the stronger this effect. The weaker the economy, the weaker this effect.

By the way: what I am arguing has nothing to do with reserve constraints. I have not mentioned that term in my comment.

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#8) On April 09, 2012 at 4:12 PM, binve (< 20) wrote:

leohaas ,

Thanks, and I apologize. I did not mean to direct those comments at you. I copied half of that comment from a previous comment and the phrase 'talking from the side of your face' was meant for professional econmists who should really know better (Monetarists mostly). But nonetheless, that comment is not helpful so I will try to tone it down.

So the FED determines indirectly (thourgh thre price) the quantity to some extent. The stronger the ecoomy, the stronger this effect. The weaker the economy, the weaker this effect.

I still think this is a false statement. Or at the very least the strength of the causality is much less than what you are suggesting. The urge to speculate either in housing or in stocks (see and the borrowing/lending associated with this has very little to do with the size of the monetary base and in most cases has little to do with the interest rate as well.

This is why monetary policy is a blunt instrument and does not drive the economy (lending, consumer behavior, corporate growth, etc.) in predicitable ways. See this post for a good list: All monetary policy does is manipulate cost channels. And in doing so introduces large distortions affect both creditors and borrowers.

I think the evidence contines to point to the fact that the Fed does not have any real control over quantity (of reserves). And I go further so say that it's control over price (interest rates) has very ambiguous impact on the real economy, much less 'useful' than fiscal / tax policy which can be targeted.

By the way: what I am arguing has nothing to do with reserve constraints. I have not mentioned that term in my comment.

This is a true statement, however it *has* to be discussed because the Monetarist position / mainstream economist position is that the banking system is reserve constrained and that the Fed controls both interest rates and the monetary base. This is absoultely central to this discussion and the quote from your comment #1 which you use directly talks about this relationship. And they proceed to base a model of the monetary system based on this false observation and it then leads to incorrect diagnosis about what is going on. ..

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#9) On April 12, 2012 at 9:39 AM, XMFSinchiruna (26.56) wrote:


Fascinating... Thanks for this. The world needs more Binve's with the deep intellectual curiosity to dive beneath the surface of topics that too often are afforded only sound-byte consideration. 

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#10) On April 12, 2012 at 12:02 PM, binve (< 20) wrote:

Thanks Sinch, I appreciate that!!

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#11) On April 12, 2012 at 12:29 PM, leohaas (30.12) wrote:


Binve is unique. The world would be a far better place if the average Joe had only a fraction of Binve's intellectual curiosity.

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#12) On April 12, 2012 at 12:39 PM, binve (< 20) wrote:


Dude, that is such a nice compliment. Thanks man!

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