One Big Mutual Fund, or, The Ownership Society

by Cosma Shalizi on July 31, 2006


Attention Conservation Notice: Over 1500 words on a wacky quasi-socialist economic scheme, from someone utterly lacking in credentials in economics. The scheme does not respect the sanctity of private enterprise, but at the same time would not reduce the alienation of labor one iota. Includes a lengthy quotation of a game-theoretic impossibility result.

In the previous installment in this series of modest proposals for the reform of corporate governance, I looked at ways of making the incentives of the managers of large, publicly-held corporations align more closely with those of their long-term shareholders. This left alone the question of the beneficiaries of corporate value; assuming that the managers are busily working to maximizing their revenue streams, who benefits from their industry and diligence? Having just read Mark Greif’s great essay on redistribution in n+1, I would like to make a suggestion. (Issue 4; long excerpt here, as pointed out by Matt in the comments.)

The text for today is Gary Miller’s Managerial Dilemmas: The Political Economy of Hierarchy, an excellent book which I learned about from Henry Farrell. Ambitiously, Miller tries to explain why hierarchical corporations exist at all, why they take some of the forms they do, and how, in part, their form relates to their performance. Much of the book, especially the first part, is a partially-successful attempt to find good economic reasons for their features, i.e., efficiency-enhancing ones. (He does not seriously consider the option that enterprises are hierarchical for non-economic reasons, say that some people like bossing others around, which hierarchies let them do, and those people are able to select hierarchies over other, more efficient, forms. After all, it’s hardly historically unprecedented for powerful people to prefer institutions which lower aggregate output but give them a bigger share of the product. See, e.g., here.) He also tries to explain why theories of corporate organization that rely solely on economic “mechanism design”, i.e., structuring information and material incentives, will actually lead to sub-optimal results, for pretty basic game-theoretic reasons; getting beyond these impasses is fundamentally a political problem. This is potentially quite subversive in its own way, but it’s really the first part of the work, about the economic justification of the hierarchical enterprise, that I’m going to twist and abuse.

One of the features of the modern corporation that Miller attempts to rationalize is the existence of shareholders who are passive and, in the overwhelming majority, utterly disconnected from the day-to-day or even year-to-year operations of the company. He does so by means of the following impossibility theorem, attributed to Bengt Holmstrom. Having tried to summarize Holmstrom’s theorem better than Miller, and failed, I’ll just quote Miller.

Holmstrom assumes that there are n agents whose actions determine a level of revenue x. The actions taken are unobservable and are costly to each of the agents. In particular, we assume the production function is a team production in which the productivity of each individual’s action is determined by other individuals’ levels of effort.

Holmstrom points out the desirability of three characteristics of an incentive system — and then shows that they are logically inconsistent. First, Holmstrom examines the Nash equilibrium outcome of an incentive system. At such an equilibrium, each individual will find that he or she could not do better by choosing a different effort level, as long as all others do not change their effort levels. Simple marginal analysis tells us that, in such an equilibrium, each person will find that his or her marginal cost of effort is exactly equal to the marginal gain; otherwise, the individual could be better off by working harder or not as hard. Second, Holmstrom stipulates that the outcome be budget balancing — that is, the incentive system should exactly distribute the revenues generated by the actors among the actors. Third, Holmstrom examines Pareto efficiency. This means that the outcome should be such that the individuals in the organization could not find a different outcome that would make them all better off.

Holmstrom shows that no budget-balancing system can create a Nash equilibrium that is also Pareto efficient. In other words, every budget-balancing incentive system will induce a social dilemma among its participants. The reason is that individuals will bring their own marginal costs of effort into equality with their own marginal gain. This means that each individual will not undertake an additional unit of effort that will produce less individual gain than individual cost — even if that extra unit of effort produces more gain for other individuals on the team.

As an example, suppose there is some individual who has a marginal revenue productivity of $12: Each unit of her own effort generates an extra $12 for the team. According to Pareto optimality, she should exert additional effort as long as the cost to her of that effort is less than or equal to $12; each such unit of effort generates more revenue for the team that it costs her as an individual. The only way to motivate her is to make sure that she gets all of the marginal revenue of her last unit of effort. In a team, it is impossible for this to be the case for every individual, as long as the incentive system is budget balancing. If everyone gets all of the last dollar produced, the team will have to pay out more in incentives than it generates. But if the individual gets only one-third of the marginal revenue from her actions, she will work only as long as her effort costs her less than $4 per unit. [pp. 129—130]

This suggests a rather unusual role for shareholders: they provide a money-sink, someplace money can go other than those actually involved in production. This means that the economic mechanism no longer has to be budget-balancing, which actually makes efficiency possible. Miller suggests that this is one reason why the modern public corporation, with its separation between legal ownership (by stockholders) and day-to-day control (by managers) can work, to the extent that it does. It is precisely because the shareholders are passive, with very limited influence over the actual running of the corporation!

Today’s modest proposal — and I should make it very clear that Miller suggests nothing of the kind — is to take this separation of functions even further. Shareholders can use their legal ownership to intervene in the running of the company, though it is hard (and managers try to make it harder). By doing so, however, they become players in the team-production game, and lose their useful role as a money-sink. To limit this danger, while retaining the advantages of competitive markets for capital allocation and corporate control, I suggest the following. A substantial fraction — say three-quarters — of all profits of publicly-held corporations are to be paid to a new institution, which we might call the National Mutual Fund. (Close corporations and partnerships are exempt.) Once a year, the Fund would pay out its accumulated profits as dividend checks, giving an equal amount to every adult citizen. And that’s it.

Substantially reducing the flow of dividends associated with stock ownership should cause a large one-time shock to the level of the stock market. (Roughly speaking, shares should drop by about 3/4.) However, because the Fund collects uniformly, it should not distort relative prices, which are what matter for purposes of capital allocation. The net worth of stock-holders, likewise, will suffer a one-time drop, but this will be partially compensated for by their receiving payments from the Fund in the future. Anyway, lots of things affect the value of stock holdings; it’s not like someone purchased their labor with a promise of future benefits, and then tried to back out of a freely-entered contract when it came time to pay up.

A further wrinkle would be to curb the practice of retained earnings. These account for a huge fraction of corporate capital formation, but they are also one of the ways in which managements escape market discipline. (For some figures on this, see Henwood’s Wall Street, pp. 72—76.) I suppose one could make a Hayekian argument in favor of the practice, but, really, if management can make a good case that a pet project will earn at least a normal rate of return, it shouldn’t be hard for them to raise funds on the open capital market, and if they can’t make such a case, it’s hard to see how they’d be discharging their fiduciary duties to shareholders by pursuing it anyway. This reform, I should add, is logically separate from that of instituting the National Mutual Fund. However, since corporations would pay more out in dividends, it would tend to increase the value of shares, reducing the shock to the level of the stock market.

It is hard to see why the actions of the National Mutual Fund could not be at least as rule-bound and de-politicized as those of a central bank run by skilled technocrats. Indeed, it would seem easier to reduce the discretion of the Fund’s officials to the vanishing point, and to strictly keep it from meddling with the affairs of any corporation, which would be deeply counter-productive. For their part, the citizens receiving the dividends would get the benefits of “portfolio diversification in their income“, but their incentives to meddle politically with individual firms, even quite large firms, would be quite muted. Moreover, they would have a direct and tangible incentive in the health of the corporate sector as a whole, making them less likely to support market-distorting measures to benefit particular firms, geographical regions or industrial sectors. We would move, in short, towards a true ownership society.

*: Actually, there’s a very substantial excerpt ; thanks to Matt in the comments for pointing it out.

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Elephantstrunk » Blog Archive » Inefficient market hypothesis
08.01.06 at 3:32 am

{ 39 comments }

1

wolfgang 07.31.06 at 4:02 pm

I am not sure I fully understand the proposal, but at first glance the ‘national mutual fund’ which collects a substantial portion of income exists already under a different name: IRS.
Also, the assumption that all companies would drop the same seems not quite right; Money loosers and companies which do not pay a dividend would actually benefit relative to the others.

2

a 07.31.06 at 4:19 pm

I’m not sure why shares would drop by only 3/4. It would seem that they should fall to 0, because it’s not clear to me what direct benefit accrues to an owner of a share.

3

Craig Ewert 07.31.06 at 4:19 pm

Each unit of her own effort generates an extra $12 for the team. According to Pareto optimality, she should exert additional effort as long as the cost to her of that effort is less than or equal to $12; each such unit of effort generates more revenue for the team that it costs her as an individual.

That isn’t how I understand Pareto optimal. If the worker spends a unit of effort and generates $12, it’s only a pareto move if her share of that $12 is worth more than 1 unit of effort.

Moreover, it’s not at all clear to me that making the budget less than balanced will increase efficiency; my first intuition is that the reverse will be true. To make your case, you’ll need an entire subsidiary argument for that point.

4

Robin 07.31.06 at 4:32 pm

Cosma, have you read Roemer’s A Future for Socialism or Bardhan’s similar bank fund socialism suggestion?

And by the way, the scheme would reduce alienated product, if not alienation along other dimensions.

5

Tracy W 07.31.06 at 4:54 pm

A substantial fraction — say three-quarters — of all profits of publicly-held corporations are to be paid to a new institution, which we might call the National Mutual Fund.

Speaking as a person who is currently saving, if such a proposal was put into action I’d invest in things other than publicly-held corporations. Eg privately held corporations, bonds (government and private), real estate, a relative’s poker ability. After all, I’d get all the payments from the mutual fund and I’d get to keep all the return (after tax) from the non-share investments.

Since it seems likely that every other investor would do this, this means that any companies who want to raise capital in the future would be biased to do so by issuing bonds rather than shares.

Consequently this policy would lead to, in the long-run, a lot less in the way of shares. Presumably shares have advantages in some situations compared to issuing debt or other means of financing, under this policy you’ll have decreased economic efficiency in the long-run.

6

Bernard Yomtov 07.31.06 at 5:28 pm

This sounds like a good way to destroy the public capital markets, as well as those companies who could not manage to go private.

Is the 75% in addition to the usual income taxes, or in place of them? In either case, as wolfgang suggests, you are simply proposing a massive increase in corporate income taxes, applied only to public companies.

if management can make a good case that a pet project will earn at least a normal rate of return, it shouldn’t be hard for them to raise funds on the open capital market,

The required rate of return for any project to be financed publicly would rise dramatically, to the extent that it is unlikely that there would be such financing.

If you have an attractive project, establish a private company to carry it out, or forget it.

7

Matt 07.31.06 at 5:29 pm

A generous excerpt from Mark Greif’s article is available right here, as indeed I suspect you may already know.

Some people might even understand it.

8

cosma 07.31.06 at 5:29 pm

a: Because the other 1/4 of corporate profits goes to shareholders as dividends, just as it does now.

9

mpowell 07.31.06 at 5:31 pm

Okay, what about privately owned enterprises thinking about going public? There is a big benefit to shareholders in a private enterprise to be able to trade their stock on a liquid market, but obviously its a bad idea to go public if you give up 3/4 of your value in an enterprise.

It seems to me that this would severely restrict the ability of a start-up to collect capitol, b/c it is this future possibility of trading ownership on an open market that attracts investors. What do you think?

10

nelziq 07.31.06 at 5:38 pm

Interesting and thought provoking idea. However, with such a high penalty to corporate dividends i think this would just cause people to abandon the corporate form as a means of organizing production. I can see lawyers and financiers making a mint out of restructuring business arrangements to avoid this tax as was done in the 70’s and 80’s to avoid high capital gains taxes. A general income tax might achieve the same goal while making tax avoidance much more unlikely. Also I think you should stick to suggestions that would be much more feasible in today’s political climate, say, for example, using the children of immigrants, terrorists and homosexuals as a food source ;P

11

Slocum 07.31.06 at 5:40 pm

a: Because the other 1/4 of corporate profits goes to shareholders as dividends, just as it does now.

Well then, why choose 75% rather than 50%, 67% or 95%?

12

Robert Vienneau 07.31.06 at 5:43 pm

Cosma,

Off-topic, but I wonder if I read your notes on Advanced Probability with attention, will I then understand Ito calculus? Thanks.

13

eweininger 07.31.06 at 6:04 pm

Robin is right–this does have a Roemer-esque flavor.

14

cosma 07.31.06 at 6:42 pm

15

Wolfgang 07.31.06 at 7:04 pm

Comrade,
your proposal would certainly boost the economy – of the Bermudas (and of all those other islands where US corporations will move their headquarters).

PS: But who would initiate this sort of revolution? Perhaps Mr. Shalizi from the Cafe Central?

16

Brett Bellmore 07.31.06 at 8:04 pm

Money flows into corporations from people who buy stock. They aren’t a money sink, they’re a money source.

Your proposal might make some superficial sense if the money was distributed to stockholders in general, not citizens, and in proportion to their holdings. But to distribute it equally to all citizens?

I’m with the others; It would simply destroy the institution of publicly held corporations.

17

a 08.01.06 at 12:28 am

Cosmo: Sorry missed the 3/4. Then Wolfgang is right: it’s just a 75% tax on corporate profits.

18

Jack 08.01.06 at 12:43 am

This seems to me to bear more than a passing resemblance to the ideas of Henry George and Rudolf Meidner as described by Robin Blackburn.

Regarding:

After all, it’s hardly historically unprecedented for powerful people to prefer institutions which lower aggregate output but give them a bigger share of the product.

That’s more or less Adam Smith on feudalism.

PS Brett, shareholders are not only a money source and overall it depends on the size of dividends and buy-backs relative to IPOs and other fund raising.

19

Jack 08.01.06 at 1:01 am

As Wolfgang and A suggest this does just look like a higher rate of corporate taxation and without other measures would lead to corporations moving offshore, either under their own steam or through purchase by companies from less heavily taxed places. However other measures could in fact be taken. It is surely not beyond the US to prevent capital flight.

I don’t think it is so straight forwardly a bad thing from the point of view of people who favour market based solutions. Retained earnings are at the disposal of the dictatorial corporate management and its command economy. If the availability of that money was substantially reduced corporations would be foced to allow the market to decide the best use of capital. That happens already to some extent but the burden of proof would be shifted from activists having to prove that management was wrong to management having to convince that it was right.

Microsoft’s huge cash pile is something to focus the mind. Do we really want Microsoft wasting billions on cable networks, MSN and XBox or just leaving billions on deposit?

20

Daniel 08.01.06 at 2:06 am

but, really, if management can make a good case that a pet project will earn at least a normal rate of return, it shouldn’t be hard for them to raise funds on the open capital market

shouldn’t but bloody well is, he grunted after a particularly savage couple of weeks. Simply the administrative burden of getting the cheques written and posted into the right accounts is an overhead cost that shouldn’t be sneezed at – the retained earnings financing method basically exists for the same Coasian reasons as the firm itself.

21

Daniel 08.01.06 at 2:06 am

(I will think about this more sensibly when I have a spare minute)

22

brooksfoe 08.01.06 at 2:39 am

I am all in favor of the ownership society. As former Harvard President Larry Summers is fond of saying, no one has ever washed a rented car. We can see this same problem in the attitude of corporations today: they are reluctant to invest in their workers (health care, training, occupational safety, etc.) because they only rent them.

I would propose that we allow companies to own their workers, rather than renting them. This is bound to lead to improvements in the quality of the workforce. Such a system was, in fact, tested in the American South at one point, with highly interesting results that could be compared to many aspects of the modern American economy.

23

bad Jim 08.01.06 at 3:44 am

If companies were actually intent on long term profits, this would be unexceptionable. Since they’re not, since the hireling executive class is typically intent on reaping a short term windfall instead, it’s mildly controversial.

In the near term, only some of us are dead, or rich enough to retire.

Firms with a particular expertise should certainly fund further development through retained earnings if they can (who else would know both the why and the how?) but the purpose ought to be a future income stream. Profits, actually.

24

Scott Martens 08.01.06 at 4:27 am

I should think the question of relocating headquarters to the Bahamas would be manageable. After all, the assets are still in the same place they always were, surely it would be possible to craft legislation making the nominal location of a firm’s headquarters irrelevant.

But I think Daniel’s argument about the Coasian reasons for retaining revenue are probably a real barrier. I can think of ways that a hypothetical revolutionary socialist society might address the issue: operate not only a national mutual fund but also a national bank able to make loans out of the revenues of that mutual fund and then forbid by statute any significant revenue retention for “public” firms. In effect, allow the state to retain revenues on behalf of firms and loan it out with fewer transaction costs. This undermines in part the “silent stockholder” argument, but since any one firm is still a small part of the entire fund’s assets, it shouldn’t be a big problem. My understanding is that the keiretsu used to do something of the sort – operating a central bank and then making it very difficult for the member firms to make enough profit to retain any revenue.

But then, this politicizes the allocation of capital – subjecting loans to political criteria and raising the spectre of the soft budget problem – which I suspect is exactly what you’re trying to avoid.

25

Richard J 08.01.06 at 5:51 am

I should think the question of relocating headquarters to the Bahamas would be manageable. After all, the assets are still in the same place they always were, surely it would be possible to craft legislation making the nominal location of a firm’s headquarters irrelevant.

Which would, of course, require unilaterally repudiating every tax treaty signed over the past sixty years… The issue of what constitutes a permanent establishment is occupying a lot of my work time right now.

26

Scott Martens 08.01.06 at 6:06 am

Which would, of course, require unilaterally repudiating every tax treaty signed over the past sixty years…

US citizens who reside abroad and have no US income or assets in the US are still required to pay US income taxes, although the IRS has no real ability or interest in tracking down non-payers unless they have seven figure incomes or more. It even assesses punitive taxes on people repudiating US citizenship on the presumption that any person with a meaningful income who gives up their citizenship must be doing it for tax purposes. Why should corporations get different treatment?

27

John Quiggin 08.01.06 at 7:44 am

I also need to think about this more. But I’m really hanging out for “Why, oh why can’t we have a better econophysics?”

28

eweininger 08.01.06 at 7:48 am

Your proposal might make some superficial sense if the money was distributed to stockholders in general, not citizens, and in proportion to their holdings. But to distribute it equally to all citizens?

My recollection of Roemer’s version (which I read a while ago, so don’t hold me to it) is that each citizen initially receives an equal per capita endowment upon reaching adulthood. However, shares of individual companies can then be traded (but not sold for cash) on an open market, and dividends are indeed paid in proportion to share ownership, thereby accepting the premise of unequal returns accordings to individuals’ luck/pluck in this market. Ownership and control do remain fully separated, per Cosma’s more egalitarian version.

29

eweininger 08.01.06 at 7:59 am

Best line from Cosma’s 1997 review: “…here in the United States, we are lucky when economic policy maintains a connection to orthodox economics.”

30

joseph heath 08.01.06 at 8:50 am

Although I’m generally sympathetic to these sorts of schemes, this one is really a non-starter. I like Miller’s book, and use an excerpt in my business ethics class, but it isn’t the clearest in the world. If you have the time, Milgrom & Roberts, _Economics, Organization and Management_ covers the same material better. Another book that is extremely useful to read along with Miller is Henry Hansmann’s _The Ownership of Enterprise_.
The most important thing to remember is that capital markets represent only one way that individuals can choose to invest their savings. They also have the option of lending their money under explicit contractual terms, for a fixed rate of return. They generally do so by depositing it in banks, who then look after the lending part. Targeting profits in the way that you suggest (btw, the previous comments are correct — because the NMF you propose holds no ownership stake, but merely redistributes profits, it is basically the IRS), simply makes the cost of equity financing astronomical, relative to debt. So all that your scheme would do is make bank loans far more attractive for firms, and deposits more attractive for investors. If you respond by hitting up interest payments as well for 75%, then all you are doing is imposing an extra tax on savings, which you could do through the income tax system (although that would be an insane, perverse incentive — on this subject, see Peter Lindert, _Growing Public_).

31

Bernard Yomtov 08.01.06 at 10:39 am

At #9:

Okay, what about privately owned enterprises thinking about going public? There is a big benefit to shareholders in a private enterprise to be able to trade their stock on a liquid market, but obviously its a bad idea to go public if you give up 3/4 of your value in an enterprise.

It seems to me that this would severely restrict the ability of a start-up to collect capitol, b/c it is this future possibility of trading ownership on an open market that attracts investors. What do you think?

I don’t know what Cosma thinks, but I think your point is exactly correct.

It is one of many reasons why this proposal is utterly insane.

at #19

corporations would be foced to allow the market to decide the best use of capital.

And the market would make no capital available to corporations.

32

cosma 08.01.06 at 1:54 pm

nelziq (at #10):
Also I think you should stick to suggestions that would be much more feasible in today’s political climate, say, for example, using the children of immigrants, terrorists and homosexuals as a food source

Speaking as a knowledgeable American, allow me to assure you that such babies are indeed a most delicious, nourishing, and wholesome food, whether stewed, roasted, baked, or boiled, and will equally serve in a fricassee or a ragout.

33

Tracy W 08.01.06 at 3:35 pm

However other measures could in fact be taken. It is surely not beyond the US to prevent capital flight.

As others have said, investors do not have to purchase shares in publicly-held companies. Investors can put their money in all sorts of things. If the US government stops capital flight in response to this policy, then bonds or invseting in private companies or any other of a multitude of options will become a massively more popular way of investing. If you were to implement this policy you’d not only have to stop companies moving offshore but stop investors moving their money around inside the economy, with all the inefficiencies that entails. (Eg my grandma could not keep any of her money in shares, she would lie awake at night worrying about them so much that Dad insisted she stay invested in government bonds. At the moment I am not putting any of my money in shares since I don’t want the risk of a capital loss over the next 2-3 years. Any policy to make us invest in shares would make us worse off.)

34

Brett Bellmore 08.01.06 at 6:29 pm

“It is surely not beyond the US to prevent capital flight.”

No, actually it IS beyond our capabilities, in the long run. The only really effective way of preventing capital flight is by not giving capital a reason to flee.

35

Dan Karreman 08.02.06 at 7:36 am

Sweden tried a version of this 20 years ago, although the extra taxation was on something called “excess profits”. Predictably, the right hated it (actually provoking them into lending a page from the left’s handbook and more and less organize an entrepreneur’s union), and the left never really managed to explain to the public what the point was, possibly because many leftist economists were luke-warm at best about the idea anyway. The right won the election in 1991 and quickly dismantled the system, partly through putting the money in a trust financing research, thus making it practically impossible for the left to reinstate the program, and partly through privatizing it. With the possible exception of inflating research funding in Sweden during the mid-nineties, the social impact of the program was neglible.

36

Michael Sullivan 08.02.06 at 2:06 pm

Wow.

just. Wow.

I got pointed to this here blog a few months back via catallarchy of all places. Despite theoretically sitting on opposite ends of the normal (read: broken) political spectrum, I saw an awful lot of agreement between the two cultures.

But we don’t appear to be in Kansas anymore. Looks more like Stockholm, circa 1975. Or even perhaps about 1000km to the east?

Please, cosma, tell me that “modest proposal” was intended to be a signal that you are not to be taken seriously. That you are satirizing some proposals (unclear which) you’ve seen out in the blogosphere, or a particular viewpoint of which you believe this represents the reductio ad absurdam.

Yes. That must be it. This almost reads like it could have been written by a catallarchist in a swiftian mood. Perhaps this is a triple-entendre, satirizing the potential satirizer?

Brilliant!

Michael

37

MattXIV 08.02.06 at 3:16 pm

I agree with the other commenters that this ultimately boils down to a 75% corporate income tax, the major consequence of which is that the public corporation would rapidly fall into disuse as a means of raising capital.

Substantially reducing the flow of dividends associated with stock ownership should cause a large one-time shock to the level of the stock market. (Roughly speaking, shares should drop by about 3/4.) However, because the Fund collects uniformly, it should not distort relative prices, which are what matter for purposes of capital allocation.

This is wrong. While the value of stock as an investment would drop 75%, the value of stock as a representation of capital would be unchanged – you could still aquire a company’s assets by aquiring it’s stock. Investors would be selling the corporations stock, but the stock would get bought up by companies and investors (foreign or domestic) that want to acquire the corporations’ assets for use in a setting where the profits wouldn’t be so heavily taxed.

Even in a closed economy where corporations are the only holders of capital, the 75% tax would just vastly reduce the economy’s investment to consumption ratio by reducing the returns on delaying consumption (if $100 now or $200 later becomes $100 now or $125 later, a lot more people are going to take the $100 now).

38

Danny Yee 08.03.06 at 6:17 am

Under this regime, wouldn’t companies simply buy back shares instead of paying dividends?

39

Michael Sullivan 08.03.06 at 8:26 am

39 — that would result in retained earnngs, which this plan would outlaw. Which is probably the *biggest* problem with the plan, as it forces every company to use the bond financing model, which is inappropriate for riskier (and generally most potentially profitable) ventures.

A 75% tax after all, has been tried, and while it doesn’t appear to have been a good idea, it didn’t sink the countries in question into abject poverty.

Michael

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