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Will The Real Inflation Please Stand Up? - Aaron Krowne

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  • Will The Real Inflation Please Stand Up? - Aaron Krowne

    Will The Real Inflation Please Stand Up?

    by Aaron Krowne (AutoDogmatic) - October 4, 2006

    A chorus of criticism has been rising, directed at how we measure inflation. For much of the past decade, no one really cared, because by basically all measures, inflation was low. But now, the balance sheet of consumers is deteriorating, and it looks very much like real median incomes are falling. There are also wider senses in which the extent of inflation seems to "change" the prognosis--e.g., what the GDP is, and therefore whether or not we are in recession. Thus, how inflation is measured has suddenly become of interest.

    Taking a cue from Adam Hamilton, I decided to delve a little deeper into a specific analysis of what inflation really is, by looking at the costs of business. In specific, a non-manufacturing business, which essentially runs exactly at cost: The US Postal Service.

    The US Postal Service only raises rates when it has to–it doesn't structurally turn a profit. I think there is legislation that essentially forces this; excess income is escrowed and the Postal Service has to explain how it needs to be retained for improvements and expansion if it is not to be confiscated by the rest of the Federal government.

    Using first-class postage rates as a proxy for post office costs, I compared this measure to the M1 money level (hard currency plus money in demand accounts) and the BLS's all-items, nationwide CPI series. The result is given in the following chart.


    This chart is pretty striking, and confirms the trend Hamilton was seeing: postal rates unmistakably shadow M1 money, not the BLS CPI. In fact, the only interval for which postage significantly diverges from the M1 curve is the 1974-1986 period, which precisely spans the energy crisis. Postage had to go up even more rapidly during this period because the post office's costs are transportation-heavy.

    There are a couple of other provocative artifacts on this chart. The first is that M1 and CPI are essentially the same until about 1983, then they diverge markedly (with M1 to the upside). This confirms a suspicion I've long held: around this time, the US switched from "current" inflationary policies (printing money) to debt-based policies (issuing bonds) to fund the fiscally-unbalanced activities of government. That is, the policy became to take on more debt to fuel spending, spreading inflation out longer-term into the future (as taxes sure as heck weren't raised to pay the debt back). This was quite a stroke of genius, as people were pretty sick of rapid inflation by the early 80s, but of course, the government wasn't about to shrink itself. But take note that much of this debt still hasn't been worked off (in fact Bush II has doubled it), so it would seem to me that a lot of that inflation is just "stored up" and waiting to burst out.

    There's another interesting event around 1995: the M1 level actually falls. Remember people thought we were going to have a recession here. This is when the Fed began worrying about "irrational exuberance" and began ostensibly "tightening" monetary policy--raising interest rates. It appears the Fed intentionally tried to reduce M1, possibly to stave off a bubble in stocks. But instead, what happened is that loosening in the fundamental controls in the banking system seems to have led to an explosion of broader money, which ended up fueling a stock market bubble anyway (high interest rates would attract creditors to corporate debt). At this point, I propose that M3 became a more central "kind of money", and has since evolved to play an even greater role in influencing the economy.

    But back to the core point. We can immediately conclude from this analysis that one government bureau is lying: either the Postal Service is squirrelling away vast quantities of accrued profits somewhere (from charging too-high postage), or the BLS is lying about the CPI serving as a realistic inflation/cost of living metric.

    If you agree with me that the latter is more likely and that M1 makes a better baseline estimator for inflation than the BLS's CPI, then the real average rate of inflation since 1983 has probably been closer to 5.3%, rather than 2.4% as the official CPI figures would imply. So the BLS is understating inflation by almost two percent per year. The compounding effect of this methodical lowballing has resulted in a situation where the CPI today has become about 42% understated, and therefore the cost of living is being underestimated by at least that much.

    What are some secondary implications for government and the economy? Glad you asked:
    1. People on social security and inflation-indexed pensions and any other inflation-indexed payment are being swindled. Suddenly it becomes crystal-clear why non-wealthy retirees depend on senior citizen discounts, and rumors that the government knows it would be even more insolvent if it honestly accounted for inflation become a lot more plausible.
    2. The CPI computation apparatus of the BLS is completely superfluous--price levels are and always have been a direct factor of the money quantity. This is a damning critique of the economic establishment, which expressly dismisses the money quantity theory of Austrian economics (because it is politically inconvenient). So feel free to add the budget of the CPI computation subunit of the BLS to your "government waste" roster.
    3. The bond market is a complete joke. Shaving 2% off the inflation estimator (even worse if you're looking at core-CPI) puts most "risk-free" fixed-income investment in the null or negative real returns category. This explains why the activities of foreign central banks have become so important: they aren't really buying US Treasury securities for investment, they're buying them to manipulate trade or simply to park their reserves cash (which is in dollars thanks to the legacy of Bretton Woods). Real people and businesses can't possibly earn money or even preserve wealth using offical securities.
    4. Even more ominously, undermining the "zero-risk" bond market undermines all other financial markets, which naturally calibrate themselves relative to it. Given that the real Dow is around 1.6% (rate of return), a 2% inflation haircut may mean that the average performance in the stock market is actually negative in real terms. Also, since inflation is lowballed like this, banks have more problems making money off of traditional lending activities, which I suspect has made them more aggressive about fees and more reliant on "exotic" lending (i.e. in housing), hedge funds, and proprietary trading.
    Sadly, this is just the beginning of the problems. As pointed out above, M1 has diminished in economic importance compared to even "higher" forms of money (somewhat indicated by M2 and M3, but not totally). When you consider that people buy not only "real goods" using M1-level money, but also "quasi-real goods" using financing (which reflects in M2 and M3), it becomes apparent that there is more to the "cost of living" than just M1.

    Kinds of "quasi-real goods" I'm thinking of are homes, automobiles, education, and big-ticket retail items which are typically financed. The very activity of financing these things both "creates more money" in the broad money sense, and makes the items more expensive (because more people can afford them, and afford to spend more on them). The financing itself has a cost, and "leaks" some expansion of money into the M1 level.

    John Williams has done work in looking at inflation in an even broader sense, which I think includes these housing and financing aspects. While I think his work is excellent and provocative, I now think the truth is somewhere between the 5.3% indicated here and his present ~8%, which he obtains by adding adjustment factors for historical changes in the CPI computation methodology. As pointed out here, immediate inflation has indeed been lowered by shifting from the literal printing of money to debt-based financing. Note that I'm not saying this is actually a good thing–but it has succeeded in at least delaying a lot of immediate inflation and other forms of pain.

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    Biography

    Aaron Krowne, M.S., is a computer scientist working at Emory University's Woodruff Library as Head of Digital Library Research. Here he leads the technical development of digital library grant projects, and works for the integration of new technology into library systems. He is the founder and president of PlanetMath.org, a collaborative digital library and virtual community for mathematics.

    One of his core areas of practical and theoretical interest is in the economic aspects of commons-based peer production, a ``third mode of production'' that has recently been recognized alongside markets and firms. He has written a number of articles in this area and has demonstrated practical results via PlanetMath. He is also interested in the relationship of mathematics to the market (especially its limitations). Krowne frequently comments on economics on major blogs and his own web site. He has no formal economic training, and is damn proud of it.
    Last edited by FRED; 10-04-06, 12:36 PM.
    Ed.

  • #2
    Re: Will The Real Inflation Please Stand Up?

    Originally posted by Fred
    John Williams has done work in looking at inflation in an even broader sense, which I think includes these housing and financing aspects. While I think his work is excellent and provocative, I now think the truth is somewhere between the 5.3% indicated here and his present ~8%, which he obtains by adding adjustment factors for historical changes in the CPI computation methodology. As pointed out here, immediate inflation has indeed been lowered by shifting from the literal printing of money to debt-based financing. Note that I'm not saying this is actually a good thing–but it has succeeded in at least delaying a lot of immediate inflation and other forms of pain.
    I'm very happy to see this issue getting more & more coverage, and thank you for your thoughts. I maintain that its the single largest "unknown" factor in the investing world. I believe its George Soros that noted something like "Find the false premise, and bet against it".


    I must however respectfully disagree and submit that John Williams numbers are much closer to reality, and probably spot on, than an average between his figures and the CPI-U.

    First, just using postal rates and M1 ignores the very real and increasing debt and credit basis of the culture and economy, as was partially noted. The growth rate difference between M1 and credit is very large over the period 1983 to present. In other words, using M1 automatically biases that 42% overall increase (the lies component) to the very low end of extreme possibilities in my opinion.

    Using John Williams public adjustment numbers since 1983 and calculating a "real" CPI adjustment for lies leads to about a 61% rate of increase (the "real" CPI-U would be approximately 329 as opposed to it current value of 203.9).

    Second, John Williams adjustments have grown over the years. The original "Owner's equivalent rent" boondoggle invented by the BLS in 1982 was only a 1% adjustment. Then the effects of the Boskin Commission in 1996, added another 1%+ to the cumulative total adjustment. Today its around 5%, about 1/2 of which has been since 2000.
    My point here is that the issue and lying has been growing over the years, and not at a fixed rate as might be interpreted from your article.

    Lastly for now, the current rate is closer to 10-11% per Mr. Willams most recent data.
    And all hail having no formal economic "training" - I plead being damn proud of it too. ;)



    Some additional links:
    Grossly distorted procedures

    Statistical Wizardry

    Real inflation

    My own CPI lies page

    Hedonics, my glossary

    Hedonics, at onelook.com
    http://www.NowAndTheFuture.com

    Comment


    • #3
      Re: Will The Real Inflation Please Stand Up?

      You're probably right.

      In fact I confess I haven't delved deep into Williams' adjustments; I just know the basics.

      I do think care must be taken because of the semi-separation of "real goods" from "financial goods" from "financial assets". Measured inflation in all of these areas can be quite different, and averaging them together may obscure distinct effects.

      The nice thing about "real goods" (and services) inflation is that it is pretty much a component of everyone's cash flow.

      As a sidebar on "pigeonholed inflations", I saw somewhere that the luxury goods segment is experiencing a high inflation of its own---though this isn't terribly surprising in a world of increased wealth condensation (e.g., "Debt and super cars replace soup lines and super cars", http://www.itulip.com/newdepression.htm).

      Comment


      • #4
        Re: Will The Real Inflation Please Stand Up?

        I couldn't agree more about the "real goods" and "financial goods" and "financial assets" issue. CPI was never intended, to the best of my knowledge, to cover them - with the exception of housing of course.

        CPI doesn't bear much resemblance to total inflation either except during short periods when financial goods and assets aren't volatile or being pumped or dumped by some Fed or central bank related set of actions. I think Finster's FDI is the only approach that even attempts to measure actual total relative inflation or deflation.

        You may be thinking of the recent Forbes piece The Cost of Living Extremely Well Index in the luxury goods area? It was not only illustrative but also a fun 'window shopping' excursion.



        My favorite image in the CPI & inflation area. ;)

        http://www.NowAndTheFuture.com

        Comment


        • #5
          Re: Will The Real Inflation Please Stand Up?

          i absolutely agree that the cpi is systematically understated, and tend to agree with john williams' analysis. and although i was, at first, attracted and amused by the postal service model, i think the post office example is misleading, narrow and too easily blown off by those who don't want to look at these issues. the inputs used by the post office are too narrow, fuel and labor mostly, and so don't reflect price changes in so many other products and services. the fact that it looks like it follows m1 is likely an artifact or coincidence, unless someone has a theory connecting the 2.

          Comment


          • #6
            Re: Will The Real Inflation Please Stand Up?

            I think I can address most of your skepticism:

            1) The example was intentionally narrow and the selection of the postal service also quite intentional. Why? Because this sets one government bureau off against the other: if the M1 correlation is spurious, then the USPS will be hard pressed to explain why it is charging more postage at a rate 2% higher than "inflation". If the M1 correlation is not spurious, either (a) there is some unknown cost component rising enough to make up the difference, which I challenge you to find, or (b) the BLS is "lying" about what inflation really is.

            Given the total milieux of evidence and Ockham's razor, I think (b) is compellingly the case.

            2) I think my observation of the degree of divergence of the postal rate during the energy crisis does a pretty good job of accounting for the energy factor. Other than that, the fit is amazingly close---much closer to M1 than the CPI. It seems odd, then, that the onus should be on me to show that the postage increase is "caused" by M1 instead of CPI. I think the BLS is the one with the 'splainin' to do.

            3) I think labor is actually a very good component for studying general price increases, because workers pay comprehensive real costs, and these costs are folded into their pay (by definition). You might argue that "real" improvements in pay could be surfacing here, and of course, we cannot use a real adjustment to wages to prove that this is not the case, but other indicators (such as the null savings rate) are highly suggestive here.

            In any case, I don't see why services aren't as susceptible to real inflation dynamics as goods and transportation. You increase the supply of "base" money, all else held constant, and the cost of everything will go up proportionally. That is the phenomenon being highlighted.


            As I allude to in the essay, the "theory" you call for in fact does exist: the Austrian theory of prices and money quantity.

            The only wrinkle I can think of in the general theory is that M1 money is surely not uniformly distributed, so in theory part of it could be "sequestered" and not show up in the broad price level. But this doesn't seem to happen, perhaps because most of the "lumpiness" is actually at the higher money level, and M1 money is generally used for immediate spending on real consumption, which by definition propagates it very quickly.

            Comment


            • #7
              Re: Will The Real Inflation Please Stand Up?

              Originally posted by akrowne
              ...
              we cannot use a real adjustment to wages
              ...

              Sure we can... ;)

              I actually agree with all your points but thought you might like to see hourly wages and the employment cost index (ECI) adjusted by both the CPI and the CPI with John Williams adjustments. The ECI does not include things like stock options, in case you didn't know.

              Both charts show annual rates of change.







              http://www.NowAndTheFuture.com

              Comment


              • #8
                Re: Will The Real Inflation Please Stand Up?

                Excellent charts. Quite sobering, really.

                What I meant in the previous message by saying we "can't use [inflation] adjustments to wages" is that this would be begging the question, in that particular context.

                But if real compensation is falling, as the charts you present (and other data) seem to show, then it strengthens my original argument, because it is unlikely that labor is simply becoming more expensive for the post office. In fact, it is likely becoming cheaper.

                Thanks for the data!

                Comment


                • #9
                  Re: Will The Real Inflation Please Stand Up?

                  Originally posted by akrowne
                  Excellent charts. Quite sobering, really.

                  What I meant in the previous message by saying we "can't use [inflation] adjustments to wages" is that this would be begging the question, in that particular context.

                  But if real compensation is falling, as the charts you present (and other data) seem to show, then it strengthens my original argument, because it is unlikely that labor is simply becoming more expensive for the post office. In fact, it is likely becoming cheaper.

                  Thanks for the data!
                  You're most welcome, and I agree whole heartedly that they bolster your case, and also agree with your original statement about wage inflation adjustments.

                  Even just using the bogus CPI alone sure does present a less than bright picture, especially during the last two years - and yet another indication of an impending "Ka".
                  http://www.NowAndTheFuture.com

                  Comment


                  • #10
                    Re: Will The Real Inflation Please Stand Up?

                    Wow...great thread.

                    I know that I have a much more basic understanding of everything that is discussed on these itulip boards than most of you, and I am just hanging on by a thread understanding how the many iTulip contributor's charts are created and what they mean (but I do very much appreciate these lengthy discussions and explanations...)

                    I understand the political and economic reasoning behind keeping the "official" CPI number low...there are too many institutions and individuals profiting from it for anyone to attack that position, and a change to a more accurate number sounds like it would explode growth in entitlement programs. But when a comment is made about how the bond market and even perhaps the stock market are actually producing negative returns, that really gets me scratching my head.

                    There are a lot of very smart people who seem to have no problem making a buck...are they accepting negative returns because the alternative is worse? Are you saying that complacency drives investment decisions, because they've decided there are not better ways to apply capital?

                    Someone is investing in industries that create more value than inflation eats away. Whether the employees of such a venture ever get to enjoy the fruits of that labor is another issue, I guess, but it seems that someone has to be benefitting from the increase in value created, and someone investing has to be reaping returns.

                    Something doesn't sit right with me on this...

                    Comment


                    • #11
                      Re: Will The Real Inflation Please Stand Up?

                      Originally posted by lobodelmar
                      ...
                      But when a comment is made about how the bond market and even perhaps the stock market are actually producing negative returns, that really gets me scratching my head.

                      There are a lot of very smart people who seem to have no problem making a buck...are they accepting negative returns because the alternative is worse? Are you saying that complacency drives investment decisions, because they've decided there are not better ways to apply capital?

                      Someone is investing in industries that create more value than inflation eats away. Whether the employees of such a venture ever get to enjoy the fruits of that labor is another issue, I guess, but it seems that someone has to be benefitting from the increase in value created, and someone investing has to be reaping returns.

                      Something doesn't sit right with me on this...

                      I'm honestly not sure what the question is, but I'll take my best shot at commenting on what I think are your points.

                      I have no intention to criticize you or your understanding and hope it doesn't come across that way, but how many people do you know who have a decent idea of what the inflation (CPI) adjusted return on the Dow has been over the last year or 5, 10 or even 20 years?

                      My point here is that the folk whom you think are smart may not be as smart as you think they are. And yes, they are making a buck but how much real and true world purchasing power are they actually getting?

                      My point is also that the general level of understanding of basic economics, per the Austrian school (and also just raw common sense), is woefully lacking and has been for literally decades. I had no idea they even existed until I did independent study in the '70s for example.

                      There's no question that some are investing in industries that create more value than inflation eats away too.
                      http://www.NowAndTheFuture.com

                      Comment


                      • #12
                        Re: Will The Real Inflation Please Stand Up?

                        Bart, I think he was agreeing and understanding, but feeling pretty awful about the ramifications of the reality of what you are saying. I'm feeling pretty much the same way - when you think that you have to have a return of 5% minimum before you even start gaining wealth (after inflation).

                        When most reports will say you are losing 2-3% a year to inflation, most people can stomach that, and can understand that (as we see prices on food, gas, clothing go up over time). But when you show strong evidence that your 5% online savings account or bond fund in fact is not beating inflation, when you look at it the first time and that light goes on, you do a double take.

                        The argument and numbers that Mr. Krowne have shown in this posting are very clear, and should be very convincing to anyone with an open mind. That does not make it any easier to stomach.

                        Indeed, reality is often the hardest thing to accept, whether it's how much weight you've gained since high school or how much your bank account, your currency, or even your country is in trouble because of factors such as the ones illuminated here.

                        Comment


                        • #13
                          Re: Will The Real Inflation Please Stand Up?

                          Originally posted by DemonD
                          Bart, I think he was agreeing and understanding, but feeling pretty awful about the ramifications of the reality of what you are saying. I'm feeling pretty much the same way - when you think that you have to have a return of 5% minimum before you even start gaining wealth (after inflation).

                          When most reports will say you are losing 2-3% a year to inflation, most people can stomach that, and can understand that (as we see prices on food, gas, clothing go up over time). But when you show strong evidence that your 5% online savings account or bond fund in fact is not beating inflation, when you look at it the first time and that light goes on, you do a double take.

                          The argument and numbers that Mr. Krowne have shown in this posting are very clear, and should be very convincing to anyone with an open mind. That does not make it any easier to stomach.

                          Indeed, reality is often the hardest thing to accept, whether it's how much weight you've gained since high school or how much your bank account, your currency, or even your country is in trouble because of factors such as the ones illuminated here.

                          Thanks DemonD, I totally missed that side of it.

                          I can't tell you how many times over the last few years, as I've been continuing to bring myself more out of the dark about finance and economics and the whole "game", that I've been mad or sad or disgusted or even in despair.

                          I was rattled and upset enough about what I found with the TIO issues (another thread and the subject of an article I wrote recently) that it took about a month after I'd worked out what was possibly going on with stock market manipulation before I could actually write the article.
                          http://www.NowAndTheFuture.com

                          Comment


                          • #14
                            Re: Will The Real Inflation Please Stand Up?

                            Originally posted by DemonD
                            Bart, I think he was agreeing and understanding, but feeling pretty awful about the ramifications of the reality of what you are saying. I'm feeling pretty much the same way - when you think that you have to have a return of 5% minimum before you even start gaining wealth (after inflation).

                            When most reports will say you are losing 2-3% a year to inflation, most people can stomach that, and can understand that (as we see prices on food, gas, clothing go up over time). But when you show strong evidence that your 5% online savings account or bond fund in fact is not beating inflation, when you look at it the first time and that light goes on, you do a double take.

                            The argument and numbers that Mr. Krowne have shown in this posting are very clear, and should be very convincing to anyone with an open mind. That does not make it any easier to stomach.

                            Indeed, reality is often the hardest thing to accept, whether it's how much weight you've gained since high school or how much your bank account, your currency, or even your country is in trouble because of factors such as the ones illuminated here.
                            It has been said regarding boys and their toys, that he who ends with the most wins, or something like that. That is meant to be cute and catchy. I think in a more serious sense, the same can be said for wealth even if it is denominated in Bonars--which is the denomination of the average person's assets in the US which is essentially where I and most of us have earned or will earn every cent that comes into our possession. When I think of achieving some level of wealth (financial security) my thoughts are to make it to the end of my life and my wife's life while remaining out of penury. This is no grandiose notion of wealth accummulation.

                            At age 65, looking back I am continually cognizant of how many Bonars I have just plain pissed away, meaning spent because I happened to have had them, buying stuff I wanted but did not need. I spend no time lamenting my prodigality, but I do have a sense of shame for many some of the ways I have succeeded in not managing money more wisely. Everyone knows you cannot change the past, the only thing is we can change our on-going behaviors, and even today at 65, I try to be more frugal so as to have fewer regrets of wastefulness between now and whenever is the end of my line, which might be tomorrow or 30 years off.

                            The point I wish to make, after living through many sorts of good and bad times mainly appreciated from looking at charts of one thing and another that depict the movement of various assets, inflation, etc. of which I had no serious awareness as I lived day-to-day through them, is that I believe if one who is young and wise (if those two states are not mutually exclusive) is serious about savings over a long period of time, then such an individual will come out way ahead of the crowd of his/her earnings-level peers.

                            Now if your goal is to be whatever qualifies as filfthy rich and you are starting from scratch, then you better get a job in the one of the industries where people are known to become really wealthy, or have ideas like Gates or Sam Walton and whatever it takes to see them through, but for average people, not necessarily intellectually average, but just people who want a job, earn a living, raise a family and hopefully educate the kids in something and obtaining some reasonable financial security, then having a serious savings ethic is I believe the most likely way to get there. I think this is true whether you beat inflation or not, and perhaps probably you won't end up beating inflation. At any point, the more money you have, compared to your peers, then the better off you will be regarding having more control over your life than they will have.

                            You know a question I often want to put to poll on iTulip is: How much money do you want? I cannot imagine the really wealthy going to the trouble to employ highly costly, highly risky investment managers to try to make more money when they seem, from my low vantage point, already to have more money than a reasonable person could spend in several life times. May be some of those mothers have figured out how to take it with them, that is if they think they will someday die.

                            To me the future right now is frightening, and if I were younger and grasped what may be the reality if any of us really have such a grasp, then I think I would worry a lot. There are not innumerable things as I see that one can do to protect themselves and family in any absolute sense. You can save a lot, invest a lot and either make a bit, a lot, or lose a bit or lose your ass. Those possibilities to me suggest the safest thing is to keep saving as much as you can as safely as you can. I think Richard Russell said recently (and perhaps for a long time) "now I'm more interested in not losing money than I am in making money." Patience and wisdom are both hard things to have, but if one is young (whatever that is) and has earnings and the ability to earn and save, and educate oneself about what is happening, or may likely happen, then adding to the savings as one exercises one's patience may result one's arriving at a time when it will seem wise to jump into to some asset class.

                            I figuratively lost my ass from 2000 to 2002, and have made a decent recovery thanks to the liquidity bubble but still am way below where I was in 2000 in just nominal Bonars (I think I am intellectually honest and generally do not mind hearing the answers to hard questions); however, I have so far been unwilling to figure out what has been my degree of recovery since 2000 if inflation were taken into consideration. Figuring it and knowing it would just make me feel worse to recognize the number, and it would be similar to lamenting the Bonars I frittered away in times past. Cannot change the past, only what lies in front of us.

                            I personally am about ready to get out of the markets. They may continue to go up for who knows how long or in which asset classes, but to me there is tremendous risk in everything. How do I plan on making it to 90-95 with no earned income, with unknown degrees of on-going inflation? By hanging on the what I have, spending only on what I need, being patient and hopefully garnering the wisdom of when to invest in liquid asset classes again. May work, may not.
                            Jim 69 y/o

                            "...Texans...the lowest form of white man there is." Robert Duvall, as Al Sieber, in "Geronimo." (see "Location" for examples.)

                            Dedicated to the idea that all people deserve a chance for a healthy productive life. B&M Gates Fdn.

                            Good judgement comes from experience; experience comes from bad judgement. Unknown.

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