THE FEDERAL RESERVE, QE, AND THE ECONOMY
Since 2008, the economy has been dependent on Quantitative Easing by the Federal Reserve, which has funded this measure mostly through the sale of securities to oil-producing countries, in particular, China. These securities back up the printing of money (at 4 cents a bill) with “collateral” in the form of T-bill debt. The Federal Reserve now holds more than five times the amount of securities it had before the 2008 financial crisis. With this amount of debt ($4 trillion), will the Federal Reserve be able to stabilize the economy?
Even after the markets were stabilized, the Federal Reserve continued to purchase assets because of the slow recovery. The most recent monetary policies have been ineffective, causing taxpayers further losses and increasing the possibility of inflation in the future. The Federal Reserve has increased the national debt from $850 billion to $4.4 trillion, which causes many to question the strength of the Federal Reserve. Some go a step further and question why it even exists.
The Federal Reserve was created by the Federal Reserve Act in 1913 to restore faith in the country’s banking system after the financial crisis of 1907. Congress needed to act quickly to regain the American public’s trust in the banking system. Congress passed the Federal Reserve Act and the Federal Reserve was born. The Federal Reserve was to act as a lender of last resort.
When banks failed, JP Morgan, the world’s most powerful banker, and John D. Rockefeller, the oil tycoon, led the campaign that used the fear of the American public to sell them the idea of a central bank, something they could trust in. This is how the American people came to accept the idea of a central bank. Rockefeller and JP Morgan exploited the fear of the American people and used it to make them feel safe. And so, the Federal Reserve was born.
The Federal Reserve is a central bank owned by many small, private banks that earn a 6% annual dividend. Presidential appointees run the Federal Reserve and it can issue currency and government securities. However, the profits are returned to the treasury.
The main function of the Federal Reserve is to set the federal funds rate, which affects the interest rates that banks charge each other, and ultimately, the consumer. When the Federal Reserve moves this rate, it has a huge impact on the economy. When the Fed lowers interest rates, the economy grows. When they increase them, inflation decreases, but the economy slows down.
The Federal Reserve is there to keep everything balanced. It’s also the Federal Reserve’s job to supervise the U.S. banking system and to protect the consumer. The Fed also sustains the steadiness of the financial markets, provides banking services to and regulates commercial banks and processes checks. The Fed handles other types of payments, provides banking services for government agencies and collects and analyzes economic data.
PURPOSE AND SCOPE
The purpose of this report is to study the Federal Reserve and determine whether there is a need for its existence. This report aims to weigh the pros and cons of having the Federal Reserve supervise and control the U.S. banking system, monetary policies, and the economy. The goal is to analyze QE policies and determine whether they have helped or hurt the U.S. economy.
“Instead of creating new money through additional lending, the Fed’s QE policies have greatly expanded the number of excess reserves in the banking system. In other words, banks have mostly decided to hold onto the cash that the Fed gave them when it executed all those securities purchases. Consequently, it is rather difficult to argue that these Fed policies have done much to expand the economy” (Michel and Moore, 2014).
This report will determine whether QE policies have worked or failed miserably. It will answer questions such as:
|How did the Federal Reserve come to exist?|
|Who benefits from the Federal Reserve?|
|Who owns the Federal Reserve?|
|What is Quantitative Easing?|
|How has QE affected the U.S. economy?|
|What would’ve happened if the Fed hadn’t used QE?|
|Is there a need for the Federal Reserve?|
|Does the Fed actually create the problems it claims to solve?|
|Should the Federal Reserve be abolished?|
|How does the selling of securities to oil-producing countries affect the U.S. economy?|
This report explores the questions above by analyzing what led to the creation of the Federal Reserve; how Americans came to put their faith in the Fed; the ideas of well-known economist, John Maynard Keynes; and how the U.S. economy would fare without the Federal Reserve. It identifies failures in the Fed’s monetary policies since its foundation, the amendment of the Federal Reserve Act in 1977 by Congress to redefine the Fed’s purpose, and what it would mean if the U.S. returned to a gold standard. Finally, the report will investigate U.S. dependence on foreign investments, how the Fed has been operating thus far, how QE has worked thus far, what to do about QE policies, and whether there is a need for the Federal Reserve at all.
This report used pragmatic analysis by expending the best method suited to the research problem, which gives it the freedom to combine both qualitative and quantitative analyses if warranted. Quantitative analysis was used to by comparing the economic status of the U.S. in 2008 to the status prior to that. Qualitative analysis was used to uncover any possible deeper purpose of the Federal Reserve using a bottom-up approach, which uses specific information to draw conclusions or make generalizations. Data collected includes journal articles and trade magazine articles related to economics.
After articles were collected, the data was then analyzed for sub-topics related to the topic at hand. Each article was read and/or skimmed for important data and then used in the resources section. After completing preliminary research, more research was done to find additional sources to back up the claims found in this report.
The key articles referenced are from Amadeo (Economy Section of About.com), Julie Borowski (Freedomworks.org), New World Encyclopedia, Gary Gorton and Andrew Metrick (Journal of Economic Perspectives), The Concise Encyclopedia of Economics, Skousen (The Ludwig von Moses Institute), Marotta and Russell (Hudson Valley Business Weekly), and the video Money, Banking and the Federal Reserve (YouTube).
The findings below answer the questions raised in the Purpose and Scope section. This report will first explore the history of the Federal Reserve and its decisions throughout time. By analyzing the past and current decisions of the Fed, an informed decision can be made about whether the Fed has lived up to its purpose, as well as whether there is a need for the Fed. The report will investigate how the Fed’s actions have continuously and negatively affected the American public since 1913. Finally, the report will discuss significant events that may have been caused by the Federal Reserve, such as the Great Depression. It will also discuss the abandonment of the gold standard and how the Fed was involved in that decision.
The Panic of 1907 was a time in which people were tired of instability in the banking industry, including bank runs, panics, lack of credit and cash crises. Congress was compelled to find a solution to these complications. The Federal Reserve Act was passed in 1913 by President Woodrow Wilson to ensure the U.S. banking system could withstand financial shocks.
In 1913, the gold standard was still being used, but “it was quickly eroded as the Fed continued to expand the money supply” (Money, Banking and the Federal Reserve, Video). The first thing to happen was backing the Federal Reserve Notes with only 40% gold. This allowed the money supply to be increased by more than twice its current supply.
Not long after the Federal Reserve was established, the U.S. entered World War I. Like in nearly every major war, the U.S. abandoned the gold standard temporarily in order to print more money to finance the war. The national debt rapidly climbed from $1 billion to $27 billion. A staggering increase in inflation was the result.
To relieve the strained U.S. economy, the Federal Reserve ceased its inflation, which doubled interest rates in just 18 months (Money, Banking, and the Federal Reserve).
The market began recovering in 1921 but crashed a few years later in 1929 when the “Fed-generated bubble burst in the Wall Street Crash of October 1929. The stock market lost one-third of its value” (Money, Banking, and the Federal Reserve).
- The Death of the Gold Standard and Implications
In 1933, the gold standard was on its way out. For World War II, the gold standard was once again abandoned in order to print more money to finance the war using central bank-generated inflation. Once the war was over, “there was an attempt to use the prestige of the gold standard to establish a global inflationary system. The world’s financial leaders met at Bretton Woods in New Hampshire under the direction of the famous economist, John Maynard Keynes” (Money, Banking, and the Federal Reserve).
The purpose of this meeting was to set up a new international monetary system that would implement both the gold standard and inflation.
Social welfare programs and the Vietnam War contributed to the printing of even more money in the 1960s. The more money that was printed, the less value the dollar maintained. Some foreigners even began cashing in their dollars for gold out of trepidation. “After paying out billions in gold, the U.S. was left with $36 billion worth of outstanding debt to foreign creditors and gold reserves were worth just $18 billion.
Since the abandonment of the gold standard, “…no U.S. Federal budget has been balanced…” (Money, Banking, and the Federal Reserve). According to economists, the best money is market-determined money and the only way to accomplish that is to abolish the Federal Reserve.
- Keynesian Economics
John Maynard Keynes was an influential economist in “the middle third of the twentieth century that an entire school of modern thought bears his name. Many of his ideas were revolutionary; almost all were controversial. Keynesian Economics serves as a sort of yardstick that can define virtually all economists who came after him” (Library of Economics and Liberty).
- It was clear how Keynes felt about the gold standard. “Echoing centuries-long inflationist views, he opined that the gold coin ‘wastes’ resources, which can be ‘economized’ by paper and foreign exchange” (Rothbard, 1992). Because of his influence and apparent fame, Keynes’ ideas influenced many economists who came after him, as the passage from the Library of Economics and Liberty states above. In Keynes, the Man by Murray N. Rothbard, he describes the “phony gold standard” as something that “allows for far more room for monetary management and inflation by central governments. It takes away from the public’s power over money and places that power in the hands of the government. Keynes praised the Indian standard as allowing a far greater ‘elasticity’ (a code word for monetary inflation) of money in response to demand” (Rothbard, 1992).
- Keynes favored a more tangible currency than gold. “Keynes explicitly looked forward to the time when the gold standard would disappear altogether, to be replaced by a more ‘scientific’ system based on a few key national paper currencies.’ A preference for a tangible reserve currency…[is] a relic of a time when governments were less trustworthy in these matters than they are now” (Rothbard, 1992). Keynes was a man who despised the values of the middle class such as savings and thrift, conventional morality and the basic institutions of family life (Rothbard, 1992).
- THE POWER OF THE FEDERAL RESERVE
The Federal Reserve has more power than they should. They have a monopoly on the printing of money. No one can control how much or how little they print. No one polices this organization, yet it has full control over the U.S. economy and monetary system. The Federal Reserve’s power is untouchable by both Congress and the President of the United States. At a time of economic uncertainty, even then President, Bill Clinton, didn’t want to intervene in the Federal Reserve’s operations. The meetings held by the Federal Reserve board are “held in secret and nobody knows exactly what goes on” (Money, Banking, and the Federal Reserve).
Part of the problem is that the member of the board of the Federal Reserve are not elected and some have no financial backgrounds, leading Americans to question whether having a Federal Reserve is in the best interest of the country as a whole. After all, who benefits from the Federal Reserve’s existence? Do the American people benefit? Do the member banks benefit?
The main function of the Federal Reserve is to set the federal funds rate, which affects the interest rates that banks charge each other and interest rates charged to consumers. When the Federal Reserve moves this rate, it has a huge impact on the economy. When they lower interest rates, inflation decreases, but the economy slows down. The Federal Reserve is supposed to keep things balanced. It’s also the Fed’s job to supervise the U.S. banking system and to protect the average American consumer. The Federal Reserve also sustains the steadiness of the financial markets, provides banking services to and regulates commercial banks and processes checks. It handles other types of payments, provides banking services to government agencies and collects and analyzes economic data.
- Implementing Federal Reserve Notes
In 1971, instead of stopping inflation, President Nixon printed more money and the United States dropped the gold standard. “The country had been keeping it in name only since the Fed’s intake of ‘free gold’ from the 1920s onward. Shortly after, the U.S. dollar, previously a pure silver coin, was replaced and redefined as Federal Reserve Notes” (Marotta and Russell, 2014). In 1977, Congress Amended the Federal Reserve Act and also revised the purpose of the Fed. The Federal Reserve’s new purpose was to seek “‘the goals of maximum employment’ as well as ‘stable prices and moderate long-term interest rates.’ This is often called the ‘dual mandate of the Fed: to keep employment high and inflation low’” (Marotta and Russell, 2014).
Quantitative Easing is “the Federal Reserve’s program of buying bonds from its member banks. The Fed purchases U.S. Treasury notes and mortgage-backed securities (MBS), and issues credit to the banks’ reserves to buy the bonds. The purpose of this expansionary policy is to lower interest rates and spur economic growth” (Amadeo, 2014). The money used to purchase these assets basically comes out of thin air when the Fed creates it, which has the same effect as printing money.
“Quantitative easing is a massive expansion of the Fed’s normal open market operations. Even before the recession, the Fed held between $700-$800 billion of Treasury notes on its balance sheet, varying the amount to tweak the money supply…As a result of QE, the Fed’s balance sheet has more than quadrupled, to $4 trillion. That makes QE the most massive economic stimulus program in world history” (Amadeo, 2014).
- How QE Works
Quantitative easing works this way:
Quantitative easing is accomplished when the Federal Reserve “adds credit to the banks’ reserve accounts in exchange for MBS and Treasuries. The reserve account is the amount that banks must have on hand each night when they close their books. The Fed requires that around 10% of bank deposits be held either in cash in the banks’ vaults or at the local Federal Reserve bank” (Amadeo, 2014).
This process leaves excess reserves in banks, which means the banks would now have more to lend to other banks. Interest rates are dropped when banks try to get rid of their excess reserves. This is how the federal funds rate is determined.
Quantitative easing results in an increase in the money supply because of lower interest rates. Lower interest rates equal more people borrowing money. Consumer credit is on the rise and as a result, the value of the dollar decreases.
According to Amadeo:
Quantitative easing stimulates the economy in another way. The Federal government auctions off large quantities of Treasuries to pay for expansionary fiscal policy. As the Fed buys Treasuries, it increases demand, keeping Treasury yields low. Since Treasuries are the basis for all long-term interest rates, it also keeps auto, furniture, and other consumer debt rates affordable. The same is true for corporate bonds, allowing businesses to expand more cheaply. Most important, QE keeps long-term, fixed-interest mortgage rates low. And that’s important to support the housing market.
Therefore, QE policies can be seen as a tool to control the U.S. economy and keep it stable. The question is whether that’s being done. Is the Federal Reserve operating in the best interest of the American public? Taking a look at the most recent implementation of QE as well as the history of the Fed’s decisions can help answer that question.
- QE 1 (December 2008 – June 2010)
The Federal Reserve announced that it would purchase $800 billion in bank debt, mortgage-backed securities, and Treasury notes from member banks on November 25, 2008 (Amadeo, 2014). The purpose of this was to help banks stay afloat by taking subprime MBS off of their balance sheets. The Fed bought $175 million in MBS created by Fannie Mae, Freddie Mac, and the Federal Home Loan Banks, and bought “$1.25 trillion in MBS that had been guaranteed by the mortgage giants” (Amadeo, 2014).
Once the economy began to pick up, the Fed ceased purchases. However, two months later, the economy started slowing and the Fed renewed QE 1. “It bought $30 billion a month in longer-term Treasuries to keep its holdings at around $2 trillion” (Amadeo, 2014). The Federal Reserve does this when the economy needs a boost.
- QE 2 (November 2010 – June 2011)
The Fed announced plans to expand quantitative easing by “buying $600 billion of Treasury securities by the end of the second quarter of 2011. This second round of easing was known as QE2. The Fed was actually hoping to spur inflation a bit by increasing the money supply. Expectations of inflation increase demand, which would spur economic growth” (Amadeo, 2014). People are generally more willing to buy goods and services now if they know the prices will go up in the future.
- Operation Twist (September 2011 – December 2012)
Operation Twist was launched by the Federal Reserve in September 2011. It was comparable to QE2. The only differences were that the Federal Reserve bought long-term notes once their short-term Treasury bills expired and it bought more mortgage-backed securities. The Fed did this to “support the moribund market” (Amadeo, 2014).
- QE 3 (September 2012 – Present)
QE3 was announced by the Fed on September 13, 2012. The plan was to purchase $40 billion in mortgage-backed securities and follow through with Operation Twist.
- QE 4 (January 2013 – Present)
The Federal Reserve announced QE4 in December 2012, saying it would buy $85 billion in long-term Treasuries and mortgage-backed securities. Operation Twist ceased when QE4 began. The Federal Reserve promised to “keep QE4 until one of two conditions were met: either unemployment fell below 6.5% or inflation rose about 2.5%” (Amadeo, 2014). The Federal Reserve usually focused on inflation in the past, not unemployment. That it did this, proved it was concerned with economic growth as well as preventing inflation.
- S. Dependence on Foreign Investments
As a result of the low savings rate, the U.S. depends on foreign capital inflows from countries with higher savings rates, such as China. This is because the U.S. needs to meet its domestic investment requirements and also fund the federal budget deficit. Foreign investors of the U.S. help to keep the real interest rates low. Some opine that such low-cost capital inflows were one of the causes of the U.S. housing bubble and the successive global financial crisis of 2008 (Labonte and Morrison, 2013).
The problem with China holding so much of the U.S. government’s debt is that China could sell large portions of its U.S. securities holdings. This could set off a chain reaction, causing other foreign investors to sell their U.S. holdings also. This would be devastating to the U.S. economy, causing destabilization nation-wide. Some argue that China could use their large holdings of U.S. debt as collateral or a bargaining chip when dealing with the U.S. However, the issue is not how large China’s holding of U.S. securities is, but how heavily the U.S. relies on foreign capital.
- IMPACT ON AMERICAN PEOPLE
President and Director of Research at Wainwright Economics, R. David Ranson publicized his feelings about the Fed in an article called “Why the Fed’s Monetary Policy Has Been a Failure”. A summary of his thoughts:
The Fed’s decisions are hampered by the need to preserve banks that are “too big to fail” and by flawed methods of evaluating the labor market or the cost of living in public discourse. But there are reasons to fear that, even if all obstacles could be corrected, there is something inherently ineffective about the Fed’s current monetary policies. The assumption that they have stimulated or bolstered the economic recovery is based much more on doctrine than on evidence. When a policy is unsuccessful, policymakers should rethink it and try something different. But that is unrealistic here. Opponents of existing policy argue that it has failed because it is wrong. Supporters counter that it needs more time to work, or has been deployed on an insufficient scale.
The Federal Reserve’s monetary policies have failed because, like Ranson said, policymakers should learn from their mistakes. The Federal Reserve implements policies that don’t help the American people but hurt the majority of them instead. Looking closely at the Federal Reserve’s policies since the Federal Reserve Act was established, nothing has really changed permanently for the U.S. economy. The same cycles continue to persist, which begs the question: Does the Federal Reserve cause the problems it claims to solve? Simply, yes.
- Affect on the Poor and Middle Class
The poor and middle class are the groups most affected by the Federal Reserve and its existence. Hidden inflation taxes, in essence, steal the hard-earned money of the average American. “It is often wrongly defined as the general rise in the price of goods and services. But higher prices are actually a direct consequence of inflation since increasing the supply of money decreased the purchasing power of the dollar” (Borowski, 2012). She opines, “Inflation hurts the poor most since they have less disposable income. Consumers with low disposable incomes will be negatively impacted by higher prices for food and clothing” (Borowski, 2012).
The middle class has been slowly disappearing in America in the last decade. The Federal Reserve constantly manipulates the economy and the prices of goods and services have been rising consistently over decades, therefore, it’s safe to say the Federal Reserve does not exist to benefit the middle class.
- Destabilization of the U.S. Economy
Since its foundation, the Federal Reserve has dragged the U.S. economy through what Borowski calls “endless boom-and-bust cycles.” She claims, “The U.S. economy was much more stable before the Federal Reserve came into existence. It bears significant responsibility for every financial crisis over the past century including the Great Depression, the stagflation of the 1970s and recent economic meltdown.” Borowski also goes into detail about how the boom-and-bust business cycle is created by the Federal Reserve and ended by them as well:
The Austrian Business Cycle Theory explains why we see such wide fluctuations in the economy. The theory states that a false boom occurs when the Federal Reserve lowers interest rates below the market rate, which increases the supply of money. Artificially low credit cost sends out misleading economic signals to producers. They are inclined to respond by greatly expanding their production around the same time. In retrospect, these investment decisions called malinvestments are seen as a bad allocation of resources. Malinvestments will lead to wasted capital and economic losses. The expansion of credit cannot continue permanently which means that inevitable bust will follow a false boom created by the Federal Reserve.
This illustrates how the U.S. economy operates. When the Federal Reserve lowers interest rates, people borrow more, which means they spend more. If people are spending more, businesses produce more. When it’s time for people to pay back the money they borrow (through loans, credit cards, etc.), they stop buying. Businesses then have too much product, resulting in lost revenue. Also, when businesses lose money, they have to fire employees, which leads to higher unemployment. This is another factor that affects the economy. When people don’t have jobs, they don’t have money to spend. The cycle then repeats itself. This demonstrates how unstable the U.S. economy is because of the vicious cycle it is stuck in.
- Benefits Special Interests
The Federal Reserve benefits only a select, well-connected few: the elite. “The central bank serves big spending politicians, big bankers, and their friends. Special interests receive access to money and credit before the harmful inflationary effects impact the entire economy. This is why high power lobbyists protect and defend the existence of the Federal Reserve” (Borowski, 2012).
- Encourages Deficit Spending
The federal government has a history of overspending and the Federal Reserve is responsible for that. The government has only a few ways to get more money, one of which is printing money. This seems to be the preferred method as opposed to taxation and borrowing money (Borowski, 2012).
- Run By Unelected Board Members
Not only is the Federal Reserve run by appointed members, but those appointed members aren’t held responsible for their actions. In other words, the American people have no say in who’s running the country’s monetary policy and economy even though it directly affects the entire country. The Federal Reserve’s existence prevents a free market economy and is not in the best interest of everyone (Borowski, 2012).
- The Federal Reserve Itself Is Unconstitutional
The Constitution, which the U.S. bases all of its laws on, doesn’t mention anything about a central bank. “The Constitution makes no mention of a central bank. While there have been historical debates on the constitutionality of a central bank, I see no justification for the argument that the Federal Reserve is constitutional” (Borowski, 2012). The Federal Reserve does not have the power to create a central bank. Nowhere in the Constitution does it grant them permission to do so. Therefore, the Federal Reserve essentially violates the U.S. Constitution (Borowski, 2012).
- DID QE WORK?
Quantitative easing on the economy did accomplish some of its goals, but according to Amadeo, the Federal Reserve failed to accomplish other goals completely. It most likely created the housing bubble. What QE did resolve was bailing out banks from subprime mortgages and regaining consumer trust. QE also stabilized the economy and helped to stimulate economic growth by lowering interest rates, which helped significantly. However, not as much as the Federal Reserve had planned (Amadeo, 2014).
The Fed’s QE policy did fail to make more credit available. When the Fed gave money to the banks, they still weren’t lending. “Banks used the funds to triple their stock prices through dividends and stock buy-backs. The large banks also consolidated their holdings, so that the largest .2% of banks control more than 70% of bank assets. Since banks didn’t lend out the money, inflation wasn’t created in consumer goods” (Amadeo, 2014). Amadeo states that this resulted in the Fed’s measurement of inflation remaining within the target. The Fed created an asset bubble in gold, stocks and other commodities. Investors lost their bonds.
- A World Without QE
Many question what would have become of the U.S. economy if the Federal Reserve hadn’t implemented its QE policies or if the Federal Reserve itself didn’t exist. If the Federal Reserve hadn’t implemented QE in the first place, what would the country look like today?
- Abolishing QE and the Fed
Economists believe that the U.S. economy would be more stable if it readopted the gold standard. That, along with the abolishment of the Federal Reserve would benefit the American people in the following ways: more jobs, secure savings, the end of the boom/bust business cycle, more secure jobs, a stable dollar, and more business opportunities.
SUMMARY, CONCLUSION, AND RECOMMENDATIONS
The Federal Reserve was created to stabilize the U.S. economy in 1913 and Congress revised the goals of the Federal Reserve in 1977. Their new job was to control inflation without triggering a recession. The Federal Reserve’s decisions have a huge impact on the average American. When the Fed lowers interest rates, they decrease the value of the dollar, thereby decreasing the spending power of the poor and middle class.
The Fed has engaged in several rounds of quantitative easing on the U.S. economy since 2008. While QE worked initially, it didn’t live up to all of its goals. The Fed still holds a large number of securities and the economy is showing slow growth. The Fed has stated that it won’t hesitate to begin purchasing securities again, should the economy need a boost. The question is, is that the solution to the problem?
Considering the effect that the Federal Reserve has had on the U.S. economy throughout history, it’s safe to conclude that the Federal Reserve does more harm than good for the average American. Not only does it completely control the U.S. monetary system without supervision, but also it looks out for the best interests of the government, bankers and the rich.
It also encourages deficit spending, bails out big banks, devalues the dollar, and is unconstitutional. The Federal Reserve’s controlling interest in the U.S. and world economy spells trouble for the general American public. It has led to nothing but trouble for the American middle class and it continues to prove that it only serves the interest of government agencies and the wealthy.
The Federal Reserve should be abolished. The U.S. economy would be stabilized without a central bank controlling interest rates, inflation, and unemployment. The average American would be better off financially and their spending power would increase dramatically. The Federal Reserve has proved to create the problems it supposedly “fixes,” therefore, there isn’t a real need for the Federal Reserve. Yes, the Federal Reserve acting as a lender of last resort makes a lot of Americans feel safer, but its usually saving the American people from problems they caused. This report is a case study of that and clearly proves why the Federal Reserve should be abolished.
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