Should we worry about all that debt held by foreigners?

I think we should, and here’s why.

I love the name of Steve Conover’s blog, The
Skeptical Optimist
. This week Conover asks, href="http://www.optimist123.com/optimist/2005/07/whats_so_scary_.html">What’s so scary about
debt held by foreigners? He answers that we shouldn’t be worried, and reasons as
follows:

I’m sorry, I don’t buy the scary, emotional rhetoric. Why? Because I am one of an apparent
minority who is not just happy– but delighted– that foreign investors with dollars to spare
think the USA is the one of the safest, most stable places in the world to invest their
money.

Ten (or so) years ago, Milton Friedman explained it this way:
“It is a mystery to me why… it is regarded as a sign of Japanese strength and American
weakness that the Japanese find it more attractive to invest in the U.S. than Japan. Surely it
is precisely the reverse – a sign of U.S. strength and Japanese weakness.”

I like that reasoning. But to explain why I’m nonetheless still quite concerned, let me call
your attention to some facts from the U.S. national income accounts. If we produce more as a
nation than consumers, firms, and the government spend, the residual will be used to lend to
other countries or acquire foreign assets. If we produce less, we must borrow or sell off
assets. We can break down that gap between our production and spending by further
distinguishing between purchases of structures and equipment (investment spending) and other
categories of spending. If we leave depreciation out of the measure of both production and
investment, we have the accounting identity that U.S. net saving minus U.S. net investment
equals net lending from the U.S. to foreign countries. Net foreign lending is positive if our
saving is greater than our investment, and negative (meaning we’re borrowing from other
countries) when saving is less than investment.

saving_pic.gif

The graph at the right plots these three quantities, net saving, net investment, and net
foreign lending as a percentage of GDP for the U.S. Up until the mid 1980′s, net saving and net
investment tended to be pretty close to each other, and there was little net lending or
borrowing from foreigners. Since then, net saving has drifted significantly down as a
percentage of GDP, and has averaged less than 2% of GDP for the last three years. The
difference between what we produce and what we spend has shown up as an increasing volume of net
foreign borrowing.

I agree very strongly with Conover that net foreign borrowing is not in and of itself a bad
thing. In my mind, it really all depends on why we’re doing the borrowing. If businesses were
using the borrowed funds to do additional investing in plant and equipment, then even though
we’d be owing more to foreigners, we’d also be creating the additional productive resources with
which to pay them back and provide for our own future as well. Or if there was some good reason
why we temporarily have a great need to borrow and would be in a better position to pay for what
we now want at some point in the future, it might be a good idea to sell off some of our assets
or go more deeply into debt to those in other countries.

But I see neither of these as a good description of our current situation. Investment has
actually declined as a fraction of GDP over this period, and I don’t see why it’s going to be
that much easier for either the government or private households to pay off that debt in the
future. Instead to me it has more the appearance of a consumption binge.

And the problem has to do with the magnitude of that binge. When net foreign lending is
negative, we either have to sell off U.S. assets or go deeper into debt. And more than 5% of
U.S. GDP in one year represents a huge quantity of assets. href="http://www.roubiniglobal.com/setser/archives/2005/06/selling_off_lit.html"> Brad
Setser and Peter
Schiff
have noted that if, as some have predicted, the U.S. current account deficit were to
rise to $800 billion, we could pay for one year’s worth of net imports by selling off half the
companies that make up the Dow Jones Industrial Average.

I should also note that I agree with Conover that the problem is not the fact that we’re
borrowing from foreigners per se. If we were not able to borrow from them and still had such a
low saving rate, we’d have practically no net investment in the U.S., which would be an even
bigger disaster. So I would say that the problem is not the large amount of foreign borrowing, it
is the low U.S. saving rate.

And what exactly is the problem with that? It means we’re basically further impoverishing
the Americans of the future with each years’ asset sell-offs or debt accumulation. If you don’t
find that scary, at least it seems to me a little sad.

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34 thoughts on “Should we worry about all that debt held by foreigners?

  1. ZiggyCarmichael

    As an economics Masters student, I have been taught to view the state of the current account as a reflection of optimal intertemporal decision-making by agents. A current account surplus or deficit is neither inherently good or bad, but is rather a reflection of current and expected income flows and investment opportunities. In this view, a current account deficit results from agents transferring higher future income to the present and thus smoothing their consumption. Could not the current account deficit be viewed as a vote of confidence in the future state of the economy?
    The caveat to this approach is that market disortions may result in savings and investment decisions that lead to a suboptimal current account balance. Am I correct in thinking that perhaps the voracious willingness of Asian central banks to purchase US government debt in an attempt to keep their currencies artificially competitive may be one such distortion? If this is to leading to a narrowing of bond yields, which I believe you address in one of your recent posts, surely this will discourage domestic saving?

  2. Houston's Clear Thinkers

    The risk of rising U.S. debt

    Awhile back, this post made the point that, rather than focusing on CNOOC’s bid to overpay for a second tier U.S. oil & gas company, the real issue that needs to be addressed is that American society is currently impoverishing…

  3. Dave Schuler

    While we’re on the subject of the national savings rate could you address a question for me? Doesn’t saying the national savings rate needs to rise actually mean that the savings rate for people in the top income quintile (or decile or even the top 1%) needs to rise? That is, after all, where most of the income growth has been for quite some time now.

  4. JDH

    Ziggy, let me make a couple of points here. First, the view of the current account deficit as the outcome of optimal intertemporal decision-making takes as given the U.S. fiscal deficit. So you could say, given the level of government borrowing, it’s optimal to be doing that borrowing from foreigners rather than crowd out domestic investment, but that still leaves open the question of whether the fiscal deficits are themselves desirable. Second, there are a number of possible reasons one might suspect that the drop in the private saving rate could be the result of some distortion, such as social security or bankruptcy laws. You’re right that by not identifying the source of the decline in the savings rate, I was to some extent putting the cart before the horse. But I nevertheless find it useful at this point to summarize what the consequences of that drop in the saving rate appear to be.
    The other question that I have for the story Ziggy tells is, what is the nature of the change in this dynamic intertemporal calculation that has produced these deficits? William offers one possible answer here, which is Mandel’s thesis that it is driven by an expectation of faster U.S. productivity growth. I’d be much more comfortable with this explanation if I saw U.S. investment rising rather than falling. I’m skeptical of the global savings glut story as well, though I admit that I haven’t yet completely sorted out all the facts on that issue in a satisfactory way. That would leave us with the story that there’s just been a change in U.S. preferences, in that Americans care less about the future than they used to. If that’s the root of what’s going on, then, Ziggy’s right, it’s optimal for us to go about the process of methodically surrendering U.S. wealth to foreigners and watch them become richer and us poorer. Even if that’s regarded as the optimal thing to do, given people’s preferences, I still see it as something sad.

  5. JDH

    That’s an interesting question, Dave. I haven’t seen an analysis of that, but maybe someone who has can add some information for us here.

  6. Hal

    If people do care less about the future, I think what we really mean is that they care less about their children. That’s why it seems sad, because evolution has programmed into us a desire to take care of our children and it seems immoral for people not to follow those evolutionary programs.
    However, note that there are many differences today from back when we lived in caves. For one, we have economic growth driven in large part by technological improvement. Even without production growth we still get improved quality of life due to better science, medicine and technology. Our children are doing just fine, thank you. In fact, each generation is doing much better than the previous one, with opportunities and tools that were unimaginable just a few decades earlier. Things weren’t like that for the cave men, and evolutionary instincts programmed into us back then shouldn’t be followed too literally today. Emotional responses based on those instincts should be taken with a grain of salt.
    A major difference over the situation in previous generations is that people are having fewer children – usually just one or two. Most western countries have birthrates falling below the replacement rate. This means that parents’ assets will not be diluted as they pass to their children. In many cases they will be concentrated, and in a substantial percentage there are no children at all. Families that have no population growth do not need to transfer as much wealth to the future in order to provide for their children. Rather, it makes sense to consume more in the present.

  7. walker

    JDH said…”If that’s the root of what’s going on, then, Ziggy’s right, it’s optimal for us to go about the process of methodically surrendering U.S. wealth to foreigners and watch them become richer and us poorer. Even if that’s regarded as the optimal thing to do, given people’s preferences, I still see it as something sad…..”
    Well, if you asked a person on the street whether surrendering their and their children’s wealth to foreigners was their preference I suspect the answer would be no, even though these “revealed preferences” are reflected in their consumption patterns. The same can be said of a business executive who chooses, for example, to relocate a facility offshore. Is it not possible that the current market conditions are sending out signals to individual actors (consumers, businesses) that do not reflect society’s preferences in the aggregate? If so, is it not also possible, in theory, to craft a regulatory framework that aligns the incentives of individual actors and society? Finally, is there anything in the past or current literature that explores situations in which individual “revealed preferences” undermine the interests of the group?

  8. touche

    The average American has no knowledge of the huge debt that is being accumulated. Household debt is about $11 trillion and rising by about $1 trillion per year. The ratio of this debt to GDP or disposable personal income is skyrocketing to new heights. The public hasnt been warned about too much debt so they are unaware of any potential problem. In fact, the economic profession, represented by Greenspan (they think), has told them everything is rosy. So why should they worry?

  9. Stuart Staniford

    The natural way for me to think about the trade deficit is to think of the US economy as like one big company – our revenues are rising a few percent each year (economic growth), but we are running a 6% loss (trade deficit), and borrowing to make up for the fact that we are unprofitable. Is this simple minded analogy valid, or does it miss something important?
    Stuart.

  10. Joe

    “And what exactly is the problem with that? It means we’re basically further impoverishing the Americans of the future with each years’ asset sell-offs or debt accumulation. If you don’t find that scary, at least it seems to me a little sad.”
    But that is exactly the decision that has been made by the current crop of wealthy politicians. When you talk about national wealth, that is just an average and these people don’t care about averages. They and their children are going to be just fine. They have no use for Social Security, Medicare, or universal health care. Reckless and irresponsible fiscal policies are no problem for them.

  11. JDH

    Stuart, I think a better analogy is a company that wants to borrow money because it’s spending more than it’s taking in as revenues. If the company is using that borrowed money to fund profitable investments, it can turn out to be a great thing for the company and a great thing for a nation. My concern is, I don’t think that’s what America is doing with the money we’re borrowing right now.

  12. Heiko Gerhauser

    The borrowing is in US currency though and on extremely favourable terms. So favourable in fact that the US is running an income surplus, ie it gets more income from its $9 trillion in investments abroad than foreigners get on their $11.5 trillion on US investments.
    If you can effectively borrow without having to pay interest, I mean, who wouldn’t?
    And look at how easy it is to wipe out the net debt. Drop the Dollar by half, and the $9 trillion of US assets abroad nearly double (because most of the foreign holdings are in foreign currencies).

  13. walker

    Heiko said…”And look at how easy it is to wipe out the net debt. Drop the Dollar by half, and the $9 trillion of US assets abroad nearly double (because most of the foreign holdings are in foreign currencies)”…..
    This point is addressed here:
    http://www.roubiniglobal.com/archives/2005/06/us_net_foreign.html
    An excerpt:
    “Some make a big deal of these capital gains and argue that the U.S. can systematically reduce the real value of its foreign debt via a dollar depreciation that increases the dollar value of U.S. foreign assets and reduces the value (in foreign currency) of U.S. foreign liabilities. I.e. you could try to wipe out the real value of your foreign debt through a dollar devaluation. This arguments is faulty in a number of ways:
    First, You can fool some of the people all of the time and all of the people some of the time but you cannot fool all of the people all of the time. In other terms, if foreign investors were to expect a systematic and persistent fall in the value of the dollar, they would require ex-ante a higher yield on the dollar assets they hold in order to be compensated for the expected currency losses; in other terms, interest rates would go up and thus the attempt to reduce the real value of foreign debt via depreciation would not work.
    Second, most of the U.S. foreign assets are in countries/regions (Eurozone, U.K., Canada, Australia) whose currencies have already sharply appreciated relative to the U.S. between 2002 and 2004; thus, these gains are temporary and limited. The U.S. does not hold as many foreign assets in Asia; and the next leg of the U.S. dollar fall is likely to be in Asia (rather than Europe) once China moves its peg and the rest of Asia follows. Thus, once the dollar starts to fall relative to the Asian currencies, the capital gains from currency moves will be much smaller.
    Third, all of the capital gain on the currency that the U.S. obtained in 2004 has been wiped out by now because of the appreciation of the U.S. dollar relative to the Euro and other floating currencies in 2005.”

  14. Jim

    Given the observation of a declining domestic savings rate, and a choice between the competeing hypotheses of 1) a change in U.S. tastes for consumption vs. investment, and 2) a global increase in demand for US$ assets, you casually (as well as causally) dismiss the latter on no basis other than vague skepticism. It seems perfectly reasonable and suited to facts, assuming you buy into the whole ‘supply and demand’ and ‘intertemporal marginal utility’ stories.

  15. Stuart Staniford

    JDH: Generally only startups (developing countries?) should borrow/raise capital to run at a loss. Mature companies (developed countries?) should be profitable despite the need for ongoing investment in future operations. Running at a loss for extended periods generally points to the need for major restructuring. In our case, we are being undercut at our traditional core competence as a nation (manufacturing), and our new core competence (consulting on product design, management, and marketing) appears to be a significantly smaller business. It also appears to have an uncertain future, given that we are so far from our manufacturing customers in Asia.
    Could the US govt buy Chinese currency on a large scale? It would appear to be an excellent investment, and that might force the Chinese to drop the peg, allowing us to, in the business analogy, lower our prices in a more graceful way.
    Stuart.

  16. Texas Al

    Sorry to dilute this discussion with a naive question but…
    How would the theoretical ideal consumer/investor who did care about the future behave differently?
    Would they invest more of their income? Use less consumer credit? Pay off their loans faster? Buy fewer luxury goods? Buy US government bonds (or foreign government bonds)?

  17. JDH

    Texas Al, the saving rate is entirely determined by total consumption spending as a fraction of income earned. A change in that ratio could show up in any of a number of ways, such as less borrowing or more discretionary income put into a pension plan. Basically any change in your spending that causes your debts to go down or your assets to go up would be an increase in saving.

  18. Robert Schwartz

    I agree with Mr. Conover, and am untroubled by the whole issue. I think most of the issues raised here simply do not hold up.
    First, the concern that Americans are consuming too much/not saving enough. How can anyone know this? Why should men save more than they need. Who knows what their needs are. Economists? Bureaucrats? Politicians? Or they themselves?
    Second, I think we should remember that saving does not create investment in real capital. Given the amount of cash accumulating in the corporate sector, it is most likely that we can fund business investment without borrowing offshore. More saving will not change the level of investment in real capital because we must assume that entrepenures know better than economists, bureaucrats, and politicians what profitable investment opportunities are available; and the evidence from statistics and low interest rates is that they are funding all of them.
    Third, worrying about international creditors foreclosing on the homestead is silly. They may own trillions of dollars of bonds, but that does not mean they can do very much other than wait politely to be paid in due course. They can convert those bonds into the ownership of other assets, but that may not help them nor hurt us. They could buy whole companies, but what do they do then? Either they run them or they loose value. They cannot just magically translate the corporate assets out of the country. They could, like the Japanese, build factories in the US. That would be good news. They could buy real estate, but they can’t take it home. If foreigners owned the majority of real estate in the US, real property taxes would go up and rent controls would be imposed.
    Let us suppose that the Chinese buy Unocal. What could they do with it. They cannot physically move the reserves, the pipelines, the refineries, the pipelines or the gas stations. They can operate them in place and try to make a profit. The most realistic fear is that they will take control of Unocal’s Asian reserves and send their output to China. How does this hurt us? We do not collect the severance on the oil. It cannot affect the market price of oil, or its availibiltiy. Unocal is just too small a player. I just do not see the problem.
    Fourth, remember the maxim, if you owe the bank a thousand dollars and you cannot pay it back its your problem; if you owe the bank a million dollars and you cannot pay it back its their problem. We owe trillions to foreigners. Its their problem. The Chinese have worked like oxen to pile up Treasuries. Many people claim that they have undervalued their currency by half in order to do that. Should we be upset. No, we should be grateful. Its the Chinese people who have a complaint.

  19. Jim Glass

    “First, the concern that Americans are consuming too much/not saving enough. How can anyone know this? Why should men save more than they need. Who knows what their needs are.”
    Well, one thought by Edmund Phelps on this is that the absent Social Security and especially Medicare, people would “naturally” have saved trillions of dollars to meet their old-age expenses. If they had (or the government had saved corresponding amounts to finance these programs) there’d have been a significant effect on the national accounts, affecting savings, the deficit, the value of the dollar, etc.
    As it is, when these amounts finally come due, there will be.
    http://online.wsj.com/article/0,,SB110419530705710585,00.html?mod=opinion&ojcontent=otep

  20. STS

    Stuart:
    >Could the US govt buy Chinese currency on a large scale?
    That’s an amusing suggestion. For me it conjures an image of Greenspan playing currency speculator and buying up huge sums of RMB just in time for a big revaluation, then buying back enough additional dollars to cover our fiscal deficit. It would be a neat trick to end his tenure at the Fed ;)
    But seriously, we’re so broke we’d have to borrow the dollars from China (or maybe Japan) to pay for the RMB, even supposing China would sell them to us! All very circular.
    With Warren Buffett playing at being George Soros, why not Greenspan too …

  21. pgl

    James – very nice analysis. David Altig notes his take. My Angrybear post tries to address both your and David’s posts. Let’s just say – I wish I had written what you just did. Well done!

  22. James Kroeger

    JH: “If we were not able to borrow from them and still had such a low saving rate, we’d have practically no net investment in the U.S., which would be an even bigger disaster.
    I think I’d have to argue that this is factually untrue, for a number of reasons. Lets consider one…
    When the US Treasury sells bonds to the PBOC, where do the dollars come from that were lent by the PBOC? Well, they were originally held as un-lent reserves by an American bank. Their status changes from ‘un-lent reserves’ held by an American bank to ‘lent-out reserves’ borrowed by Americans.
    Any way you look at it, foreign-owned dollar reserves are loanable reserves available to American borrowers. The fact that Asian banks might own the reserves is of no significance whatsoever. The funds are effectively “on American soil”, available to Americans, and are a part of the nation’s money supply.
    You point out that other countries will earn more interest income from Americans than Americans will earn from the Chinese. So what? What are the Chinese going to do with those dollar earnings except make them available to potential borrowers in America?
    Foreign ownership of American assets has no impact whatsoever on the availability of loanable funds in America (and therefore no impact on interest rates).

  23. JDH

    James Kroeger, national saving is a measure based on the physical production of goods and services, and does not have any necessary relation to the number of dollars held as bank reserves. Bank reserves change hands many, many times each day, and end up being held by some U.S. bank at the end of each day, regardless of the physical quantity of whatever gets produced and sold.
    You should think of national saving as whatever we produce as a country that doesn’t become household or government consumption goods and services. Suppose for illustration that the only thing the economy made was steel. Suppose we produce 100 million tons of steel in a year, and that 98 million of those tons go to making consumer goods. Then our national saving rate would be 2%. If we don’t go into debt as a nation to import steel from other countries, that would only leave 2 million tons of steel with which to build investment goods.

  24. James Kroeger

    JDH: I agree that it makes theoretical sense to define investment as “whatever we produce as a country that doesn’t become household or government consumption goods and services.” But it makes no sense whatsoever to also refer to those real goods & services as “savings.” There is no sound theoretical or empirical justification for doing so.
    To conceptually equate Savings with Investment one must necessarily embrace several implicit assumptions:
    (1) Firms always have economic efficiency projects they would invest in if only there were enough loanable funds available at an affordable price
    (2) All money borrowed by firms is used for economic investments
    (3) All economic investments by firms are financed by borrowed money and therefore by savings
    (4) All saved money is borrowed by firms
    (5) All money borrowed by firms comes from saved money
    Nearly all of these assumptions are flawed. Empirical evidence reveals that:
    (A) Between 1988 & 1997, an average of nearly 85% of the money that corporations spent on investment came from retained earnings or other internally generated funds. This empirical fact would seem to strongly refute the assumption that firms are desperately dependent upon borrowed money (and therefore upon savings) when they want to make investments. What is the ultimate source of the internally generated funds? It would be the expenditures of consumers and firms, not savings.
    (B) Between 1998 & 2001 (years that included cyclically high levels of business investment) the combined borrowing of non-financial corporations and all non-corporate businesses varied between 20-34% of total borrowing nationwide. During the same period, the household sector of the economy accounted for 20-30% of total borrowing. These statistics tell us that only a fraction of total savings is directed, ultimately, to the noble purpose of improving economic efficiency.
    (C) Savings are not the only source of loanable funds. The ultimate determinant of the supply of loanable funds in the FOMC. Whenever The Fed buys securities in the open market, it pays for them with money that it creates out of thin air with a keystroke. It does not draw the money from some reserve account that is limited in size. It is “new money” that did not exist prior to the keystroke that created it. With any of its purchases of securities, The Fed provides loanable funds to banks that were not saved by any saver.
    There is no limit to the amount of money the Fed can inject into the loanable funds market. If savers were to suddenly pull most of their money out of banks and put it under their mattresses instead (equivalent to a dramatic reduction in savings), The Fed would still be able to easily maintain the supply of loanable funds or even increase it by simply buying every sort of debt instrument offered in the credit markets. Even if The Fed bought up all of the nation’s debt—something that would never happen—and there was still a shortage of loanable funds, it could maintain/increase the money supply by buying buildings or land or anything else it fancies.
    Given this last empirical fact, we can know that any time there is a drop in savings (or savings rates) for any reason, the Fed will keep interest rates low enough to appeal to economic investors if that is what the Fed wants to do. It is therefore irrational to conceptually equate Savings & Investment for analytical purposes. Just remember: Most investment funds come from the consumption expenditures of households, firms, and government. This means that although national savings are an interesting statistic, they don’t tell us anything about the real investment that an economy is experiencing.

  25. James Kroeger

    Citations above:
    “Between 1988 & 1997, an average of nearly 85% of the money that corporations spent on investment came from retained earnings or other internally generated funds.” (Brealey & Myers, Principles of Corporate Finance, 2000, pp. 383-384)
    “Between 1998 & 2001 (years that included cyclically high levels of business investment) the combined borrowing of non-financial corporations and all non-corporate businesses varied between 20-34% of total borrowing nationwide. During the same period, the household sector of the economy accounted for 20-30% of total borrowing.” (Flow of Funds Accounts, The Board of Governors of the Federal Reserve System, http://www.federalreserve.gov)

  26. Unpaid Punditry Corps

    Chinese Re-valuation effects

    Due to the massive number of marginal mortgages that have been made as short term adjustable rate mortgages, the stressed out American consumer with little real wage growth in the past four years is shouldering significant interest rate risk.
    Since…

  27. Anonymous

    Robert Schwartz :
    “Third, worrying about international creditors foreclosing on the homestead is silly. They may own trillions of dollars of bonds, but that does not mean they can do very much other than wait politely to be paid in due course”
    China is not waiting politely. It is using funds to build up it’s Military (90+ billion). They are also usurping investment in Venezuela oil fields, which is a traditional source of oil (45%) for the US. This is not an economic move; it is a geo-strategic move to potentially cut off supplies to US. Also they have been selling satellite missile technology to Iran in exchange for exclusive oil rights. China has muted US economic power by guaranteeing supplies to Iran if the US forces sanctions due to Iran’s nuclear buildup. China is not Japan/South Korea; it is not a complementary but a competing power to the US. They will not foreclose on us but they can spend their reserves on ways that can harm us.
    “They can convert those bonds into the ownership of other assets, but that may not help them nor hurt us”
    As owners of post US companies China would move their manufacturing base up the value-added-chain. These value-added intangible assets (i.e. technology, intellectual property, customer base, brands) are the cream of enterprise and they produce the better profits and the higher paying jobs. It would be reasonable to assume that China would move these jobs/profits to their own country. What would be left of the jobs for US citizens would be distribution and low level service jobs, the pay being determined somewhat by the company’s Chinese managers, who are use to working with low labor cost.
    “Fourth, remember the maxim, if you owe the bank a thousand dollars and you cannot pay it back its your problem; if you owe the bank a million dollars and you cannot pay it back its their problem.”
    This US isn’t Argentina; because it is the world’s currency it must retain some integrity. The world of finance will not allow full devaluation of the dollar because it’s foundation is dependent on the dollar’s acceptance in international transactions. If the value of the dollar fell below a certain unacceptable level then the US would raise interest rates to regain credibility. The cost of higher interest rates would be borne by the US public, by increase borrowing costs, higher public debt cost and a possible recession. There is no free lunch for the US public.

  28. TCO

    the debt itself is the issue. (and the spending that causes it.) Who holds it is a bunch of neomercantilist foolala.

  29. Debra Riley

    746565: Hey, does anyone know where I can find a list of gas stations with low prices in my area?

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