an inflationary gap of $190 billion. It seems to be an axiom that wars cannot be fought on a 'pay-as-you-go-plan.' The Treasury officials recognized this problem and planned accordingly. The Secretary of the Treasury summed up the wartime experience by stating, "One of the major goals of the Treasury financing was to try to channel back into the Treasury as much as possible of this $190 billion that people were accumulating as a result of this Federal deficit." 3

The manner in which these funds were channeled to the Treasury was very important, and requires a brief explanation of the relations between the Treasury and the banking system. Under the principles of banking and the regulations of the Federal Reserve System, banks are required to keep only a small portion of their customers' deposits on reserve to meet withdrawal requests. The rest of those deposits, as loaned, add to the total money supply. Each loan that is made generates an additional deposit which can then be loaned out again and again, until the amount held in reserves is exhausted. When banks are holding excess reserves, this money-creating capability is only a potential problem. Anything that translates these inactive reserves into active reserves can create money, lead to an increase in purchasing power and an increase in the inflationary gap.

It would have been very efficient for the Treasury simply to sell the bulk of its debt to commercial banks to finance the war. To do so, however, would have been inflationary. Idle funds that were already being saved would then be spent. What was needed was to reduce current demand by inducing individuals to save their extra income.

War Securities

The Treasury employed a strategy of tailoring its securities to meet the needs of the purchasers to encourage current saving through the purchase of government securities by individuals. A broad mix of securities was offered, ranging from short-term to long-term. A class of debt which was restricted from purchase by banks was sold to keep too much debt from going to banks. Special Tax Savings Bonds, enabling individuals and corporations to set aside funds for future tax liabilities, were sold until 1943 when withholding taxes were imposed. The Third War Loan, for example, contained a mix

3 Secretary, Annual Report, 1945, 82-83.

of seven securities dated September 1, 1943: 7/8 percent certificates due September 1, 1944; 2 percent Treasury bonds due September 15, 1953; 2 1/2 percent Treasury bonds due December 15, 1969; Series E, F, and G Savings Bonds; and Series C Savings Notes. 4

The inclusion of savings bonds in a Loan Drive was a marked departure from previous financing methods. As noted previously, Alexander Hamilton had stressed the need to have holders of public debt feel secure in the transferability of their securities, and his advice has since been followed. But efforts to encourage purchase of government securities by small savers created a new situation. While a government security is marketable (i.e., able to be sold in a securities market), it does not follow that it can be sold at its par value. As with any other security, the price of a government issue can fluctuate, and a purchaser who wants to sell a bond prior to maturity may lose money if bond prices fall.

Many small savers, for example, had been brought into the government securities market during World War I through the sale of small-denomination Liberty Bonds, which were completely negotiable. Immediately after the war, the price of Liberty Bonds fell; the 4 1/4 percent bonds of the Fourth Liberty Loan, for example, fell to a low of $82.75 for a $100 par bond on May 20, 1920. Many of the purchasers of these bonds were unsophisticated investors, who, when they sold their bonds at a loss, felt cheated, and blamed the government for their losses. They also had a difficult time understanding why the government could not readily replace negotiable bonds which were lost or stolen. 5

Nonmarketable Securities

The Treasury, in an effort to appeal to small savers during World War II, placed greater reliance on nonmarketable securities in the savings bond series, especially Series E. They were available in small denominations, redeemable in cash two months after issue, and carried interest in fixed amounts depending on when they were redeemed. As they were non-negotiable, their value would not change, and because they were redeemable before maturity at the option of the holder, they could easily be turned into cash. They

4

Secretary, Annual Report, 1944, 40.

5 Henry C. Murphy, National Debt in War and Transition, (New York: McGrawHill Book Co, 1950), 106-107.

were sold in registered form, which meant that they could be replaced if lost, stolen, or destroyed. They were designed this way to make the small saver feel very secure in purchasing them. This effort was so successful that savings bonds constituted 17.6 percent of total public debt outstanding by the end of the war. 6 Comparatively, savings bonds comprised about 10 percent of the debt just before the war began.

This increased reliance on nonmarketable securities also helped the Treasury attain one of its other goals: widespread ownership of the debt. One reason for paying for a war by borrowing instead of taxing has to do with equity. The government was spending as much as 40 percent of national income during World War II, meaning taxes would have had to average 40 percent of individual income for a 'pay-as-you-go plan' to work. Even if the income of the wealthy was taxed at higher rates, as was done during the war, people of lower income would still have faced a relatively more severe tax burden. A policy of deficit financing would merely shift this burden into the future, if it was not done carefully. As taxes were later collected to pay for the debt or for interest payments on the debt, if ownership of the debt was skewed toward upper income persons or toward banks, payment of debt or interest on it could represent a transfer of income from lower-income to higher-income persons. To offset this possibility, Series E Savings Bonds carried higher interest rates (2.9 percent if held to maturity) than other securities. In addition, there were limits set on the amount of savings bonds an individual could purchase in a year, so wealthy persons could not receive an unfair share of those higher interest rates.

Establishing Interest Rates

The issue of interest brings up another goal of the Treasury's debt management plan, the sale of debt at levels of interest that were as low as possible and as steady as possible. This was not achieved during World War I, when each successive debt offering carried a higher interest rate. This pattern was unsatisfactory for the government for two reasons. First, higher rates of interest meant higher expenses for debt service, and it was one aim of debt policy to keep those costs as low as possible with low interest rates. Second, when

6 Secretary, Annual Report, 1945, 51. 7 Secretary, Annual Report, 1941, 18.