interest rates were rising, it became harder to sell bonds as purchasers were determined to wait until interest rates rose before making their purchase of bonds. This second aspect is complicated and requires some elaboration.

Government securities at that time were all sold with a fixed maturity value (e.g., $1,000) and at a fixed interest rate (e.g., 5 percent). The market in government securities, however, will see to it that the rate of return or yield on all bonds is made equal by adjusting the market price of individual issues to values different from their maturity values. If interest rates rise, the market value of previously sold bonds will fall. For example, if a new issue of government bonds carries an interest rate of 6 percent, the price of previously issued 5 percent bonds will fall to $83.33 to give the bonds an equivalent yield. This process is often referred to as "interest rate risk," and the rise of interest rates during World War I helps to explain why the value of some issues of Liberty Bonds declined. A prudent investor has two choices to avoid facing interest rate risk. One can purchase short-term securities, and when interest rates change, wait a short time for the securities to mature and receive the full purchase price for them. As they are not subject to interest rate risk, short-term securities usually carry a lower interest rate than do long-term securities. If an investor wants the higher return of long-term securities, but anticipates rising interest rates, the investor can decide to wait until interest rates hit their peak before making his purchase(s).

The Treasury determined to maintain interest rates at a constant level throughout the war to avoid this problem. At the time the government began its wartime borrowing, interest rates were still in the low ranges which had persisted throughout the Great Depression of the 1930s. Short-term notes carried rates of less than 1 percent, with long-term issues yielding in the range of 1.25 percent to 2.5 percent. The Treasury needed the cooperation of the Federal Reserve Banks to maintain these rates.

The Federal Reserve & Open Market Operations

As noted previously, there is an inverse relationship between the market value of a marketable security and its yield. As interest rates rise or fall, the market price of securities will change inversely to bring the yield on all securities to a constant, adjusting for different dates of maturity. Consequently, when the market prices of secu

rities fall, their yields rise, requiring subsequent new issues to have higher interest rates if they are to be successfully sold. Whenever the Treasury sells a new issue of securities, then it must be careful that it does not push the price of all securities down and force interest rates up.

8

One way for the Treasury to avoid this problem would be to sell securities directly to the Federal Reserve, which has the power to print new money which could be used to purchase government securities. However, the Banking Act of 1935 prohibits the Federal Reserve from making direct purchases of securities from the Treasury, except to the extent of any holdings of maturing securities that the System would like to exchange for new securities, when offered. With that exception, the Federal Reserve is only permitted to purchase government securities on the open market, from commercial banks, dealers, and brokers, in what are called open market operations. This procedure for purchase (and sale) of government securities is, of course, the major tool the Federal Reserve uses in its role of controlling the nation's money supply (nonborrowed reserves), and thus, interest rates to a great extent.

During World War II, the Federal Reserve cooperated with the Treasury in terms of interest rate management. The interest rate on long-term bonds was set at 2 1/2 percent for the term of the war, and while presidents of some Federal Reserve banks indicated they would have preferred to see 3 percent, they agreed to support the lower rates. While no official statement to that effect was made, the financial markets assumed that this policy would be followed. 9 There was debate about the amount of interest for the short-term rate, with the Treasury desiring it to be at 1/4 percent, and the Federal Reserve lobbying for 3/8 percent. The Federal Reserve prevailed in this matter. As Secretary of the Treasury Henry Morgenthau reported, "On April 30, 1942, the Federal Open Market Committee directed the twelve Federal Reserve Banks to purchase for the System Open Market Account at a rate of 3/8 of 1 percent per annum all Treasury bills offered to them." 10 There would be no problem of rising interest rates during the war with the Federal Reserve willing to follow this plan.

The wartime debt management plan of the Treasury was a relative success. The deficit caused by the war would have been financed in

any event, but the methods used by the Treasury did help to eliminate some of the inflationary gap caused by the government expenditures. The level of inflation was managed by price controls, enforced by the Office of Price Administration, but the Treasury's policies made it an easier fight against inflation.

Savings Bonds & the War

The main focus of the effort to reduce the purchasing power of consumers was the Savings Bond Program. The sale of nearly $50 billion in savings bonds during the war went a long way toward eliminating the total inflationary gap estimated at $190 billion. The payroll deduction savings plan initiated in 1942 is of special interest in this regard. Nearly 28 million workers were participating in the plan by June 1944, with monthly deductions totalling $500 million. This amount represented 10 percent of the total pay of those participating in the plan, resulting in a sizable reduction in their purchasing power. 11 Furthermore, there were few redemptions of savings bonds during the war, with only 15 percent of savings bonds sold having been redeemed by June 30, 1945. 12 This low level of redemption meant that purchasers were willing to hold on to bonds as savings, which reduced their demand for goods and services. It also meant that individuals were satisfied with the security of the bonds. Treasury officials were aware of the "propaganda value" of the Savings Bond Program in fostering patriotism and national unity, and many of the savings bonds sales campaigns reinforced other patriotic appeals. The low level of redemptions would indicate that this aspect of the program was also a success. It is estimated that during the course of the war the sale of Series E, F, and G Savings Bonds absorbed 6.7 percent of total personal income. 13

The high sales volume of savings bonds also indicated that the distribution of ownership of the government debt was fairly broad. While there are no records of government debt ownership by income groups, the Treasury did keep track of individual versus bank holdings of the debt. The record shows that both groups held shares of debt ownership over the years. Individuals held 20 percent of government securities and commercial banks held 39

Secretary, Annual Report, 1944, 53.

12 Secretary, Annual Report, 1945, 57. 13 Murphy, National Debt, 196.

percent on June 30, 1941. Both groups had increased their shares slightly by June 30, 1945, with individuals holding 23 percent and banks holding 40 percent. The remainder of the debt in 1945 was held by insurance companies (9 percent), mutual savings banks (4 percent), corporations (12 percent), state and local governments (2 percent) and government agencies and trust funds (10 percent). Additionally, the bank holdings listed above include those of the Federal Reserve, which amounted to 4 percent of the total debt in 1941 and 8 percent in 1945. 14

The Federal Reserve and the War

This increase in the Federal Reserve's holdings of government securities was in part caused by the policy of interest rate stabilization. The range of interest rates agreed to by the Treasury and the Federal Reserve was maintained successfully throughout the war. As a result, the computed rate of interest on government debt fell during the war, as shown in Table Three (the computed rate of interest is determined by dividing the total debt by the actual amount of interest paid). This decline in computed interest indicated that the Treasury's goal of financing the war at low and steady interest rates was achieved.

Source: Annual Reports of the Secretary of the Treasury, 1941-1945.

The cost of accomplishing this goal was increased ownership of government securities by the Federal Reserve. The pattern of interest rates agreed to by the Treasury and the Federal Reserve, namely low short-term rates and high long-term rates, would indicate that under a free market, investors were anticipating an increase in interest rates. Therefore, investors would be buying short-term securities (pushing their interest rates down) and avoiding long-term securities (forcing their rates up); the spread between the long- and short-term rates would be the premium for being

14 Secretary, Annual Report, 1946, 61.

subjected to interest rate risk. There was no interest rate risk with the Federal Reserve standing ready to 'peg' the interest rates through open market operations. Consequently, investors of all classes had no incentive to purchase short-term securities.

The Treasury was tempted at the same time to do as much short-term borrowing as possible and take advantage of the lower interest rates on this class of security. Long-term bonds constituted 77 percent of marketable securities in 1940, but only 60 percent in 1945. 15 Federal Reserve open market operations thus had to be concentrated in short-term securities, which by December 31, 1944, resulted in the Federal Reserve holding 68 percent of all Treasury bills outstanding, 12 percent of marketable notes and certificates, and only 1.5 percent of long-term marketable bonds. 16 While the Federal Reserve would have held a similar amount of government debt in any event, this skewing of its portfolio toward short-term securities meant that the low rates at which the Treasury financed the war were, to some degree, at the expense of the Federal Reserve.

As noted above, the sale of government securities to the banking system was viewed as being inflationary, while those sold to individuals who paid out of current income were non-inflationary. The Treasury hoped to pull as much of new savings as possible into its securities. During the four years of the war, sales of government securities absorbed about $121 billion out of $189 billion of new savings. Approximately $38 billion of the remaining $68 billion were put in highly liquid checking accounts, where they were in the greatest danger of being spent immediately. But to some extent, these funds represented new accounts opened by persons who had been so impoverished during the depression that they had no liquid funds prior to their increases in income during the war, and they were now determined to save. As a result, it was concluded at the Treasury that "only a relatively small part of the $38 billion increase in demand deposits is dangerous money in the inflationary sense" and "the inflationary dollars involved in the $68 billion in money savings made over the four-year period represents a small portion of the total." 17 To be sure, government securities that could be turned into cash rather easily always presented a threat of inflation. However, Seymour Harris, a noted economist, calculated that only a