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. 7

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.

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