The Fetish of Bond Parity

September 27, 1948

The support of the government bond market by the Federal Reserve System, in order to hold the price at par, is today the principal inflationary factor in our economy. Chairman McCabe of the Federal Reserve Board virtually conceded this in his recent testimony before the Senate Banking and Currency Committee: “If the policy of maintaining the 2½ percent yield level on long-term Treasury bonds is continued . . . additional reserve funds would be made available to banks which . . . could sustain a further very large inflationary expansion of bank credit.”

Yet the policy has not only been continued since he spoke, but continued on an increased scale. The Treasury and the Federal Reserve authorities, in short, prefer to risk a reckless inflation to doing anything to halt or curb the present policy of pegging government bonds at par. Perpetual parity for the outstanding government long-term bonds has become sacrosanct and untouchable. It is a fetish to which all other economic aims are now subordinated.

Yet the reasons for this policy, when ventilated, turn out to be far from convincing. The most important of them is that, if the government bonds were left to a free market, they would fall to a discount that would threaten the solvency of our banking system. I shall postpone to a subsequent column discussion of the possible ways of preventing such a consequence. The fallacy in the argument that the government must hold down interest rates “to reduce the burden on the taxpayer” I have already pointed out in a previous column “Cheap Money Means Inflation” (Newsweek, Dec. 8, 1947).

But perhaps the greatest irony of the inflationary bond buying policy is that even its supposed direct beneficiary, the government bondholder himself, is not protected by it. On the contrary, he is a victim of it.

There is a widespread notion that the government “broke faith” with its bond buyers of the first world war because Liberty bonds were allowed to fall at one time to as low as 82 in the open market. Never again, said the second world war authorities, would so awful a thing happen. The new bonds would always be kept at par or better. So far they have been. And as a result the government bondholder of the second world war has suffered a much more real loss than the bond buyer of the first. When the Fourth Liberties fell to 82 in May of 1920, their owners were certainly not happy. For the cost of living had risen 26 percent from the day the bonds were issued in October 1918. When the bonds had fallen to 82, in other words, the purchasing power of the investor’s original dollars had fallen to 79 cents. For every dollar he had invested in the bonds the buyer then had a net purchasing power of only 65 cents. But this situation lasted for only a few months. It adversely affected merely the few who were forced to dispose of their bonds in that short period. Those who held on to them until they were redeemed in 1933 were not only paid off 100 cents on the dollar, but had the added advantage of a decline in living costs. For every dollar he had invested the buyer received in return (in addition to the interest in the meantime) a purchasing power of $1.28.

True, the present war bonds have been maintained on the market at par—in terms of dollars. But in order to keep the bonds at par the debt has been monetized, inflation has been increased, and the purchasing power of the dollar itself has been lowered. Though the war bonds issued in November 1942, for example, still sell around par, their purchasing power at par, in terms of living costs, is now only 69 percent of what it was when the bonds were bought.

The holder of these bonds, in other words, has not only suffered a decline of some 30 percent in the purchasing power of his bonds if he has to sell them now, but he is destined to suffer an even greater decline if an even higher price level prevails at the time of redemption. And an even higher price level surely will prevail if the present bond support policy is continued. So far as the interests of the bondholders are concerned, in short, the mere dollar “parity” maintained by present inflationary support policy is a delusion.