why investors voluntarily purchased 30-year bonds with 3 and 4 percent
coupons ignoring a government policy that favored inflation?
But there must have been other reasons for the decline in real re-
turns on fixed-income assets. Theoretically, the unanticipated inflation
of the postwar period should have had a significantly smaller effect on
the real return of short-term bonds, such as Treasury bills. This is be-
cause short-term rates may be reset frequently to capture expected infla-
tion. But, as noted previously, the decline in the real return on short-term
bonds actually exceeded the decline in the real return on long-term
bonds.
Another explanation for the fall in bond returns is investors’ reac-
tion to the financial turmoil of the Great Depression. The stock collapse
of the early 1930s caused a whole generation of investors to shun equi-
ties and invest in government bonds and newly insured bank deposits,
driving bond returns downward. Finally, many investors bought bonds
because of the widespread but incorrect predictions that another de-
pression would follow the war.
But it was not just the risk preferences of investors that kept fixed
rates low. The Federal Reserve actively supported the bond market
through much of the 1940s to keep the government’s interest expense
low. This support policy was abandoned in 1951 because it led to inter-
est rates that were inconsistent with one of its primary goals of main-
taining low inflation.
And finally, one should not ignore the transformation of a highly
segmented market for short-term instruments in the nineteenth century
into one of the world’s most liquid markets today. Treasury bills satisfy
certain fiduciary and legal requirements that no other asset can match.
But the premium paid for these services has translated into a meager re-
turn for investors, who have paid a high price for gaining short-termsta-
bility of their assets.
THE EQUITY PREMIUM
Whatever the reasons for the decline in the real return on fixed-income
assets over the past century, it is very likely that the real returns on
bonds will be higher on average in the future than they have been since
the end of World War II. As a result of the inflation shock of the 1970s,
bondholders have incorporated an inflation premium in the coupon on
long-term bonds. In most major industrialized nations, if inflation does
not increase appreciably from current levels (2 to 3 percent), real returns
of about 2 percent will be realized from government bonds whose nom-
16 PART 1 The Verdict of History