To the Congress of the United States:
1970 was the year in which we paid for the excesses of 1966, 1967, and 1968, when Federal spending went $40 billion beyond full employment revenues. But we are nearing the end of these payments, and 1971 will be a better year, leading to a good year in 1972--and to a new steadiness of expansion in the years beyond.
We are facing the greatest economic test of the postwar era. It is a test of our ability to root out inflation without consigning our free economy to the stagnation of unemployment. We will pass that test. But it is a real test and we shall pass it only by doing all we are capable of doing.
The key to economic policy in 1971 is orderly expansion. While continuing to reduce the rate of inflation, total spending and total output should rise as rapidly as possible to lift the economy to full employment and full production. Fiscal policy must play its full and responsible role, and the economy's course in the year ahead will also reflect the extent to which the monetary and credit needs of economic expansion are met. With the stimulus and discipline from the budget that I have put forward, and with the Federal Reserve System providing fully for the monetary needs of the economy, we can look forward confidently to vigorous and orderly expansion during 1971.
At the same time we must be relentless in our efforts toward the greater stability of costs and prices that is the foundation for an enduring and full prosperity. Much has already been accomplished. Prices in the market place have been rising less rapidly, and some that usually change early have actually declined, responding to changing pressures in the market.
In some cases the response of costs and prices has been slow, as the result of insulation from market forces. Often these market problems have been created by the Government itself. Accordingly, the Government has a responsibility to prevent misuses and imbalances of market power which impede orderly operation of our free economic system. This Administration intends to carry out that responsibility fully and fairly.
To get the economy rising at the right rate, neither too rapidly nor too slowly, is never an easy task. Economic policy does not operate with the precision needed to keep the economy exactly on a narrow path. But fortunately absolute precision is not required. What is required is that we operate within a range where both unemployment and inflation are moving unmistakably downward toward our goal. The full resources of Government, with the understanding and cooperation of the citizens, can accomplish that.
THE DUAL TRANSITION OF 1970
Faced with one of the largest inflations in American history we have sought first to stop its rate from speeding up and then to get the rate down. This has been done. The annual rate of increase of the consumer price index, which was 6.0 percent from June 1969 to June 1970, dropped to 4.6 percent in the last half of 1970. Wholesale prices, which usually move before the prices consumers pay, have slowed down even more, from a 5.3 percent rate in the first half of 1969 to a 2.1 percent rate in the second half of 1970. Because productivity began to rise, after earlier sluggishness, labor costs per unit of output rose much less in 1970 than they did in 1969, and this contributed to slower price increases.
While the Nation was making the transition to a less inflationary economy it was also making the transition to a lower level of defense spending. Men released from the Armed Forces have been out of touch with the civilian labor market and need time to readjust. Workers laid off from defense production are likely to be concentrated in particular areas, which are often not the areas where nondefense activity is expanding. Their curtailed purchasing power further tends to lower employment of others in their area. During 1970, the number of persons in military and civilian employment for defense was reduced by about 1 million. Most of these people have found work, and others will soon do so. But during the transition many were unemployed, and their number added to the total unemployment rate.
These two simultaneous transitions, from a wartime to a peacetime economy and from a higher to a lower rate of inflation, would inevitably be accompanied by some decline in output and rise in unemployment. The aim of our policy was to keep the decline in output and the rise in unemployment as small as possible.
Fiscal and monetary policy both became more expansive early in 1970, in order to get output rising again while the cost of living slowed its rise. This result was achieved. Total output declined only 1 percent from its high reached in the third quarter of 1969 to the first quarter of 1970; it leveled out in the second quarter and rose in the third. Fourth-quarter output was held down by the auto strike; without it, another increase would have been shown.
The timely shift of policy limited the decline of output; it also helped counter the increase in unemployment caused by the dual transition. The average unemployment rate for the year was 4.9 percent. At the end of the year, partly as a result of the auto strike, the unemployment rate was about 6 percent. About half of the unemployed had been without work for less than 6 weeks. Most of the unemployed who had lost their most recent job were receiving unemployment compensation.
THE ROAD TO ORDERLY EXPANSION
Our first task now must be to assure more rapid expansion and so to reduce the unemployment rate. We are now in a position to do that, while the progress against inflation continues. The restraint of 1969 and the slowdown of 1970 have set in motion strenuous efforts at cost reduction. These actions, as the pace of the economy quickens, will bear fruit in better productivity and costs. Prices have begun to rise less rapidly. There are the first faint signs of a retardation in wage increases in some sectors. Much of the anti-inflationary effect of the 1970 slowdown still has to be felt. And if the expansion is properly controlled in 1971 the conditions for further slackening of the inflation rate will remain. The expectation of continued rapid inflation has been weakened by the firm policies of the past 2 years and we must strengthen this growing confidence in the future value of money.
Forces now present in the economy, partly resulting from policies of 1970, make economic expansion in 1971 probable.
--The greater supply and lower cost of mortgage money has stimulated a 40-percent increase in the rate at which construction of new houses is started.
--Improved financial conditions are leading to a strong increase of State and local spending.
--Interest rates have dropped; the prime rate is down sharply from its peak of 8 1/2 percent.
--Consumers' after-tax incomes have increased and their saving has been high.
--In the early part of 1971 the economy will get a boost as the production lost during last year's auto strike is made up.
--Exports have been strong, and in 1970 were 14 percent above those of a year earlier.
These are powerful upward pressures, but existing and foreseeable expansionary forces in the economy are not strong enough to assure that output will rise as much as is desired and feasible. These forces must, therefore, be supplemented by expansive fiscal and monetary policies.
The full employment budget that I have submitted will do its full share in stimulating a solid expansion. Outlays will rise by $16 1/2 billion, or about 7 1/2 percent, between the current fiscal year and the next--appropriate for orderly expansion, but far short of the inflationary 15 percent average annual increases from 1965 to 1968. In addition, receipts have been reduced $2.7 billion by the depreciation reform which I have initiated to stimulate investment, jobs, and growth.
In fiscal 1971, the Federal Government will spend $212.8 billion, which is equivalent to the revenues the economy would be generating at full capacity. The actual deficit is expected to be $18 1/2 billion. In fiscal 1972, also, the planned expenditures are equivalent to the revenues we would get at full employment. How big the actual deficit will be next year, in fiscal 1972, will depend on economic conditions. If the economy follows the expected path of a vigorous noninflationary expansion, the deficit will decline to $11 1/2 billion. This combination of deficits is appropriate to the situation through which the economy has been passing. The budget moved into deficit during calendar 1970 as the economy lagged below its potential. Accepting this deficit helped to keep the decline in the economy moderate. It was a policy of not subjecting individuals and businesses to higher tax rates, and of not cutting back Federal spending, when the economy is weak because such actions would have weakened economic conditions further.
To say that deficits are appropriate in certain conditions is not to say that deficits are always appropriate or that the size of the deficit is ever a matter of indifference. Such a policy of free-for-all deficit financing would be an invitation to inflation and to wasteful spending.
As I stated last June, we need to abide by a principle of budget policy which permits flexibility in the budget and yet limits the inevitable tendency to wasteful and inflationary. action. The useful and realistic principle of the full employment budget is that, except in emergencies, expenditures should not exceed the revenues that the tax system would yield when the economy is operating at full employment. The budget for fiscal 1972 follows this principle.
Balancing the budget at full employment does not deny or conceal the deficit that will exist this year and almost certainly next year. It does, however, avoid large deficits when they would be inflationary, like the swing to a big deficit in fiscal 1968. It means that even when the economy is low we must not allow our expenditures to outrun the revenue-producing capacity of the tax system, piling up the prospect of dangerous deficits in the future when the economy is operating at a high level. Moreover, to say that expenditures must not exceed the full employment revenues draws a clear line beyond which we must not raise the budget unless we are willing to pay more taxes. This is an irreplaceable test of the justification for spending. It keeps fiscal discipline at the center of budget decisions.
Fiscal policy should do its share in promoting economic expansion, and our proposed budget would do that. But fiscal policy cannot undertake the responsibility of doing by itself everything needed for economic expansion in the near future. To try to do that would drive taxes and expenditures off the course that is needed for the longer run. The task of economic stabilization must be accomplished by a concert of economic policies. The combined use of these policies, starting near the beginning of 1969, finally checked the accelerating inflation that had kept the economy overheated for years. A turn of fiscal and monetary policies in a more expansive direction at the beginning of 1970 limited the economic decline and initiated an upturn. Concerted policies of expansion are needed now to lift the economy fast enough to make rapid progress toward full employment, and these needs will be fully met.
PRICE STABILITY AND FULL PROSPERITY
In a fundamental sense, as I have always emphasized, the control of inflation and the achievement of full employment are mutually supporting, not conflicting, goals. Nothing would contribute more to the new expansion than confidence that the threat of inflation is fading. As part of my program of expansion I propose to justify that confidence.
The basic conditions to bring about a simultaneous reduction of unemployment and inflation are coming into being. We are going to continue to slow down the rate of inflation in the middle of an orderly expansion. And we are going to do it by relying upon free markets and strengthening them, not by suppressing them. Free prices and wages are the heart of our economic system; we should not stop them from working even to cure an inflationary fever. I do not intend to impose wage and price controls which would substitute new, growing and more vexatious problems for the problems of inflation. Neither do I intend to rely upon an elaborate facade that seems to be wage and price control but is not. Instead, I intend to use all the effective and legitimate powers of Government to unleash and strengthen those forces of the free market that hold prices down. This is a policy of action, but not a policy of action for action's sake.
The process of reducing inflation is a process of learning. Business and labor must learn a pattern of behavior different from the one they have learned and practiced during the inflationary boom. Labor contracts and price lists cannot embody the expectation that prices will continue rising at the peak rates of recent years. Businesses cannot expect to pass all cost increases along in higher prices. The ritual of periodic increases in prices has no place in an economy moving toward greater stability.
These lessons are being learned. Most of all they are being taught by the facts of economic life today. Consumers are already imposing stern discipline in markets where sellers have not begun to adapt their pricing to the new, less-inflationary conditions of the economy.
But there are cases where these lessons are not being learned and actions have been taken or are under review. In those cases the Government will act to correct the conditions which give rise to excessive price and wage increases.
Actions were taken to augment the supply of lumber, and to deal with domestic copper prices that were out of line with world markets. To restrain increases in the price of crude oil, this Administration took steps to permit greater production on Federal offshore leases and to increase oil imports. Faced with inflationary price increases for some steel products, I have ordered a review of the conditions which permit or cause such increases, and threaten jobs in steel-using industries.
We have been particularly concerned with increases in the costs of construction. It is now more critical than ever to check inflationary wage and price increases in an industry where unemployment is high. The 1972 Budget provides for a large increase in construction expenditures. This should support increased employment in construction, but will do so only if the larger appropriations are not eaten up by higher wages and other costs. I have asked the leaders of labor unions and contractors in the industry to propose a plan for bringing the behavior of construction wages, costs, and prices into line with the requirements of national economic policy. A workable voluntary, plan will avert the need for Government action.
Those of us who value the free market system most cannot disregard the cases where it is being kept from working well. In some of these cases it is Government which limits the free market's effectiveness and Government has the means to make it work better. We must constantly review our economic institutions to see where the competitive market mechanism that has served us so well can replace restrictive arrangements originally introduced in response to conditions that no longer exist. We must also devise efficient solutions to problems that have become more urgent recently, such as those of pollution and adequate health care. Where inadequate market arrangements are delaying our advance toward full employment with price stability, we have a responsibility now to correct them.
In our market-oriented policy, our domestic goals and our international goals are interrelated. Success in our struggle against inflation will help to safeguard our international economic strength, and allow our highly productive enterprises and workers to compete in world markets. The liberal policy with respect to international trade to which .this Administration is committed will help keep price increases in check here while giving our farms, factories, and banks a profitable market abroad. At the same time we have to make sure that the burden of adjustment to changing conditions in world markets does not fall entirely on a few exposed industries.
With the cooperation of the private sector, an expansionary public economic policy will achieve a goal we have not seen in the American economy in many years: full prosperity without war, full prosperity without inflation.
In the record of progress toward that new prosperity, I am convinced that economic historians of the future will regard 1970 as a necessarily difficult year of turnaround but a year that set the stage for strong and orderly expansion.
February 1 1971