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Beginning in the late 1950s New Classical Macroeconomists began to disagree with the methodology employed by Keynes and his successors. Keynesians emphasized the dependence of consumption on disposable income and, also, of investment on current profits and current cash flow. In addition Keynes posited a Phillips curve that tied nominal wage inflation to unemployment rate. To buttress these theories Keynesians typically traced the logical foundations of their model (using introspection) and buttressed their assumptions with statistical evidence. ^[4] New Classical theorists demanded that Macroeconomic be grounded on the same foundations as Microeconomic theory, profit-maximizing firms and utility maximizing consumers.^[5]

The result of this shift in methodology produced several important divergences from Keynesian Macro economics: ^[6]

1. Independence of Consumption and current Income (life-cycle permanent income hypothesis)


2. Irrelevance of Current Profits to Investment (Modigliani-Miller theorem)


3. Long run independence of inflation and unemployment (natural rate of unemployment)


4. The inability of monetary policy to stabilize output (rational expectations)


5. Irrelevance of Taxes and Budget Deficits to Consumption (Ricardian Equivalence)

The permanent income hypothesis (PIH) is a theory of consumption that was developed by the American economist Milton Friedman. In its simplest form, PIH states that the choices made by consumers regarding their consumption patterns are determined not by current income but by their longer-term income expectations.

Measured income and measured consumption contain a permanent (anticipated and planned) element and a transitory (windfall gain/unexpected) element. Friedman concluded that the individual will consume a constant proportion of his/her permanent income; and that low income earners have a higher propensity to consume; and high income earners have a higher transitory element to their income and a lower than average propensity to consume.

The financial relief comes from the redefinition of jumbo loans, a category that includes all mortgages greater than $417,000.

Because area home prices are so high, jumbo loans have often been the only option for buyers. But such mortgages carry interest rates of at least half a percentage point more than smaller loans.

Federal law has barred Fannie Mae and Freddie Mac, the two companies that buy loans from lenders and sell them to investors, from buying loans of more than $417,000. Because lenders have no guaranteed market for their bigger mortgages, they assume more risk - hence the higher rates charged on loans over $417,000.

Under the proposed stimulus plan adopted by the House last Tuesday, Fannie Mae and Freddie Mac would be permitted to buy loans of up to $729,750

That extra money can make a huge difference in affordability.

Monthly payments on a 30-year fixed-rate mortgage of $625,000 at an interest rate of 6.25 percent - the average jumbo rate in late January - would total $3,848.23. The same loan at the nonjumbo rate of 5.5 percent in late January would cost $3,548.68 a month, a difference of $299.55.

Michael Daversa, president of Atlantic National Mortgage, a brokerage firm in Westport, Connecticut, said he had already received calls from borrowers who wanted to refinance their current loans at the nonjumbo rates, even though it is not yet known if the new loan policies will get final congressional approval.

The government's proposed new loan policies also include an increase in the size of Federal Housing Administration, or FHA, mortgages, which qualify for federal insurance. These loans carry less risk for lenders and therefore better terms for borrowers. Among other things, FHA loans require down payments of only 3 percent.

The loans are available to all borrowers, but their top limit is typically too low for many New York-area borrowers to take advantage of them.

In Fairfield County, Connecticut, and Essex County, New Jersey, for instance, the maximum FHA mortgage is about $363,000, which is far less than the median house price. Under the stimulus plan passed by the House, the FHA limit rises to $729,750 for all areas.

• By
  
  
  
  James J. Cramer
  
  







• Published Jan 24, 2008

* An exclusion of all co-op apartments, which make up 75 percent of residential homes in Manhattan and a substantial portion in the other boroughs.

* An exclusion of two-family homes, of which the city has more than 400,000.

* Restrictions on cash-out refinancing.

But most shocking is that the interest rates for mortgage loans from $417,001 to $729,500 are much higher than expected - and, brokers say, than the average rate of those seeking to lower their monthly costs.

Experts had counted on about a 6 percent interest rate extended for loans up to $729,750. Instead, rates for stimulus-package loans above $417,001 were listed late last week as high as 6.85 percent - which seems to go against the spirit of the information initially released about the plan.

One Power Express client, a day trader who owes $400,000 on his $700,000 Staten Island house and holds a $75,000 home-equity loan, had planned to streamline his debt and refinance. But the new rates won't save him any money.

Part of the problem is a 2-point fee Fannie Mae and Freddie Mac are charging to refinance mortgages at that amount.

Increasing the eligible loans to $729,750 from $417,000 would change the characteristics of mortgage-backed securities, leading traders to exact a premium for increased interest-rate risk.

Borrowers with large, jumbo loans are more likely to refinance since their savings are greater for each incremental drop in rates than for a smaller loan. The loans will taint the bonds since traders don't initially know the make-up of the securities known as "agency" MBS.

CBO
TESTIMONY

Statement of

Peter R. Orszag

Director

Options for Responding to
Short-Term Economic Weakness

before the

Committee on Finance
United States Senate

January 22, 2008

Principles for an Effective Fiscal Stimulus

The most effective fiscal stimulus policies share two common features:

Lump-Sum Rebate

A lump-sum rebate of taxes puts cash directly in consumers’ wallets. As a matter of nomenclature, a true rebate is limited to what a household has already paid in taxes. In practice, however, rebates may be larger than the household’s tax liability. In those cases, the "rebates" are actually transfers administered through the tax system.

Rebates can be designed and implemented in a variety of ways. For example, they may be the same for all recipients (or subject to a ceiling), or they may vary in amount according to the size of the tax liability. In addition, they may be based on income tax returns or on some other tax, such as payroll taxes.

Approaches to Providing Incentives for Businesses

Tax cuts for businesses may also take two forms. They may be general, such as reducing the corporate tax rate, or they may apply only to new investment, such as the investment tax credit. That distinction materially influences the effectiveness of the proposed approaches. Although a general business tax cut may leave a corporation with higher cash flow, which can affect investment decisions in some cases, its stimulative effect comes principally from how much it increases the attractiveness of new investment. Because a general tax cut applies to income generated from a firm’s productive assets regardless of when they are placed in service, only part of the cut affects a firm’s decision to undertake new investment.

Even business tax reductions focused on new investment, however, may have only a limited effect on decisions to invest. For one thing, they may apply to investment that would have been undertaken anyway. In addition, like general business tax cuts, their stimulative effect depends on firms’ having tax liability in the first place; without such liability, tax cuts generate no cost reductions for firms. The portion of investment by firms with no tax liability varies, but it is significant. By one measure, the share of investment among firms subject to the corporate income tax ranged over the past few years from a little less than 30 percent to more than 45 percent. Moreover, the efficacy of some types of investment stimulus (such as accelerated depreciation) may be muted by the corporate alternative minimum tax, which can effectively undo cuts in regular corporate taxes.

Cut in Corporate Tax Rates

The most common form of a general cut in business taxes is a reduction in the corporate tax rate. This approach, however, is not a particularly cost-effective method of stimulating business spending: Increasing the after-tax income of businesses typically does not create an incentive for them to spend more on labor or to produce more, because production depends on the ability to sell output.

But because taxes on business income essentially lower the return that firms earn from capital investment, reducing such taxes can increase firms’ willingness to acquire more capital—that is, to invest. As a result, the principal influence of taxes on a firm’s decision about investing depends on the prospective profits from its new investments, not on current profits made from old investments. However, a substantial effect of reducing current corporate tax rates is to increase the returns from past investments rather than increase the attractiveness of new investments.

Proposals for Home Mortgage Markets

Because problems in the housing and home mortgage markets have contributed to weaker economic activity and concerns about a recession, some current actions and proposals to address economic weakness are tied specifically to the housing market³⁴ Effective stimulus need not be directed specifically at the source of economic weakness, however. Indeed, actions and proposals to bolster housing and financial markets are not fiscal stimulus in the traditional sense as discussed above. They do not directly affect large numbers of consumers and businesses, nor do they involve sums of money that would probably be necessary to push the economy out of recession should it enter one. Nevertheless, by addressing specific problems in those markets that private participants might find difficult to resolve, they could play an important role in reducing the severity of a potential recession.

Expanding Opportunities to Refinance Subprime Mortgages

The effects of securitization in complicating the ability of lenders to negotiate loan modifications suggests that policymakers might more fruitfully focus on creating favorable opportunities for borrowers to refinance. That is, borrowers may be able to avoid default by paying off existing mortgages with the proceeds from new, more affordable loans. Policies to do so quickly might focus on making increased use of existing federal credit programs and the housing government-sponsored enterprises (GSEs). Alternatively, the Congress could consider new or expanded programs to increase federal assistance to community-based organizations that provide services, counseling, and foreclosure protection to households. The Administration has also recommended that the Congress pass legislation that would allow state and local governments to issue tax-exempt bonds to help troubled borrowers.

Government Purchases of Subprime Mortgages

Efforts to encourage the restructuring and refinancing of subprime mortgages may be insufficient to stabilize this mortgage market, and the market may not begin to function effectively again until some of the current uncertainty about the value of subprime mortgages has been dispelled. Some analysts have therefore proposed that the federal government buy subprime mortgages.⁵¹ Under such proposals, the federal government would create or empower an agency to establish a schedule of prices for different tiers of loans. The prices would be steep discounts from the estimated values of the loans in the tiers. The agency would evaluate and classify the loans it was asked to buy. Proponents believe that such a program would put a floor on the prices of subprime mortgages and allow market participants to price the assets of financial institutions. The agency would aim to sell the mortgages at higher prices when financial markets were better able to price them and were more amenable to undertaking the risk.

The rebates - including the $300 rebate for kids - start to shrink when your adjusted gross income hits $75,000 (single) or $150,000 (married). Adjusted gross income includes income from all sources, but before most deductions and exemptions have been subtracted.

The rebate is reduced by $50 for every $1,000 you earn above the income limit. It disappears at some point which varies depending on your family size.

Singles with more than $87,000 in gross income and couples with more than $174,000 get no rebate if they have no children.

Those with children can earn a bit more before losing their rebate because it's bigger to start out with. A married couple with two kids, for example, get no rebate when their income exceeds $186,000, says Mark Luscombe, principal tax analyst with CCH.

The Internal Revenue Service will start issuing rebates - via check or possibly direct deposit - in early May.

The rebates represent a 2008 tax cut. But instead of getting the tax cut next year, when you file your 2008 return, you'll get it this year.

• Gross domestic product grew at an annual rate of 1.7 percent in the six quarters before the 2003 tax cuts. For the six quarters following the tax cuts, the growth soared to an average 4.1 percent rate.

• Non-residential, fixed investment declined for 13 consecutive quarters before the 2003 tax cuts. It has expanded for 13 consecutive quarters since then.

• The S&P 500 dropped 18 percent in the six quarters before the 2003 tax cuts. It increased 32 percent over the next six quarters.

• The economy lost 267,000 jobs in the six quarters before the 2003 tax cuts. In the next six quarters, it added 307,000 jobs. More than 8.3 million jobs have been created since August 2003 -- the longest continuous run of job growth ever.

Housing.

The plan tries to make it easier to secure or refinance mortgages for more expensive homes. First it would allow Fannie Mae and Freddie Mac, for a year, to buy loans of up to $729,750. The current limit is $417,000. The package would similarly increase the $362,790 limit on loans insured by the Federal Housing Administration, while making it easier for borrowers to qualify.

The market for bonds containing so-called jumbo loans, those above Fannie and Freddie's current $417,000 limit, has essentially dried up in recent months due to turbulence in the mortgage market. Lenders making such loans are requiring even borrowers with good credit to come up with larger down payments and are charging higher interest rates. That's a particular problem in states like California where the median existing home price is about $490,000.

Richard Moody, chief economist at Mission Residential, says he's skeptical as to how much good raising the Fannie and Freddie limits will do, given lenders' recent, tougher standards.

"When you're talking about a $700,000 house, a 20% down payment is still a good chunk of change," Moody says.

Further, the plan shifts more risk to taxpayers, because FHA loans are insured by the federal government.

Business.

The package includes more than $40 billion in business tax breaks, including allowing businesses to more quickly deduct the cost of new equipment. The package provides a 50% bonus deduction on new equipment during the year it is put into service, with some exceptions. It also allows faster expensing of property in some cases.

Republicans say previous similar measures brought about a 4% increase in business spending in the first six months they were in effect. The non-partisan Congressional Budget Office in a recent analysis said the impact of such tax breaks was "relatively modest."

Kent Bentsen, president of the Equipment Leasing and Finance Association, which not surprisingly liked the plan, noted that investment in plant, equipment and software made up 15% to 17% of economic output.