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Scholarly opinion

The Obama stimulus package: Boom or bust?

By Rachel Farrell

Politicians have made their opinions known about President Barack Obama's $787 billion economic stimulus package. For an academic perspective, Kellogg World turned to Mitchell Petersen, the Glen Vasel Professor of Finance at the Kellogg School. The finance and economics expert researches empirical corporate finance and how firms evaluate and fund potential investment projects.

Kellogg World: What are your first impressions of the economic stimulus plan?

Prof. Mitchell Petersen: Part of [the plan is driven by] psychology and part of it is economics. In the depths of the Great Depression, FDR made speeches that were light on economic specifics and heavy on psychology. He realized that psychology does influence the economy. If you're optimistic and feel good about tomorrow, you're more likely to invest, more likely to work, more likely to make sacrifices today for the future. If you're very scared about the future, you're going to save more, you're going to consume less and most importantly, you're not necessarily going to invest for the future.

KW:  What changes could improve the stimulus package?

MP:  I think for the markets to be comfortable with the stimulus, two things need to happen. One, there needs to be a clear articulation of what we're trying to accomplish. And it can't be [something as general as] "We're trying to get the economy going," or "We're trying to solve the banking crisis." [The government] needs to articulate the fundamental problem with the banking crisis or the economy, and explain how this stimulus is going to fix it. Two, it would be nice to have some benchmarks for how we're going to evaluate progress.

KW:  Why is it so difficult to predict how effective this stimulus package will be?

MP:  If we borrow money [to spend], that means we're going to have to cut spending or increase taxes next year [or at some future date]. If I tell you I'm going to give you $1 today, and I'm going to tax you $1.05 next year, how do you change your spending? Some people will say, "I'm not going to increase my spending at all; I'm going to put that dollar in the bank and save it for the $1.05 I'll owe next year." In that case, government spending has no effect. For the spending to have an effect, we need people to not think too much about that future tax liability. They need to believe that they received a dollar for free, and that they can go spend it. It's incredibly difficult academically and in practice to estimate [how people will spend], since we must compare what did happen to what would have occurred had there been no increase in government spending. We can't measure the other reality that did not occur.

KW:  In what areas should the government invest?

MP:  The answer is the same as I give my class. Invest in projects whose future value exceeds the cost of the capital. Driving around, it seems like we have a lot of potholes. So [infrastructure] seems like an investment which needs to be done anyway. The issue I worry about is if you ramp up spending in a small sector of the economy very quickly, supply curves are very steep. It's difficult to get enough equipment and capacity and labor into small sectors of the economy quickly. So what often happens is you essentially increase the price of all those inputs, and you don't see a large increase in quantity. Education is another area to consider. In the last two decades, we've said that our schools are in desperate need of capital. If we're going to spend money somewhere, maybe that's where we should spend it — not just to get the economy going, but as a long-term investment.

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