Does inefficient risk-bearing change the opportunity cost of government borrowing?

Let’s say the private sector is using a hurdle rate of five percent and the government a rate of one percent.  (Those numbers are illustrative only.)

Furthermore say the private sector uses five percent because it faces private risk which is in fact not social risk from a welfarist point of view.  In other words, the private sector ought to use a one percent hurdle rate, even though it does not, but people worry about their own portfolios rather than the broader social portfolio of projects in toto.  If the private sector switched to the one percent rate, of course, it would invest much more and lower the marginal rate of return on capital from five percent down to one percent, adjusting for all the required adjustments (taxes, transactions costs, etc.).

In such a world, if a new government project displaced private capital, the opportunity cost would be one percent at the margin.

But we are not in such a world, even if you think we ought to be.  If a new government project displaces some private sector capital, the marginal cost there is still five percent.

You can read Brad DeLong’s take on my post yesterday on the opportunity cost of extra government projects.  Brad longs for that cross-sector equalization down to one percent on both sides of the ledger and he makes many fine points.  But there is nothing in his argument which rebuts, or even tries to rebut, the claim that, given current imperfections the marginal opportunity cost is still five percent.

So the message of my original post stands as well, and you will note that is simply the mainstream micro take on this question which has been around since the 1970s, with the commonly understood answers pretty much crystallized by the early 1980s.

Addendum: Here is me, from the comments: “It is amazing how much “free lunch” economics one can read in these comments. Of course we should in fact apply multiplier analysis to the percentage of previously unemployed resources targeted by the new project, and a higher hurdle rate to the rest. You can argue over what is the percentage mix here, but please don’t pretend scarcity is no longer a ruling economic principle.”